We recently reviewed GrainCorp (ASX:GNC) after a stronger-than-expected upgrade to the winter harvest. In this note, we examine the effects on the Company’s earnings growth expectations. After a challenging FY20, where a 3rd year of drought continued to impact earnings, at what point does the market start to price in this potential upside?
GrainCorp is an agribusiness and food ingredients company with operations across two segments: Agribusiness and Processing. The Agribusiness segment (which accounts for 85% of FY20 group revenue) is a leading bulk grain handling company along East Coast Australia (ECA). The Company provides handling, storage, marketing, logistics and agronomic service to the grain industry. The Agribusiness segment focusses on wheat, barley and canola, which are grains produced in drier climates. The Company has a strong market position and an up-country network connected to seven bulk ports by rail, which connects grain to customers worldwide.
ABARES Release Materially Lifts Group Earnings Expectations
In mid-November 2020, GNC released its results for the 12 months to 30 September 2020 (FY20). The FY20 result for the Agribusiness segment was impacted by a drought. The segment reported EBITDA of $79m. This was significantly weaker than forecast. (ECA) in FY20, with ECA grain production (winter and summer) of 12.3Mt well below the long-term average of 18.6Mt.
Importantly, the earnings outlook the Agribusiness segment have been boosted materially, following the updated estimate by Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) for the 2020/21 winter grain harvest, which was released on 1 December 2020. The significance of the ABARES release is that GNC’s Agribusiness earnings are fully leveraged to the upward revisions in the East Coast Australia (ECA) winter & summer harvests.
ABARES has increased its forecast winter harvest by 17% to 28.6Mt. This is led by upgrades for NSW (+19%) and Victoria (+17%). The latest figures released by ABARES were not a major surprise to the market. In particular, GNC noted at the time of its FY20 results release that the 2020/21 winter crop had been shaping up to be similar size to the extremely strong 2016/17 (FY17) winter crop (28.2Mt). Although, at the time ABARES had maintained its forecast of 24.4Mt.
The winter harvest is also supported by the Bureau of Meteorology’s rainfall outlook for January-March 2021 indicating a wetter-than-average summer for most of Australia. This follows favourable conditions for majority of the year, which have supported the 2020/21 winter crop.
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The Company commented at the FY20 results release that they are witnessing good demand for Australian grain across the board, with the grain being competitively priced across most markets. This provides a hedge against uncertainty in relation to any China-related impacts with counterparties. However, GNC is not seeing any evidence of this as yet.
Agribusiness Earnings are Highly Leveraged to the Increased ABARES Forecast
Whilst the Company has to date not provided FY21 guidance (this is likely at the AGM in February 2021), GNC expects earnings growth in FY21 will be driven by a significantly larger 2020/21 East Coast Australia winter crop and ongoing benefits from its recent operating initiatives.
Insurance Contract Payments Are Capped at Lower Winter Production Forecast (24.4Mt). As such, there is strong leverage for a winter crop above 24.4Mt. In addition, the increased ABARES forecast results in a large exportable surplus, which commands a higher margin for GNC. The Company also expects the scale of the FY21 crop to benefit FY22, given the flow-through benefit of grain ‘carry out’, assuming FY22 is at least a normal crop year (~18Mt).
Balance Sheet Provides Optionality
GNC’s balance sheet is in good shape. As at 30 September 2020, gearing was 3%, with gearing on an ex-lease basis of 22% below GNC’s target of 45%. This provides optionality for potential future growth opportunities in areas such as animal nutrition, digital and AgTech and alternative protein. The Company’s 8.5% stake in United Malt Group (ASX:UMG) (retained following the demerger of UMG from GrainCorp in March 2020) provides additional balance sheet flexibility.
GNC expects to see a considerable increase in net debt, due to an increase in commodity inventory, and an increase in core debt. Further increased working capital requirements are expected as a result of the larger harvest. While this has an impact on operating cashflow in the short term, the impact is likely to be short-lived.
The shares are currently trading on a 1-year forward P/E multiple of ~16x. While this multiple is broadly in line with the average for ASX-listed processors of farm production – it appears that the market is factoring in a reversion back to a below-average winter crop (as was the case in 2018/19 and 2019/20).
While a lower-than-average winter crop in 2021/22 would clearly be a risk for FY22 earnings, we note the potential upside to current EBITDA estimates from:
i. Operating initiatives yet to be realised, and
ii. The potential for a further upgrade to ABARES’ estimate at its next quarterly update (due 16 February) to >30Mt underpins upside earnings risk to current EBITDA estimates for FY21 and FY22.
Other key catalysts for the shares include: i) Further details on strategy and earnings outlook at the AGM (11 February) and ii) The Investor Day in early March.
From this perspective, we consider GNC is an investment worth considering.
It is clear that for the last 5 years, levels around $4.60 have provided very strong resistance for GNC. At the moment we can see the shares testing that level again. However, they are holding in fairly well at the moment, which means we may see it attempt another push beyond that level again. Either way, we don’t want to be buying the stock so close to this resistance level. A break of resistance would therefore be the buying opportunity. Given that the $4.60 level has offered strong resistance for about 5 years, any push beyond that should result in a fairly substantial rally.
Michael Gable is managing director of Fairmont Equities.
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