Description

MGPI

MGP Ingredients ("MGP", or "the Company"), is a producer of premium distilled spirits, industrial alcohol and specialty wheat proteins and starches. The Company was previously written up 3 times on VIC, most recently by hbomb5 in 2016, and I refer you to that writeup for more details and a primer on the bull case. The stock has been a huge winner over the last five years as perception of the Company has shifted from being regarded as a commodity processor to a premium beverage / consumer goods Company. CEO Gus Griffin has executed well since arriving in 2014, the Company is benefiting from a whiskey boom and earnings should benefit from increased sales of aged distillate over the next couple of years.

Despite all of this, we think the stock is far ahead of itself and presents a good short opportunity. We see a number of challenges to the long case:

•         We think that a meaningful part of the growth and margin improvement has been from temporary supply shortages which are in the process of reversing.
•      The bull case rests on sales of aged distillate. This is also a commodity, and we don’t see current prices holding up long-term as many customers are now aging their own inventory rather than pay the 300% markup that MGP talks about.
•         Analysts are over-optimistic. The Company has missed EBITDA estimates in each of the last 3 quarters, despite selling some high margin aged inventory.
•       Ultimately we think the Company is still just a maker of semi-commodity food & beverage ingredients. The barriers to building new distillation capacity are low, and while there is a lag before supply shows up due to the aging process, high returns have attracted competition which will impact margins going forward.

MGP’s management has done a good job but they have also found themselves in the right place at the right time. We think that the ultimately sustainable level of profits is lower than believed (~$4 of EPS appears to be baked into the current stock price) and that competition will erode the apparently attractive margins in “merchant” sales of both fresh and aged whiskey. Specialized commodities are still commodities, and producers of them should be valued as such.

We see downside to $50 or below.

Business Description:

MGP has two operating divisions:

1.       Distillery Products: The main focus (~89% of gross profit) and growth area for MGP is the production of alcohol – both “premium beverage alcohol” - bourbon and rye whiskeys, but also including grain neutral spirits (GNS) for vodka and gin; industrial alcohol for use in both food and non-food applications, as well as fuel grade alcohol and distillers feed as a by-product.  
2.          Ingredient Solutions: supplies proteins and starches for the packaged goods industry. This only contributed around 11% of gross profit in 2017, so we will not focus on it.

MGP has been publicly traded since the 1980s, with a focus revolving around grain-based products and ingredients including industrial alcohol. Industrial alcohol is a commodity business, and profits were impacted by input costs and frequent excess supply. In the last seven years, MGP’s fortunes were transformed by two events.

The first event was the purchase of the old Seagram’s whiskey distillery in Lawrenceburg, Indiana at the end of 2011 for the price of $11 million. In hindsight, it was a hell of a deal. The distillery was cheap since American whiskey volumes had fallen in half from a peak of just under 80 million cases in 1970 to the nadir around 2000, and many distilleries had been shut down. The Lawrenceburg distillery, dating back to 1847, gave MGP the capacity to produce whiskey just as demand was starting to pick up steam again. The distillery produces bourbon and rye (it claims to produce about 70% of US rye whiskey) and supplies both large customers like Diageo (for whom it produces “Bulleit Rye” for example) and smaller independents. The consumption of whiskey has been leading the spirits category over the last decade, with American whiskey volumes increasing at an 6.4% pace in 2017. Premium whiskies (retailing prices of $30+) have led the way. Vodka and gin have a very short production time and so increased demand can be met on short notice given the commodity nature of the GNS base. Whiskey on the other hand requires aging - bourbon for a minimum of two years, many whiskeys for much longer - and requires greater skill to produce consistent quality product. As a result, there can be quite a lag between demand and supply, with outsized profits for producers who are long distillate. As demand for bourbon began to outpace supply, MGP’s fortunes began to turn. Volumes sold to firms like Diageo are done under contract with lower profit margins, but as hundreds of new independent brands sprang up MGP was one of the few reliable sources available and was able to realize significant profit margins on these new sales.

The second turning point was MGP’s current CEO, Gus Griffin, joining in 2014 from Brown Forman. He set a direction away from commodity business lines with a goal to quadruple the Company’s operating profit within four years. MGP achieved their profit goal in just one year as EBIT jumped from $8 million in 2014 to $33 million in 2015. The Company held its first analyst day in early 2016, laying out a vision of moving further up the value chain by increasing whiskey production, developing its own house brands (primarily “Till” vodka and the acquired “George Remus” brand bourbon) and increasing warehouse space with a view to selling aged product which it believes will have 3x the value of fresh distillate.

