Post-Earnings Updates on MGPI and ARE

Both stocks remain attractive at the current stock price levels.

With earnings season underway, I am sharing updates on two portfolio names, MGPI (short) and ARE. I believe the updates are highly positive, confirming the underlying investment theses. While both ideas have performed well since I incorporated them into the Idea Hive portfolio, I continue to think that the risk/reward is attractive at current share price levels.

MGP Ingredients (MGPI) — initial post here, last update here

Let’s start with MGPI.

First, for those unfamiliar with the investment thesis, MGPI is primarily a wholesale provider of American whiskey. MGPI offers an interesting way to play the expected downturn in the whiskey industry. The increasing demand for whiskey over the past decade, further amplified by a Covid-induced boost, has driven American whiskey supply to unprecedented levels. However, the industry now appears to be coming off a historic supercycle, as indicated by declining American whiskey prices reported by industry players. The expected industry downturn is likely to lead to a significant decline in the price of wholesale American whiskey barrels, MGPI’s key profit driver.

Last week, MGPI reported Q3 earnings. There were no major updates on operational performance or near-term outlook, as the quarterly results and FY24 guidance aligned with those announced in the preliminary results a couple of weeks ago. MGPI’s management once again highlighted whiskey industry challenges, including softening consumption and elevated whiskey inventories (see the quote below), which have led to a substantial 18% revenue decline in the key Distilling Solutions business (44% of total revenues).

Softening whiskey consumption and elevated industry-wide barrel whiskey inventories are having a larger and quicker-than-expected impact on not only our aged whiskey spot sales, but also on our new distillate volumes. As we moved through the third quarter, our spot sales slowed, and we saw some customers were having difficulties in meeting their contractual obligations to purchase whiskey.

To quickly illustrate the impact of the headwinds on the Distilling Solutions segment, I would point to the significant deterioration in both brown good pricing and volumes in the quarter (see the table below). While pricing has been declining over the last several quarters, what’s interesting is that volumes finally dropped sharply after multiple quarters of solid growth, including 21% growth in Q2. This sudden decline seems to confirm my earlier view that the improving operational performance seen in recent quarters might have been sustained by previously signed customer contracts at more favorable terms than those signed currently.

But the most noteworthy takeaway from the earnings release was the even dimmer outlook for the Distilling Solutions business in 2025. Given the challenging industry environment, MGPI’s management now expects to lower whiskey put-away and scale down whiskey production in 2025 (see the quote below). Management expects the headwinds to “have an even greater impact on [the] Distilling Solutions segment sales and profitability in 2025.” While MGPI did not provide full FY25 guidance, the company stated that revenues in the core Distilling Solutions segment are expected to decline by a massive 35%.

In response to the softening American whiskey category trends and elevated industry-wide barrel inventories, in 2025 we plan to further lower our net aging whiskey put away, scale down our whiskey production, and optimize our cost structure to mitigate lower production volumes. While current market dynamics will likely have an even greater impact on our Distilling Solutions segment sales and profitability in 2025, we believe that these actions will strengthen the long-term competitive positioning of our brown goods business.

And there’s a chance that operational performance in 2025 could be even weaker than expected. Why? There are two main factors: 1) the continued challenging industry demand/supply backdrop and 2) MGPI’s limited visibility into next year’s contracts.

Starting with the industry demand/supply situation: a look at the latest data from the TTB (see here) shows that whiskey inventories and production have continued to grow and remain at unprecedented highs. As of July, whiskey inventories covered over 12 years of demand while the ratio of whiskey produced to whiskey bottled stood at over 2x. I would highlight that inventories have risen from c. 11 years of demand as of 2023. As for consumer demand, a number of sources (e.g., here) indicate that after rapid growth in 2019–2022, driven by pandemic lockdowns, the American whiskey industry has seen a decline in volumes in 2023 and year-to-date 2024 (as of August).

MGPI’s operational performance is likely to continue being negatively impacted by these industry headwinds, given that a seemingly limited portion of the company’s sales for 2025 are pre-contracted. As an analyst pointed out during the conference call, Q3 is when MGPI has historically provided commentary on contract visibility for the following year (see the exchange below). However, in an exchange during the conference call management did not offer any specific details, instead quite vaguely stating they believe they have strong visibility into next year’s contracts. I would also highlight the sudden deterioration in operational performance despite the fact that the whiskey industry has been weak for 12–18 months—this was also nicely pointed out by an analyst during the call.

