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Spruce Point Issues “Strong Sell” Investment Opinion On MGP Ingredients

Spruce Point Issues “Strong Sell” Investment Opinion On MGP Ingredients (Nasdaq: MGPI) – Sees 60% – 70% Downside Potential

MGP Ingredients, Inc.

MGP Ingredients (“MGPI” or “the Company”) Is A Commodity Ingredient and Alcohol Producer Now Being Spun As A Sexy Transformation Story Into A Premium Producer of Branded Whiskey and Bourbon. MGPI is a simple story to understand. It operates two businesses: an ingredients business run from Kansas and an alcohol distillery in Indiana. Both of these facilities are old assets and prone to substantial operational hazards. Most recently, MGPI has experienced fires, work outages, and chemical disasters requiring the hospitalization of innocent people.

MGPI’s shares have appreciated 1,000% since 2014  as investors have cheered the Company’s decision to hire new management, reprioritize its businesses away from commodity ingredients, and focus on “higher margin” premium alcohol beverages. MGPI has also recently benefited from a temporary, yet unsustainable, increase in earnings from its 30% joint venture with Seacor (NYSE: CKH) called Illinois Corn Processing (ICP).

On the surface, the Company’s transformation strategy appears wildly successful. Its EPS has risen from a loss of ($0.29) in 2013 to positive earnings of $1.50 per share in the LTM 9/30/16 period. Over the same period, sales have essentially been flat, but gross margins have expanded from 6.4% to 18.1%

Spruce Point Believes Investors Should Be Cautioned Not To Extrapolate Recent Earnings Performance. We Believe There Are Numerous Business Risks And Cracks In The Growth Story That Are Not Being Adequately Discounted…

Executive Summary

  1. Rapid Whiskeyl Bourbon Sales Growth, A Key Driver of MGPI’s Recent Earnings + Share Price Expansion Won’t Continue As A Result of Substantial New Capacity Growth
  2. Diageo Is A Material Whiskey Customer Accounting For At Least 8% of Revenues, Its New Distilleg Comes On-Line In 2017; Best Case It Reduces I Eliminate Its Supply Contract With MGPI; Worst Case It Competes Directly Against It
  3. MGPI Also Appears To Be Quietly Covering Up A Large Market Share Loss In the Gin Category Associated With Seagram’s. Investors Should Study Both The Gin and Vodka Market As Case Studies For What Can Happen To Whiskey
  4. A Multitude of Other Contracts And A Key Ingredient Patent Expires in 2017 Which Significantly Increase MGPI’s Business Risk; Investors Are More Focused On The Alcohol Business, And Not Paying Close Attention
  5. MGP Ingredients Has A Histogy of Operational Disasters (Fires and Chemical Explosions) Which Could Harm Earnings
  6. MGPI’s Foray Into Branded Liguor Sales Have Shown De Minimis Results, And Are Likely To Disappoint
  7. MGPI Is Out of Cash, And Borrowing Heavily On Its Credit Facility, Funding Long-Term Construction With Short-Term Debt. It Must Turnover Its Barreled Whiskey or Face Severe Financial Strain
  8. MGPI Quietly Restated 2015 Results of Related-Party Transactions Affecting Its ICP JV With Seacor (Another Public Company) Both Companies Financial Reporting Do Not Reconcile, Which Potentially Puts MGPI In Violation of Its Credit Agreement. MGPI ls Also Quietly Restating Sales Figures Tied To Customer Freight
  9. Regulators Are Expanding An Audit Investigation of MGPI, Which May Result In Increased Taxes and Penalty Costs
  10. Follow The Money Carefully: MGPl’s Largest Shareholder And Founding Family Entered A Stock Sale Program on Dec 21, 2016 – Around The Holiday Period When Things Were “Quiet”
  11. Spruce Point Sees Approximately 60°/o – 70% Downside + Big Hangover Waiting For Investors Intoxicated By The False Hope of Future Gains. MGPl’s Valuation Will Revert To 8x-1ox EBITDA From 14.5x Currently Once Reality Selts In

Poy Close Attention To MGP Ingredients’ Recent Accounting Warnings

Taking a step back before reading our regortI we believe investors should carefully evaluate the unusual changes to MGPl’s 2016 10-0 filings it made. We believe the Comgany is signaling accounting strain and issuing a subtle warning. Look carefully at Note 1. Accounting Po/ices and Basis of Presentation. MGPI added a stronger cautionary statement suggesting its estimates may require material adjustment, and removed a statement that suggested its financials were fairly presented

