I added MGP Ingredients because their ingredients are primarily corn and wheat

Sometimes you latch on to a good idea but can’t find a stock that fits it.  That’s what happened to me as I scoured through 10-K’s looking for a way to play the fall in corn, wheat and bean prices.

I spent about a week looking and not having much luck.  Fortunately one of my twitter acquaintances came to the rescue, as @17thStrCap introduced me to MGP Ingredients (MGPI).

The Business

MGP Ingredients looks like a very good way to bet on lower grain prices.  The company operates three businesses, all of which stand to benefit from the decline in the grains:

1. Distillery Products: via plants in Atchison Kansas and Lawrensburg, Indiana, corn, barley and rye are turned into beverage alcohol and industrial food grade alcohol.  The residue from the process is sold as distillers feed.  A small amount of fuel grade alcohol (not ethanol) is also produced
2. Ingredient Solutions: specialty and commodity wheat starches and wheat proteins are produced from wheat flour
3. Illinois Corn Processing (ICP): a 30% ownership in an ethanol plant in Pekins Illinois that produces around 90 million gallons of ethanol per year.  SEACOR owns the other 70% of the plant

On a revenue basis, the Distillery Products segment is about four times the size of the Ingredient Solutions segment.

What’s the impact of lower grain prices?

MGP Ingredients doesn’t do a conference call, and finding a breakdown of cost inputs is not easy.  The best I have been able to do is the following:

1. According to slide 18 of the AGM presentation grains represented 78% of their direct input costs.
2. According to the 2013 10-K, page 42, when corn prices rose 53% year over year in the second half of 2011 (from around $3.50 per bushel to $5.25 per bushel) margins in the Distillery segment declined from 18% to 1%.  In comparison, in the first half the 2014 margins in the distillery segment were about 9%.
3. In the 10-K the company says that corn, followed by wheat flour, are the biggest input costs

While these numbers do not provide a perfect description of cost sensitivity, they do qualitatively provide evidence that the business is quite sensitive to grain prices and that changes in grain prices do impact margins significantly.  I would be happy if someone could find more data that clarified.

Earnings and the Equity Accounting of the ICP Joint Venture

The company has struggled with high grain prices for the last 3 years.  Coming into this year they had not been profitable ex-one time items since 2010.  But as corn and wheat prices have fallen the company’s bottom-line has improved.  In the first quarter the company had GAAP income of 26c per share.  In the second quarter they earned 28c per share.

Second quarter income should have been higher.  Based on the profitability of their stake in the ICP joint venture (the ethanol plant), MGPI should have recorded an equity income of $4.1 million.  The equity income they actually recorded was only $2.3 million.  The reason for the difference was that MGPI had issued a shutdown notice to its JV partner in the first quarter of 2013 when ethanol prices were low and the joint venture was losing money.  Seacor opted to ignore the request and keep the plant operating.  By doing so they took on a temporary extra 10% interest in the plant for the next 12 months.

Because of the accounting treatment of the JV and MGPI’s expectation at the time of notice that the plant would eventually be shut-down, MGPI continued to account for their stake at 30% on the income statement.  After 12 months (in the second quarter) MGPI had to re-evaluate their now enormously profitable ethanol plant interest and take a GAAP accounting charge against the extra 10% of profits they had booked in Q4 and Q1 that were in fact net to Seacor.

That’s the long story.  The short story is that earnings in the second quarter should have been higher.  If the company had recorded the full $4.1 million equity income from ICP earnings for the consolidated company would have been 39c per share.

A better third quarter

While second quarter earnings were strong, the third quarter should be better.  Second quarter earnings were driven by somewhat lower corn and wheat prices and by much higher ethanol prices at ICP.  In the third quarter corn and wheat prices have fallen quite a bit further.  While MGP does not provide their average cost of corn, looking at the results of some of the ethanol companies I follow, corn costs came in around $4.80 per bushel.  Right now corn is trading around $3.60, or about 25% lower.  Similarly, wheat prices have fallen from an average of around $6.50 per bushel in the second quarter to about $5.50 right now.

The risks are the unknowns

One of the biggest risks with this investment is that due to the dearth of detail in the financials there are a lot of elements that I can’t quantify. For one, I’m am using wheat as a proxy for wheat flour but I cannot be sure that wheat flour prices have followed wheat. I’ve looked for quotes on wheat flour but I haven’t been able to find a source.

I’m also not sure of how tightly alcohol prices are tied to their cost of inputs.  Will product prices decline along with their raw material costs or can we expect significant margin expansion as grain prices fall?  What little evidence I have, which is the historical data from MGP Ingredients, suggests we will get expansion, but it would be nice to see some detail on how prices are trending right now.

Finally, a headwind worth noting is that distiller grains, which is a by-product of the alcohol production, has been under pressure in the last few months because China has limited imports from the US.  Prices of distiller grains are significantly lower than they were in the first half of 2014. Again without the line item broken out in the financials its difficult to quantify the impact on MGPI’s bottom line.

Conclusion: A bit  of a leap of faith, but enough tailwinds to justify it

The financials are sparse but the basic picture is clear.  The company produces a product of which the primary raw materials have fallen precipitously in the last few months and for which the outlook is continued low prices for the foreseeable future.  The second quarter annualized after accounting for the one time reduction at ICP would suggest a lower bound on earnings of $1.60 per share but probably higher once the full impact of third quarter grain prices are factored in.  Margin history suggests that gross margins could double from current levels.

The years of losses has also provided a tax cushion and the company will not be paying tax any time soon.  Taken from the 10-K, at the end of 2013, MGP “had approximately $36,969 and $99,496 of federal and state net operating loss carry-forwards, respectively”.

Finally the company underwent an overhaul of their executive and board in the last year.  A prolonged proxy battle between management and the founding family (Cray’s) resulted in the changes. Reading through some of the articles describing the battle (here and here) it appears that the Cray’s were upset by the compensation and progress made by management.  The company is currently conducting a search for a new CEO.  Also worth noting is that even after the recent rise in the stock price, a number of directors have