Digesting GrainCorp post ADM

Late last week the Federal Treasurer Joe Hockey caved in to his agrarian socialist colleagues in the National Party and rejected the takeover bid by US firm Archer Daniels Midland (ADM) for GrainCorp Limited (GNC).

On November 27, in Six hot takeover targets, I warned that the risk/return trade-off for GNC was not good at a share price of $11.20 for just this reason.

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At its current and severely reduced price of just $8.23, the question on everybody’s lips is whether GNC is now a buy. The answer to this is, in the short-to-medium term (i.e. 12 to 18 months) definitely “no”. Here’s why:

1. On a near-term earnings basis, GNC is now fairly valued.

Because it is an agricultural stock, and subject to the vagaries of the weather, the multiple of earnings before interest, tax, depreciation and amortisation (EBITDA) that should be applied to GNC in the absence of a takeover bid is lower than that which might apply to less cyclical businesses. By way of international comparison, according to Goldman Sachs, overseas firms such as ADM (GNC’s spurned bidder) currently trade at 9.2 times EBITDA; Agrium (which took over AWB in 2010) at just 7.8 times; while Wilmar (which bought CSR’s Sucrogen business, also in 2010) presently commands a lofty 11.5 times.

So what is the correct EBITDA multiple for GNC? Right now, I’d put it at no more than eight times. This is because the current Federal Government has made it clear that no overseas firms are welcome to bid for GNC. EBITDA estimates for next year vary considerably, but a conservative earnings number of just $300 million (vs. $395 million this year) results in a share price of around $8 – which is pretty much where the stock is right now.

2. GNC’s competent CEO has just resigned.

By most accounts, GNC’s CEO Alison Watkins has done a very good job running the company in recent years. Amongst other things, she diversified the company’s earnings into oils and malt, which are far less cyclical than its core grain business.

Unfortunately, Ms Watkins is now leaving GNC for Coca-Cola Amatil (CCL) because she assumed that post the successful ADM takeover, she wouldn’t have a job at the new merged entity. As a result, for the time being, GNC chairman Don Taylor has been forced into the position of CEO, a position in the longer term he has no wish to fulfil.

3. The company’s alleged monopoly may soon come under investigation.

One of the main reasons ADM wanted to buy GNC is its domination of Australia’s East Coast grain trade. According to some estimates, GNC handles over 60% of wheat and barley exports on that side of the continent.

Despite the fact that the Australian Competition and Consumer Commission said it had no market control problems with ADM’s now scuppered takeover, part of the Treasurer’s opposition to the bid rested on the assumption that handing over control of a near-monopoly to foreign hands would be a silly idea. From this I can only surmise that regulatory oversight of GNC’s activities will increase rather than decrease.

4. GNC’s facilities require substantial capital investment.

Ever since it was privatised, GNC has failed to spend the money required on much of its grain handling infrastructure. As part of its takeover submission to the Federal Government, ADM promised to commit between $200 million and $250 million to upgrades of these vital facilities. Now that ADM has taken its bat and ball and gone home, it remains to be seen just where the still independent GNC will find the necessary funds for this investment.

5. But isn’t one of your takeover target criteria the existence of a previous bid?

In my experience, almost 50% of companies that receive a failed takeover bid are eventually bought by their initial suitor. The essential trick is to time correctly one’s entry back into the target company’s shares.

Right now, many hedge funds that bought into GNC on the expectation of a successful bid are busy exiting the stock. This could push the share price down further in the short term.

Over the next year, the prospect of a relatively weak East Coast wheat crop has the potential to dent the company’s earnings. In point 1 above I estimate GNC’s 2014 EBITDA to be in the $300 million range – but this figure could have $50 million added or subtracted from it depending on the weather over the next few months. Should both the weather and the crop disappoint, there is potential for the company’s earnings and share price to fall further.

Recommendation

At some stage, GNC will become a buy once more. Right now, however, its share price has only fallen back to roughly where it was pre the bid by ADM.

Given that GNC’s CEO has left, forecasts for the wheat crop are weak, and any foreign bidders will be staying away, my recommendation is that GNC only becomes a buy again when its shares fall below the $7.50 mark.

Tom Elliott, a director of Beulah Capital and MM&E Capital, may have interests in any of the stocks mentioned.