Over the past few weeks, we have built a small position in United Malt Group (UMG), a new security in the Australian Equities sub-portfolio.
We give a background on the company and outline our investment thesis below.
One plus one equals two and a half
United Malt Group is the world’s 4th largest commercial maltster.
The business was formerly part of food ingredient and agribusiness company Graincorp and was demerged (spun off) earlier this year. The United Malt assets were the more stable part of the Graincorp portfolio, with the remainder of the company exposed to variation in crop yields, commodity prices, weather and changes in grain storage and transport trends.
As we have noted in the past, it is often the smaller or unfashionable entity that is “demerged” that performs better in the longer term.
This can be seen in the chart below. On average, companies that have been spun off have outperformed the broader market in Australia.
Reasons for this are not clear but may be attributed to a number of factors:
1. the demerger allows the spun-off entity to be valued more precisely by investors;
2. more dedicated focus by management; and
3. better access to capital (which might not have been available when the company was part of a larger conglomerate).
Another important reason is that the demerged entity may be a more attractive takeover target – and in some instances command a “control premium”. We believe this was a key motivation for the demerger of United Malt Group.
However, demerged entities can initially trade poorly – as shareholders may indiscriminately sell the shares they receive in the spun off company. This presents an opportunity. Therefore, demergers often spark the interest of your Investment Team.
Who they are and what they do
The business comprises two segments: Processing and Warehousing/Distribution
Processing: United Malt procures and handles barley, which is processed into malt.
Malted grain is purchased by brewers and fermented to produce beer and whisky.
Malt is sold either in bulk directly under long term contracts or smaller quantities through Warehousing/Distribution.
United Malt operates 13 malting facilities globally across 13 processing plants in the US, Canada, UK and Australia, as can be seen below:
Warehousing/distribution: United Malt also stores a distributes bagged malt, hops, yeast and other products/adjuncts (from the distribution facilities that can be seen below).
These distribution platforms provide a “one-stop-shop” for smaller brewers (such as craft brewers) – reducing inventory requirements while also providing a wide variety of ingredients including third party and imported malts.
Malt sold through these channels typically attracts higher margins.
Why you own it
Growth of craft: While craft beer consumption is on the rise globally, particularly the US, it remains underpenetrated in certain regions. Craft beer brewing requires 2-3 times the amount of malt that mass-produced beer does. Additionally, premiums can be earned from selling speciality malts to the craft industry – which are subject to additional treating processes. This can result in significant premiums, for instance, malt sale prices of up to $1.25 per pound, versus $0.25 per pound for mass produced malt. The company, therefore, has the potential to improve its processing margins longer term. There is also potential to expand processing capacity (for example at its Bairds Malt facilties) as well as distribution to other geographies where craft beer consumption is still growing.
Strategically located malting plants and distribution: A key competitive advantage for processing facilities is their location. Malting is a lower-margin business and therefore facilities that are near barley growers, transport services and end customers have a competitive advantage.
Defensive: a large proportion of malt is-presold under long term contracts, which creates a degree of earnings stability for the company. Furthermore, a majority of its long-term contracts pass through barley prices while minimises margin volatility.
Valuation support: Prior to being spun off, there was strong interest in United Malt from both trade and financial buyers (such as private equity). We see that this provides a degree of valuation support for the company at levels slightly below our purchase price, providing a backstop.
Why it could be worth more than its current share price
United Malt’s share price has been impacted by COVID. Social distancing and lockdowns have reduced the consumption of alcohol on-premise (bars, pubs, breweries etc) and have seen a fall in beer volumes consumed and processing volumes.
However, we see that craft beer consumption will continue to grow over the long term, supported by growth in under-penetrated geographies.
At current prices, our model implies that after considering the impact of COVID on beer sales in the near term, little potential for an improvement in margins or potential to expand processing volumes is being priced in.
Where we could be wrong
Impact on microbreweries: COVID has had a significant impact on microbreweries, particularly those that rely on on-premise sales. Sales of malt to microbreweries through distribution channels typically attract high margins – thus their is potential we may underestimate the impact on microbreweries and drag on margins as a result.
More permanent impact on on-premise consumption: On-premise sales have been significantly impacted by lockdown restrictions. If there is a greater than anticipated, more permanent shift away from on-premise consumption longer term, this could have an impact on smaller businesses, the craft market, and blunt margins.
Change in drinking habits: Beer consumption has, in general, fallen during the lockdown period. If this results in a more permanent shift in drinking habits (for instance, continued growth in the consumption of low carbohydrate seltzers) this could impact margins and volumes longer term.
Further consolidation of regional and national craft brands: COVID may lead to an acceleration of regional and national craft brands, either through mergers or private equity acquisition. Consolidation of the industry may lead to customers having greater bargaining power.