The problem with the world is that everyone is a few drinks behind

Source(s): UMG Information Memorandum and Scheme Booklet, UMG FY2020 accounts, Chester Asset Management

Private Equity

This is a quote directly from the UMG Information Memorandum, highlighting one of the advantages of the demerger of GNC: “after the Demerger, there will remain the potential for GrainCorp, UMG or other GNC portfolio businesses to be sold to a third party potentially delivering a control premium”.

Malt would have been a major consideration for the failed GNC takeover bid by Long Term Asset Partners in December 2018, so there has been historical interest in acquiring the business. Whether planted by motivated shareholders or genuine, the Australian Financial Review and The Australian seem to wheel out the same article every three months regarding private equity interest in the business (10). With the level of PE deal flow seemingly accelerating in a world of cheap money and surplus liquidity, we still believe the potential exists for suitors to be interested in UMG.

Normalisation

As discussed UMG’s FY20 and FY21 earnings have been materially impacted by COVID and the disruption to on-premise consumption. This has resulted in both volume and mix shift impacts, as the craft market segment was more materially impacted by COVID. Our understanding is that around 40% of craft sales pre-COVID were on-premise vs around 20% for mainstream beer.

Notably, when we model UMG (refer to our valuation below) we arrive at a normalised EBITDA figure of $185 million (post AASB16), which is above FY22 consensus. Previously we have published notes showing upgrade candidates. This isn’t specifically one of those notes, as there are many moving parts and we can’t be too specific: the timing of recovery (given potential vaccine delays and further lockdowns) and Scottish expansion ramp-up. However, we do believe when things reopen UMG earnings should revert to a figure based on FY19 (normalised) due to the following factors:

1. Contract structure (margins)

Historical passthrough mechanisms for barley and longer-term contracts with customers provide a reasonably predictable margin (when operating closer to full utilisation).

2. Craft volumes returning (volumes/revenue)

The Brewers Association (US) is reporting US craft beer volumes down 9% in 2020 vs 2019 with dollar sales down 22%. This compares to overall beer volumes down only ~3%. Likely due to higher reliance for craft towards on-premise sales. Given the higher utilisation of malt and premium products, hence the higher value of craft customers, we believe the revenue and margin impacts have far exceeded volume impacts. Interestingly although US craft volumes were down in 2020 the number of craft breweries actually increased.

Source: Statista (with data from Brewer’s Association)

If we look to Australia as our leading analogue to recovery in the US, the two listed operators in Mighty Craft (MCL) and Good Drinks Australia (GDA) are quoting an expectation of Australian Craft sales + 7-10% in 2021.

3. Warehouse and Distribution Craft Leverage (revenue + margins)

For UMG's Warehouse and Distribution (W&D) segment, revenue is predominantly derived from craft. Hence we use US craft sales and production changes as an indicator of direction of growth for UMG. It appears to have been highly correlated over recent times with UMG W&D Revenue, although UMG has been overachieving, which could indicate increased market share in the US, or greater growth ex-US craft.

Sources: Brewers Association, Chester Asset Management

We further note that there is a degree of operating leverage in W&D earnings given the fixed costs of operating a warehouse. Completely theorectical but below we have completed an exercise considering what (variable) GM might be available if ~1/3 (AUD100m) of costs within the business are fixed. Our calculations equate to a GM of ~40%. Extending that further if craft volumes normalise back to FY2019 type levels we see a roughly AUD20-30m uplift in W&D revenues, AUD8-12m EBITDA at assumed 40% GM.

Sources: UMG FY20 Accounts, Chester Asset Management

4. Strategic value to customers (margins + revenue)

UMG is strategically located close to customers in key barley growing regions proximal to transport. Hence we see them as engrained in customer supply chains.

I.e., We have used FY2019 EBITDA as a relatively normalised base and adjusted these for the relatively ‘known knowns’ of AASB16, Corporate Costs, FX, Scottish Expansion and Efficiencies.

Source: Chester Asset Management, with data sourced from UMG announcements

Valuation

We have developed a detailed Discounted Cash Flow (DCF) of UMG that assumes a re-opening recovery in particular craft volumes (and also mainstream beer at events) that provides for a valuation of UMG of AUD5.20/share.

We believe deriving a normalised EBITDA, per our exercise above is important for performing an earnings capitalisation valuation as a cross check to our DCF. Grant Samuels within the GNC Demerger Scheme booklet IER suggested a figure of ~10x 1yr forward EBITDA as a reasonable base multiple (11x historic EBITDA, 9x 2yr forward). Notably there aren’t any listed public deals of relative comparison to UMG but the sale of Cargill’s malt business to French cereals co-operative Axereal is speculated to have occurred at close to 12x EBITDA(11). The business was a combination of 16 malthouses with combined capacity of 1.7Mtpa vs UMG at 1.25Mtpa hence represents a pretty good proxy for UMG under a takeover scenario. In the table below we combine these to provide a valuation per share.

Source: Chester Asset Management, IRESS, Grant Samuel (UMG Information Memorandum and Scheme Booklet IER)

Conclusion

Hopefully, within the next 12 months, the world will have fewer problems.