The stock price has increased from $5.20 at the beginning of 2014 to a peak of $98 in June  2018 (before pulling back to current levels around $77) as investors’ perception of the Company changed from a commodity producer to a high value-add consumer goods Company and the EV/EBITDA multiple increased from 9.8x to around 22.5x 2018 estimates. Some of the move is justified by the increased sales of bourbon and rye to independents, some on the profits from sales of high-margin aged product and part of it is a bet on the development of in-house brands.

Short Thesis:

Looking behind the numbers, we believe that some of the improvement in MGP’s profits has come from temporary effects that may reverse, and that investors are overpaying for optionality on future ventures such as house brands and increased sales of aged product.

By far the biggest concern is that the shortage of bourbon may be coming to an end, and the price inflation in aged distillate, a big part of the bull case, may be about to reverse. It’s notable that the Company’s sales of premium beverage alcohol were down Y/Y in both of the last two quarters. In addition, total gross profit for the distillery products was down H1 2018 vs H1 2017, and this happened despite sales of lightly aged product.

1.       Increased US Supply:

Whiskey is like any other market and supply follows demand, except that due to aging requirements, it happens with a lag of 2-4 years. If you are long supply when demand inflects, the opportunity for windfall profits can be substantial. It’s hard to find reliable price indices but sources have described prices for 2 year old whiskey doubling in the last few years. In the short term, startups and brands looking to satisfy increased demand have little option but to pay up for distillate, but at a certain scale it makes sense to buy fresh product and age it yourself, and/or to invest in your own production. Many former customers have completed their own distilleries, and will be buying less or no product going forward. Consultants (including MGP’s former master distillers Greg Metze and Larry Ebersold) now offer their services to startup distilleries, allowing them to make product of comparable quality.

The Distilled Spirits Council reported that the US Market for American Whiskey was 23.2 million 9 liter cases in 2017 or about 45 million proof gallons. Significant capacity additions announced based on press releases and industry coverage:

•         Brown Forman with Jack Daniels ($140 million investment on top of 2014 estimated 20% expansion of production, which is over 10 million proof gallons) and Woodford Reserve (100,000 proof gallons)
•         Campari/Wild Turkey – doubled capacity from 5 million to 11 million proof gallons with the extra capacity reaching market in 2016.
•         Diageo / Bulleit - 1.8 million proof gallons, expansion opportunities being explored
•         Beam Suntory – 20% increase in Jim Beam production (est at 500,000 barrels/year or ~30 million proof gallons), 50% increase in Maker’s Mark capacity
•         Heaven Hill – expanded from 200,000 to 300,000 barrels/year in 2014 and to 400,000 in 2017 (about 26.5 million proof gallons)
•         Bardstown - now at 6.8 million proof gallons from an initial 1.5 million in 2016
•         Sazerac/Buffalo Trace - estimate doubling of current 200,000 barrel/year production
•         Kirin/Four Roses - doubling capacity to “about 8 million proof-gallons (about 11.2 million regular gallons), enough to fill more than 211,000 barrels a year”),
•         Terresentia/O.Z. Tyler - 2 million proof gallons with ability to go up to 5 million
•         Luxco – “still’s capacity will be 1.7 million proof gallons per year, with the ability of reaching 7 million proof gallons per year”
•         SPI/Kentucky Owl – 1.5 million proof gallons/year
•         Templeton Rye – Initially 250,000 proof gallons, increasing to 500,000/year
•         New Riff – 500,000 proof gallons/year
•         Michters – Initially 500,000 proof gallons increased to 1 million/year
•         Wilderness Trail – up to 216 barrels/day or 3 million proof gallons/year
•         Rabbit Hole - 1.2 million proof gallons/year
•         Bacardi/Angel’s Envy,Willett and Castle & Key  - est. 500,000 proof gallons/year each

The list above is not exhaustive, and there are many, many smaller independents. Even excluding the major brands like Jim Beam, Wild Turkey and Jack Daniels, a huge increase in supply will be hitting the market over the next several years.

It’s worth noting that much of the new capacity coming on line is in Kentucky, where production and inventories are rising significantly. MGP’s production is in Indiana, cannot qualify as a premium “Kentucky Bourbon” and is considered less desirable by some as a result.

Paul C. Varga (CEO, Brown-Forman)

“There is, in fact, continuing to be increasing competition across the board….where we're seeing just a rise in entrepreneurism, new distilleries coming on land both in white goods and in brown goods, and so I just would chalk that up as increased competition for all of us…I definitely have been paying attention to the lower prices that some competitors seem to be pursuing as they deal with this more competitive environment in the U.S.”

2.      Customer switching:

While MGP has said that customers won’t switch suppliers as it would risk changing the flavor profile of their product, our channel checks dispute this – some independents already have and/or will substitute other sources (or their own product) for MGP’s.

