Post-Earnings Update on a Short Position

Latest thoughts on MGPI

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

In this post, I am sharing an update on MGPI as the company released its Q2’24 results yesterday.

To briefly recap the investment thesis for those not familiar, MGPI is primarily a wholesale provider of American whiskey barrels. MGPI presents an interesting way to play the expected downturn in the whiskey industry. Increasing demand for American whiskey over the last decade, combined with a further Covid-induced demand boost, has driven whiskey supply to unprecedented levels. Despite the market already being grossly oversupplied, current production continues to significantly outstrip demand. However, it seems that the market might have already inflected, as indicated by several aspects, including declining whiskey sales 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. There seems to be plenty of room for a downward share price re-rating, given that MGPI currently trades at multiples above the replacement cost.

Now, onto the Q2 earnings.

The results were what I would describe as ‘slightly negative/neutral’ for the short thesis. During the quarter, the company displayed decent growth in two of its key segments, Distilling Solutions and Branded Spirits. Meanwhile, Branded Spirits segment's gross margins have continued on their growth path driven by premiumization trends. The quarter mostly did not show any indications of negative inflection in company’s operational performance. Nonetheless, I do not think the earnings release negates the investment thesis, and I still expect company’s performance to deteriorate in the coming quarters/years.

First, let’s dig a bit deeper into the operational performance.

Starting with the Distilling Solutions business, which is MGPI’s largest segment (c. 55% of revenues) and thus key to the investment thesis. Segment revenues were up 9% in Q2 year-over-year, compared to a more tepid growth clip over the recent quarters/years (e.g. 2% in Q1, 5% in FY23). The growth has been driven primarily by growing new distillate whiskey sales to customers. For a bit of context, new distillate whiskey is sold to and subsequently aged by manufacturers of branded spirits. This is in contrast to aged whiskey, which is aged by MGPI and then sold to branded product manufacturers. As shown in the table and quote below, the growth of new distillate sales drove a significant increase in the whiskey volumes sold to branded spirit producers.

Why is this important? Well, there are several reasons:

• The volume growth is above the recent period levels, e.g. 8% seen in Q1’24 and FY23. Moreover, it indicates that new distillate sales growth more than offsets any declines in aged whiskey sales. These factors reflect significant new customer orders and thus potentially solid current demand for new distillate whiskey.

• Another aspect is related to the ongoing mix shift from aged to new distillate whiskey. MGPI’s management has previously indicated that a significantly higher portion of new distillate sales are based on longer-term contracts with customers as opposed to aged whiskey. So, customer willingness to switch/agree to longer-term contracts on new distillate whiskey might indicate their positive outlook for American whiskey sales/pricing.

So, the growing volumes could be considered a negative for the investment thesis, as they might reflect whiskey producers’ strong demand and/or positive view of industry prospects. I will continue monitoring the volume/mix dynamics over the coming quarters. For now, however, I am inclined to interpret this as a one-off quarterly jump that might have been driven by favorable timing of customer contracts/renewals. Another aspect worth highlighting is that the volume growth impact on Distilling Solutions' topline has been limited, given that new distillates carry lower prices compared to aged whiskey and, thus, margins.

Speaking of margins, the segment saw a slight decline in gross margins, from 47% to 45.5%, partially explained by the increasing mix of new distillates vs. aged whiskey. Note that these gross margins are adjusted for the impact of the closure of one of MGPI’s white goods (i.e. colorless spirits) distilleries, so comparison to previous-year levels is not straightforward. Nonetheless, it appears that, on an adjusted basis, the Distilling Solutions business continues to record gross margins in line with 2021-2023 levels (30-32% as reported) and substantially above pre-Covid levels (19-24%).

Turning to the Branded Spirits segment (c. 30% of revenues), the business has displayed a solid performance, with 11% topline growth and record-high 52% gross margins (vs. 36-44% during 2021-2023). Growth and margin increases have been driven entirely by growing premium-plus product sales, with declines/no growth in the remaining mid/value/other product portfolio (see the table below). This reflects the continuing trend of premiumization which I previously highlighted as one of the risks to the investment thesis.

During the earnings release/conference call, MGPI maintained a positive outlook, reiterating 2024 guidance. Management noted expectations of “stronger second half and fourth quarter growth,” expected to be driven by continuing growth of premium-plus brand sales and already committed customer contracts in the Distilling Solutions business (see the quote below).

So overall, I’d regard this as a ‘mixed’ earnings release for the investment thesis.

However, looking at the setup from a longer-term perspective, I still think that MGPI presents an attractive short opportunity. The American whiskey industry remains vastly oversupplied. A glance at the latest data from TTB from July (see here) shows that whiskey inventory and production continue to grow and that both remain at unprecedented highs, including inventories at over 11 years of demand and a ratio of whiskey produced and bottled at over 2x.

The supply might continue increasing, given MGPI’s expected investments into its facilities this year. MGPI’s management has guided for significant capital expenditures this year ($85m vs. $23m in H1’24 and $45m-$55m during 2021-2023), to be spent on previously announced investments primarily into warehouses and an expansion at a distillery. While this might indicate management’s confidence/visibility into strong consumer demand, the fact that these investments were already announced last year could also suggest that management is committed to completing these investments even if they might eventually be a net negative for the company.

Meanwhile, peer commentary indicates normalizing/declining consumer demand. As an illustration of this, see below the quote from Brown-Forman’s Jun’24 conference call.

So, considering these dynamics, I continue to think that the whiskey industry is poised for a negative inflection over the short/medium term, which would negatively impact MGPI’s operational performance.

The potential upside here remains substantial. Recall from the initial post that MGPI acquired its primary asset, a distillery in Indiana, for $15m vs. company’s current EV of $2.2bn. Using company’s TBV of $301m or $13.7/share as an approximation of the replacement cost would imply an 80%+ upside from short positions from the current stock price levels.

Given these aspects, I continue to like the setup and have maintained my position. I will continue monitoring MGPI and the broader industry for any indications of negative operational performance/industry inflection.