EUR 850.00 For Business Accounts Only

Morningstar | GrainCorp’s Malt Spin-Off a High-Quality Asset, but Not Value-Accretive; Maintain AUD 9.60 FVE

Following rumours in mid-March of a potential sale, no-moat GrainCorp has instead decided to divest its malts business, offering the segment in specie to current shareholders by the end of calendar 2019. We see minor value creation as a result of this transaction. We’re optimistic about the future growth in the malts business, and about the outlined AUD 10 million of pretax cost savings--about 5% of forecast fiscal 2019 EBITDA--from more-fully combining the remaining grains and oils segment. But while it’s possible investors could pay a higher multiple for the malts business on a separate basis, given lower volatility which could garner a lower discount rate, the discount rate for the remaining GrainCorp would likely be commensurately higher, netting out this impact when combined in the current valuation. We don’t see significant benefits from GrainCorp’s planned grains derivative contract, which will smooth weather-driven volatility but garner an additional annual fee and likely reduce total earnings through the cycle.

We lift our standalone valuation of the currently consolidated GrainCrop to AUD 9.30 from AUD 8.80 to account for the additional restructuring savings. However, we maintain our AUD 9.60 per share fair value estimate, as we also lower the probability that previous bidder Long Term Asset Partners’, or LTAP's, indicative offer price of AUD 10.42 is consummated to 25% from 50%. Per GrainCorp management, LTAP has remained silent despite having access to data for due diligence, which we view as testament to a lower likelihood of a transaction.

Management cites increased focus and capital availability for the malts segment as a rationale for this divestiture, but it’s not clear to us that this will prove materially different. Malts is already run almost completely separately from grains and oils, with management noting there have been essentially zero synergies gained following the original acquisition of the business; we believe it has been operated in a focused manner already. And we don’t believe malts has been starved for cash. Management’s target net debt of the business, at a maximum 2.0-2.5 times EBITDA, is similar to GrainCorp’s average 2.84 times net debt/EBITDA ratio over the past five years. Based on these figures, there doesn’t seem to be a dire need to leverage the malts balance sheet.

Similarly, although we now see a higher valuation for standalone GrainCorp given the incremental restructuring, we’re less optimistic regarding additional cost-savings estimates as part of the divestiture. Beyond the AUD 10 million in estimated benefit from combining grains and oils, management targets another AUD 10 million reduction in nonoperating costs from running a simpler business. While this may be true for the remaining GrainCorp, we see higher corporate costs for the malts business on a standalone basis that offsets these savings. Management noted it aims to offset these corporate expenses with cost savings, and if successful, this could add an additional 5% our fair value estimate. But we’re not confident these will be immediate, given malts has already proven quite efficient.

We also have concerns on GrainCorp’s planned derivative contract, through which the company will protect its downside through payments from a counterparty during periods of low east coast Australian grain production but give up some of the upside in periods of bumper crops. Financial details remain slim, given the final agreement has not yet been signed. While the deal smooths cash flows, we anticipate lower average earnings through the cycle, as the insurance provider will need to generate profits of its own. As such, although GrainCorp could see a lower cost of capital as a result of reduced volatility, the resulting value accretion to shareholders may instead find its way into the pocket of the insurance partner. It also introduces counterparty risk--albeit with a reportedly A-rated global insurance provider. But in all, derivative contracts tend to have a winner and a loser over the long run, and we see luck playing a substantial factor here; we’re concerned that any upside value creation will come primarily from unpredictable weather movements.