Question: You are into your typical contracting season now. I think this is when you have in the past made initial comments on visibility into the next year. So I guess, how much of your plan do you think is committed at this point for '25, either through existing multiyear contracts or new contract renewals? And just on this visibility you have, how confident are you with the security of those commitments? You called out some contract nonperformance in the quarter. So just any color there would be helpful.

Answer: Yes. As it goes to '25, what we -- when -- we gave you some of the color commentary on revenue and profitability. That's through us analyzing all the business that's there, who those contract customers are, which ones we've weeded out over it. The impact of sales, as somebody asked earlier, did we contact our customers, we look at their sales history. I have strong confidence in 2025. I think the visibility we have there is strong now, but if we're dropping revenue, part of it is, is we shrank that size of the business, okay?

Given these aspects, I would expect MGPI’s weak operational performance in the Distilling Solutions segment to continue, potentially beyond management’s already-weak 2025 guidance.

As for the two other operating segments, I’d quickly highlight the weak Q3 performance in both Branded Spirits (39% of revenues) and Ingredient Solutions (17%) segments. Revenues in both were down year-over-year by 6% and 18%, respectively, driven largely by increased pricing (and, thus, lower volumes) on lower-margin products in Branded Spirits and lower export sales in Ingredient Solutions due to a stronger US dollar. Management expects both segments to recover next year, with topline and profitability growth across both businesses. While I have no strong view on the reasonableness of this guidance, I would note the small size of the Ingredient Solutions business, meaning that the segment is unlikely to have a significant impact on MGPI’s overall performance. As for the Branded Spirits segment, I would expect its performance to remain weak given the ongoing post-Covid demand normalization.

So, that’s my quick take on MGPI’s Q3 earnings. The quarterly results show that the ongoing negative whiskey industry inflection has finally started to impact MGPI’s Distilling Solutions business, as contracts signed at much more favorable terms during the American whiskey market peak have continued to roll off. Given the massive and growing supply/demand imbalance, I would expect operational performance to continue to deteriorate markedly in 2025.

MGPI's share price has declined a further 5% since the earnings release and is now down over 70% since the initial ‘short’ pitch. While the thesis has played out as expected so far, I believe there remains significant room for further downside in the stock price. MGPI is currently trading at multiples above its replacement cost. A potential re-rating from the current EV of $1.3bn to the tangible book value of $0.3bn—still above where MGPI traded before the industry upcycle—would imply a potential downside of 70%+.

With the investment thesis intact and substantial downside remaining, I continue to like the setup and have maintained my position.

Aecon Group (ARE-TO) — initial post here, last update here

Shifting gears to another portfolio position, ARE.

For a quick refresher, ARE is a construction and infrastructure development firm whose profitability since 2021 has been negatively impacted by losses on four legacy projects due to COVID-related construction delays and significant cost inflation, compounded by the fixed-price nature of these projects. However, with the legacy projects finally approaching completion, the company appears to be on the brink of a substantial profitability inflection. On a normalized EBITDA basis, the company trades at a c. 6x multiple—a substantial discount to peer valuations of 10x+ EBITDA.

Last week, ARE reported Q3 results. My key takeaways from the earnings release are that 1) the quarter was solid from an operational performance standpoint and 2) the company is moving closer to the completion of legacy projects.

Starting with a brief overview of operational performance, the business continued to perform well in Q3, with revenues and EBITDA up a solid 15% and 9% year-over-year when adjusted for the impact of legacy projects and divestitures. This solid performance was driven in part by increased construction and refurbishment work at nuclear power plants in Canada and the U.S.

On the margin front, Q3 marked another quarter where ex-legacy project margins (10.6% EBITDA margins) remained broadly in line with recent quarters and substantially above pre-COVID levels (4-6%). As you might recall, the sustainability of ARE’s business margins seen in recent quarters was one of my key concerns initially. Another quarter of solid ex-legacy project margins adds confidence that actions taken over recent years—such as divesting the lower-margin road-building business in 2023 and increasing focus on design-build model projects (where ARE is exposed to capped cost overruns)—will help the company maintain margins at significantly higher levels compared to pre-COVID. Management confirmed this during the conference call, stating that recent margins could be considered "typical."