We have spoken with independent distillers who tell us they use multiple sources of new and aged product. While they must be selective in the barrels they use, even with a single supplier there will be variation and the skill is in blending. Some are in the process of switching from sourced to in-house production. For example, Sagamore Spirit and Templeton Rye source their ryes from MGP but will be producing for themselves going forward, High West is using more of its own product.

http://whiskyadvocate.com/templeton-rye-is-opening-its-own-distillery/

http://whiskyadvocate.com/sagamore-spirit-distillery-opens-in-baltimore/

http://whiskyadvocate.com/high-west-double-rye-change/

3.      End of the Aged Whiskey arbitrage

This is the biggest source of expected profit growth for MGP over the next few years and has driven the stock to recent heights. MGP expects to make 3x profits on 4 year aged whiskey vs fresh product (about 4x cost). That may have been possible over the years of shortage as customers are essentially “short squeezed”, but MGP are not the only ones to spot the opportunity. Increased supply from competitors and reduced demand from customers laying away their own product today should bring balance to the market and we would expect profits on aged whiskey to come under real pressure. MGP have said that they do not currently have specific customer orders for this aged product. In addition, customers that we have spoken to have said that they don’t expect to be in the market for aged liquor in the future, as they have been laying away their own product to meet future demand for aged whiskey, paying the relatively low warehousing costs and arbitraging away the profits on aged product. Indeed Eastside Distilling Inc. (EAST), an MGP customer, said as much on their last earnings call:

Grover Wickersham, Chief Executive Officer, Eastside Distilling:

…we maintain a rather large inventory of aging spirit products. So for example, our Redneck Riviera is a minimum of two years and it has some three-year in it. So if you can buy that, new fill and the current price we get is right around $450 a barrel versus buying two-year-old whiskey from MGP or other people at $900 a barrel or $850 a barrel. You can see by buying this new fill and letting it age, we have a major cost advantage…

While there will no doubt always be some demand for aged whiskey for new product introductions and occasional demand surges, we believe that margins for what is essentially just a specialized commodity should return to more reasonable levels as more distilling supply (including Kentucky bourbon) becomes available.

4.     International Competition

Whiskey bulls point to international growth but the “majors” dominate that market and recent tariff concerns have dampened that story a bit. It’s also worth considering competition coming from outside the US too.  The distillery boom has extended to Canadian, Irish and Scotch whiskeys too, and the US is the target export market for much of the product. Consider the following from Japan and India:

https://www.japantimes.co.jp/life/2018/06/23/food/new-distilleries-spring-forth-japans-whisky-boom-continues/#.W5BQuc5Kjuo

http://whiskyadvocate.com/india-whisky-hotspot/

5.      MGP Brands Initiative

We question the timing and magnitude of any impact from the Company’s attempts to move up the value-added scale into branded products. To date the impact has been very small. The gin and vodka markets are flat to declining and not short of new product, so we do not expect Till Vodka to be a huge needle mover. MGP also lacks the brands or distribution networks that established whiskey firms such as Brown-Forman or Diageo possess and have been moving slowly with George Remus. We think this is a sensible approach given the risk, but expect it to take years for any payoff. In a crowded market, we wonder whether MGP can scale its brands enough to move the needle for the firm, and what the contribution margin will be given the marketing support required (compare the margins of Castle Brands to those of MGP).

6.      Sell side estimates are consistently over-optimistic

The company has missed EBITDA estimates in the last 3 quarters, despite selling aged inventory which boosted margins. They have guided to a rebound in the second half, but it’s clear that they have less visibility than they would like:

Gus Griffin, (CEO MGP Ingredients) Q2 call

 “we experienced some temporary softness in the first half as a few existing customers delayed or reduced orders due to having previously purchased adequate inventory to meet their near-term needs.”

SunTrust initiated in 2016 and lowered annual EBITDA estimates twice in the first five months of coverage (2016/17/18 EBITDA estimates from $63M/$72M/$80M to $52M/$58M/$66M). Some of this appears to have been over-extrapolation of non-recurring factors:

•  Barrel shortages in 2013 and a fire in the Company’s facilities in 2014 may have caused a temporary shortfall in sales to independent bourbon brands, the highest margin business, and then a period of catch-up in 2015 / 2016.
• COGS for alcohol producers fell meaningfully in 2014 and 2015 and have stayed down since, expanding profit margins for distillers. 

We think that in a similar fashion, windfall profits from the last few years of whiskey shortages are being over-extrapolated by the sell side.