MGP Ingredients

Spruce Point Believes MGP/ ls A Strong Sell” For The Following Reasons:

MGP Ingredients (“MGPI” or “the Company”) Is A Commodity Ingredient and Alcohol Producer Now Being Spun As A Sexy Transformation Story Into A Premium Producer of Branded Whiskey and Bourbon

  • MGP Ingredients is a simple story to understand. It operates two businesses: an ingredients business run from Kansas and an alcohol distillery in Indiana. Both of these facilities are old assets and prone to substantial operational hazards. Most recently, MGPI has experienced fires, work outages, and chemical disasters requiring the hospitalization of innocent people
  • MGPI‘s shares have appreciated 1.000% since 2014 as investors have cheered the Company’s decision to hire new management, reprioritize its businesses away from commodity ingredients, and focus on “higher margin” premium alcohol beverages. MGPI has also recently benefited from a temporary, yet unsustainable, increase in earnings from its 30% joint venture with Seacor (NYSE: CKH) called Illinois Corn Processing (ICP)
  • On the surface, the Company’s transformation strategy appears wildly successful. Its EPS has risen from a loss of ($0.29) in 2013 to positive earnings of $1.50 per share in the LTM 9/30/16 period. Over the same period, sales have essentially been flat, but gross margins have expanded from 6.4% to 18.1%

Spruce Point Believes Investors Should Be Cautioned Not To Extrapolate Recent Earnings Performance. We Believe There Are Numerous Business Risks And Cracks In The Growth Story That Are Not Being Adequately Discounted

  • The biggest aspect of the “bull case” surrounding MGPI is that it is a play on the explosive growth in consumer taste for whiskey and bourbon, and can transition to a branded producer. Investors fail to realize that MGPI is primarily a white-label producer that sells to other brands. One of its largest customers (which MGPI doesn’t adequately disclose) is Diageo, which owns the Bulleit brand. Diageo is close to completing its own Kentucky whiskey distillery that is expected to be completed in 2017. At best. Diageo reduces or completely eliminates up to 80/0 of MGPI’s sales, and at worst they start to directly compete in the bulk wholesale market
  • There are now over 1,000 craft distillers for whiskey / bourbon in the United States. Just like Diageo, many of these distillers are constructing their own distilleries, which would reduce / eliminate their need to buy from MGPI. The rapid proliferation of new distilleries and brands in the market makes MGPI’s ability to brand itself all-the-more challenging. Based on our research, its recent tiny acquisition of George Remus whiskey and introduction of Metze’s Select (Metze being MGPl’s master distiller who recently departed) have had limited traction, and are nothing more than way out-of-the money call options. Many high profile Iiguor brands endorsed by celebrities and billionaires have failed in the past. There’s no reason to assume MGPI will have any success
  • Because investors are so enamored with MGPI’s alcohol business, they are not paying attention to other material risks that loom large in 2017 such as: 1) key ingredient patent expiration, 2) collective bargaining agreement, 3) supplier agreements, and 4) added fines / penalties from a) recently expanded audit investigation by the TTB, and b) from the chemical explosion in 2016

MGPI’s Barreled Whiskey Inventory Is Rapidly Rising, While Sales Are Declining, And Inventory Turnover Plunges

  • MGP Ingredients’ whiskey inventories have risen from $11 .1m in 2013 to $45.om as of 9/30/16. During the same time period, its inventory turnover has plunged from 8.6x to 3.7x and its food grade alcohol sales are declining. MGPI says everything is fine and that it is spending $29m to expand warehouse storage. It started to disclose “premium beverage alcohol” sales in its press release in an attempt to show strength in this segment, but won’t stand behind the numbers and include them in the recent 10-Q
  • MGPI’s free cash flow is sharply negative and it is borrowing heavily on its credit facility (funding a long-term asset with short-term debt). MGPI also has no cash on its balance sheet and its credit facility is now 46% utilized. As a result, its financial profile is precariously stretched in what amounts to a Ievered bet that it can sell its existing whiskey inventory either under its own brand (a speculative bet we argue is likely to fail absent enormous investment in distribution/marketing) or in the open market
  • The Company tells investors it has the “potential” to sell its whiskey at 3x the current cost. It lists its whiskey as a current asset, but must age the product for three years. We believe it should be viewed as a long-term asset, and as a result believe MGPI’s current ratio (a measure of its Iiguidity} is significantly worse than it appears
  • MGP Ingredients must turn its inventory and hope that it doesn’t decline in value because its credit facility and borrowing base depend on inventory valuation. We don’t believe investors should assume that management is correct, and its whiskey will magically appreciate 3x in value. Based on our recent channel checks, we believe there is an abundance of wholesale whiskey / bourbon available. We contacted Ultra Pure the #1 bulk wholesaler in the market. We found that prices have been largely stagnant since 2014. Additionally, we sourced price guotes from J.B. Thome, another reputable broker and found no price differential between aged MGPI rye. As substantial new supply comes into the market, we would not be surprised to see prices begin to decline