Regarding the outlook, management expects solid operational performance to continue in 2025, with revenue growth expected to be partly driven by continued demand for Aecon’s services, primarily in Canada. Another key driver is the expected significant revenue contribution from design-build projects, which are slated to enter the construction stage in 2025 and 2026. I’d note that none of the anticipated work from these projects is currently included in ARE’s reported backlog (C$6bn as of Sep’24 vs. C$4bn in TTM revenues), with management estimating that design-build projects will roughly double the company’s backlog.

But, perhaps more importantly for the investment thesis, ARE is nearing completion of the legacy projects that have been a significant drag on profitability. During the conference call, management highlighted that two of the three remaining legacy projects, Finch West LRT and Eglinton Crosstown LRT, are in the final stages, with completion expected in Q1 2025 (see the quote below). Given this progress, I would expect ARE to announce project completion by year-end, potentially with no further write-downs.

The 2 LRT, we are also making good progress. I mean, at Finch, we have finalized the stress test with 14 vehicles full speed ahead last Friday. It's now over to TCC, I mean, to take over the line because they will be the operator and bring this project to substantial completion, Q1 2025. Eglinton also, we are extremely close to finalize the stress test with TCC. And so we are also expecting Q1 2025.

As for the remaining Gordie Howe project, management noted that construction is proceeding as planned (see the quote below). Project completion has been previously estimated in Q3 2025.

I may add some information about where we are because we are pushing all those jobs over the line. I was yesterday on Gordie Howe Bridge. All our targets are being met. I mean we had to install the first overlay, which is a mix of concrete and latex on the top of the bridge before the winter, and it's going to be done. Point of entry are going quite well. The Canadian one that was an important date that had to be handed over to the border authority at the end of November will be handed over on time. The rest of the program is going well. So I'm rather confident with this one.

I would highlight that Q3 marked only the second quarter in recent years where ARE did not record any write-downs on legacy projects.

Now, there is still a chance of further significant write-downs on the Gordie Howe project. The company previously indicated that it might recognize up to C$125m in write-downs related to the completion of the three legacy projects by the end of 2025. Management stated during the call that their estimate for potential further write-downs remains unchanged (see the quote below). However, management’s reaffirmed write-down guidance and lack of Q3 impairments suggest a low likelihood of impairments beyond the guided C$125m.

No change since our Q2 disclosures. So we're currently satisfied with our positions on the projects. So that relates to the estimates that led to the $110 million write-down and then consistent with the prior disclosures, we still believe there's potential for future additional risks to Aecon, if any, to complete these 3 projects, not to exceed or should not exceed $125 million to the end of 2025. So basically, to answer your question, I appreciate the hopefulness, but we're basically steady to where we were in Q2 on the topic.

So, these are my quick thoughts on ARE’s recent earnings. I think the report was largely positive and confirmed the investment thesis. ARE’s share price has jumped by 19% since the announcement and is up over 60% since the write-up, reflecting the market’s growing awareness of the looming profitability inflection.

Let’s now turn to valuation to reassess to reassess what ARE’s profitability could look like when the legacy projects are completed. Below is an updated estimate of company’s normalized EBITDA on a TTM basis:

• C$76m in TTM reported EBITDA

• Plus C$277m in TTM legacy project write-downs (comprising C$127m related to the CGL legacy project, C$110m recorded in Q2 2024, and a C$40m write-down in Q4 2023)

• Less C$6m in TTM EBITDA from divested businesses

This results in C$347m in TTM normalized EBITDA, or a 6.1x multiple at current prices. While this is significantly above the c. 3x multiple at the time of the initial pitch, I still believe ARE is undervalued. To illustrate, company’s peers GVA, FLR, BDT-TO, and ACS-MC all trade at teens TTM EBITDA multiples. ARE’s current valuation is also significantly below the 8-9x multiples for the company’s divested lower-margin road-building business and a utility business stake. So, with legacy projects fading into the background, I would expect ARE to re-rate closer to peer and divestiture multiples.

Another potential catalyst for closing this valuation gap could be the ramp-up of the ongoing share buyback program. While stock repurchases since August have been underwhelming (<0.1% of outstanding shares bought back), if the pace of buybacks ramps up, the repurchases could create some upward pressure on the stock.

Given the substantial potential upside, I continue to see ARE as a compelling and asymmetric investment opportunity and have maintained my position.