Valuation / Downside

Base Case: $45-$55

On consensus estimates, MGP trades at 38x 2018 EPS and just over 22x 2018 EBITDA, while similar to branded spirits powerhouses like Campari and Remy Cointreau and premium on P/E to Brown Forman, Pernod Ricard and Diageo, all of whom have much higher margins. In MGP’s case, part of the profits are from commoditized products such as GNS/Vodka, industrial alcohol, fuel alcohol or distillers feed (for comparison, Ethanol producers trade at ~7x 2019 EBITDA and under book value). Another part of the profits are from the Ingredient Solutions division which compares to companies such as Ingredion (~ 8x 2018 EBITDA, 13x P/E). The Company does not disclose a full sales or profit breakdown but we estimate that brown liquor is less than 50% of current sales but perhaps 75% of profits. Even those profits are from what is ultimately competitive manufacture of a food grade chemical rather than branded goods. White label food producers like Treehouse Foods and fellow alcohol and feed player ADM trade around 10x 2018 EBITDA.

At 10x EBITDA on 2018 estimates, the stock would trade closer to $35.

To this we add the possible value of future aged whiskey sales, which management expect to ramp up over the next couple of years. The Company put away $15 million of inventory in 2017, net of sales of aged product (already captured in the segment EBITDA). If we increase this to $17 million per year and estimate that product is sold 50% at 2 year old at 200% of cost, 50% at 4 years old at 400% of cost then there would be $34million of extra gross profit. Aggressively assuming this all becomes EBITDA and using the 10x multiple would add $20 to the share price.

If pricing on aged whiskey holds that would give us $55 of total value. On the other hand if pricing on aged whiskey were to decline and we use 175% of cost for 2 year old and 250% for 4 year old, with a 10x EBITDA multiple we get to around $45.

Bear Case: $30

None of the above assumes that margins for fresh distillate are impacted by competition, which is a real possibility in the medium to long term. If that were to be the case, real downside would be replacement value. Book value of equity is $182 million, accumulated depreciation is $170 million. Lawrenceburg was bought for a bargain, and we estimate replacement value of perhaps $150 million for the distillery, $25 million for the old warehouses. So maybe $525 million replacement value, or ~$30/share.

Upside Case: $100

Pricing on aged product holds up, core business starts to grow again, and the unrealistic comparison to branded spirits businesses confers an EBITDA multiple of 20x. In this case, the stock could trade over $100.

Risks:

•         Longer Boom in US Whiskey. The US market is still below the peak consumption of 1970. However, alcohol consumption in the US has declined the last couple of years, and the spirits market has fragmented with vodka, gin and tequila having increased share markedly since 1970. Imported whiskeys compete for share too. We don’t expect American whiskey to recover to 1970 levels, and more importantly, we do expect a robust supply response based on the continuing addition of distillery capacity.
•         Successful brand building. It’s possible that MGP can build new brands for itself, though it’s not clear why they would succeed ahead of the myriad other independent players out there competing for shelf space, several of whom now benefit from relationships with marketing and distribution powerhouses like Constellation, Bacardi etc.
•         Insider Buying: After the recent price drop two directors have recently made substantial open market purchases. Insider selling has dwarfed these amounts, especially when the stock was above $80 earlier this year, but it bears noting.
•         Expanded Warehouse Capacity. The Company is spending $52 million to triple its warehouse capacity. To the extent that demand exists for this space, we think it’s likely to be from customers laying down fresh product to avoid buying aged, hurting the projected profit margin.
•         M&A – MGPI has a fairly clean balance sheet. The Company has made small acquisitions (George Remus) and could consider larger brand purchases in future. Management could also use their highly valued stock to purchase assets. Given the multiples being asked for larger brands and MGP’s own lack of distribution for its own brands, creating value here could be a challenge.
•        Short term profits boost from sales of aged inventory. The Company has managed to keep EBITDA growing over the last year with sales of “lightly aged” inventory and we expect that it could continue to grow earnings this way in the near term. However, this source of growth is limited both by the rate that MGPI is laying away inventory, and by the ultimate competitive erosion of the windfall margins of the last few years.
•        Story Stock risk. The Company has had several disappointing quarters relative to expectations over the last two years, despite selling some of their aged product during this period to gin up profits (pardon the pun). Despite this, the stock’s multiple has expanded significantly as management has done a good job of keeping investors and analysts focused on what might happen 2-5 years out if aged sales materialize at current short-squeeze levels, and their brand initiative really takes off.

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author or affiliated funds  presently has a position in securities of this issuer and may trade in and out of these positions without notice. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. Please do your own work.

·        

Catalyst

•  Further distillery additions lead to over-supply
• Gross Margin pressures as demand for aged product falls