Look To Struggles In the Vodka and Gin Market For An Indicator of What Can Happen in Whiskey / Bourbon

  • Consumer alcohol preferences are inherently fickle and constantly changing. A few years ago, the craft vodka market exploded leaving established brands such as Smirnoff and Absolut to compete with new brands such as Kettle One, Grey Goose, Ciroc, and dozens of others. MGPI claims 25% vodka market share, but industry executives recently called the vodka market “saturated” and overall vodka organic growth is stagnant at just 1% as reported by industry bellwether Diageo
  • MGPI also produces flavored and natural gin. The Company does not disclose revenues by product type, but from its recent investor presentation. the Company changed its market share from 65% to 35% share. This illustrates what can happen when a customer decides to shift production and reduce dependence on MGPI. Based on our research, we believe that MGPI has produced Seagram’s gin, and its owner Pernod Ricard has been shifting production to Arkansas away from MGPI

We See 60% – 70% Downside Risk

Warning: Related-Party Transactions and Revenues From Customer Freight Shipping Are Not Adding Up

  • Spruce Point always takes extra precaution to identify and evaluate related-party transactions when they occur at public companies. In the case of MGPI, we think investors should question its relationship with Q, an entity which it owns 30% and produces ethanol related products with Seacor, another publicly traded company
  • To our dismay, starting in (2216 we find that MGPI has been quietly restating purchase amounts from the JV in fiscal year 2015. These restatements, coincide with the period that both MGPI’s CFO abruptly resigned in May 2015 (he had been CFO since 2009) as well as its Randy Schrick who had been with the Company 42yrs in June 2015 (most recently served as VP of Production and Engineering). MGP Ingredients’ reported purchases from ICP are explicitly contradicted by Seacor. Seacor has generally reported less sales to MGPI than MGPI claims. We can understand why MGPI might report slightly higher purchases than Seacor (e.g. shipping costs), but don’t understand why in any case they would be reported lower as in 2014
  • We also observe that sales figures related to customer freight costs are not adding up YTD and being retroactively restated higher in 2015. Our concern about the validity of MGPI’s numbers could cause issues with its credit facility covenants

MGPI’s Shares Are Priced For Perfection And Now Its Largest Shareholder Is Liquidating

  • In our View, it is easy to refute the bull case. Investors are valuing its shares as if it already were the best branded alcohol producer in the world (greater than Diageo, Constellation and Brown-Formanl even though it has no firmly established brands. MGPI trades at a rich 2.5x, 14.5x and 29.ox 2017 street estimates of sales, EBITDA, and EPS, respectively. Optically, Its leverage appears conservative at just 0.8x Debt to EBITDA. But, in reality once its EBITDA and EPS start to decline, investors will focus heavily on the fact it has zero cash and is utilizing 46% of its credit revolver
  • MGPI has just two small sell-side analysts that tout its stock has 17% upside to $55/sh and seem confident it can compound its sales and earnings by at least 5% over the next two years, while expanding EBITDA margins by 17obps. Based on our price target of 60% – 70% downside, there’s a terrible risk / reward of owning shares at the moment
  • MGPI’s valuation multiple is stretched and trading near an all-time high. We believe that once it becomes clear that the whiskey market is saturated, MGPI is stuck with excess inventory, and its tiny brands fail to gain traction, investors will once again realize they own a mediocre commodity alcohol and ingredient Company, which would ordinarily be valued at 1x sales and 8x – 9x EBITDA. As a result, we see approximately 60% – 70% downside risk in MGP Ingredients’ share price to a range of $16 – $21 per share
  • Insiders always know best so follow the money. It’s no surprise to us that the Seaberg family which owns ~28% of the Company’s common stock and 84% of the preferred shares (giving them Board control) recently entered into a stock sale program in late December to start liquidating a portion of its holdings

Capital Structure Overview

MGP Ingredients

Article by Spruce Point Capital

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