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Morningstar | Rain Has Gone Away, but Will Come Again Another Day; GrainCorp's Shares Slightly Undervalued

The current grain growing season is not shaping up to be a bumper year for no-moat GrainCorp. But despite continued near-term macro challenges, we believe the firm is pursuing a reasonable strategy that will remove fixed costs, lower invested capital, and improve flexibility to deal with uncertain yearly conditions. And with an average crop year likely much better than the challenging circumstances seen recently along Australia's eastern seaboard, our long-term outlook for the firm remains intact. We maintain our AUD 8.30 fair value estimate, with shares trading at a roughly 10% discount.

The latest near-term outlook for growing conditions from the Australian Bureau of Agricultural and Resource Economics, or ABARES, doesn't paint a substantially improved picture for eastern Australian wheat and other grain volumes. In June, ABARES estimated that such production will climb 7.5% in the 2018-19 growing season, to roughly 15.7 million tonnes. And recent weather updates from the group suggest conditions haven't improved, with the July 26, 2018 update noting "the climate outlook for the August to October period indicates that drier than average conditions are more likely for most of Australia," while the Aug. 2, 2018 update noted New South Wales saw its driest July since 2002.

This forecast trails ABARES' initial outlook for the year offered in March, which suggested 10% growth for all Australian grain, and falls short of our previously assumed jump back to an average growing year, closer to 20 million tonnes of production. As such, we've lowered our near-term forecasts for GrainCorp's storage, logistics, and marketing businesses. We now expect these segments' combined EBITDA margins to climb to 4% in fiscal 2019 and 7% by fiscal 2020, versus 5% and 8%, previously. Nonetheless, this profitability is set to improve from our 2% forecast for fiscal 2018, owing to facility rationalisation, more flexible rail hauling contracts, and other efficiency cost savings.

We haven't altered our long-term forecast for these segments. We continue to expect Australian grain growers will experience highs and lows, but ultimately estimate GrainCorp's cash flows after fiscal 2020 using average production levels over the 10 years prior at close to 20 million tonnes annually for eastern Australian production. We also continue to expect GrainCorp can capture roughly 40% market share within storage and logistics of this production, and 21% of Australian exports versus our estimate for 37% and 10%, respectively, in fiscal 2018. With this higher volume, we see long-term EBITDA margins climbing to nearly 8%, slightly higher than historical averages.

We also note that our outlook for GrainCorp's other segments beyond Australian grains remains solid, and are important drivers that shouldn't be overlooked. In fact, we anticipate the malts and oils segments together will climb to more than two thirds of segment operating EBITDA by fiscal 2022, from 55% in fiscal 2017. We anticipate the secular growth of craft beer volumes in the U.S. will drive mid-single-digit revenue growth and EBITDA margins nearing 15%. Similarly, we forecast GrainCorp's oils segment will enjoy solid demand in bulk liquids storage while also benefiting from a continued profitability turnaround, ultimately leading to EBITDA margins climbing to 9% over the long term versus 6% in fiscal 2018.