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Treasury Wine Estates: Setting The Long-Term Course

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About: Treasury Wine Estates Limited (TSRYF), TSRYY
by: Mark Ashton
Summary

At its recent investor day, management reiterated steady FY20 EBIT growth of 15-20%.

Earnings will be skewed to favor 2H due to implementation costs associated with an outsourced global business services model, plus a route to market changes in the US.

Optimizing the route-to-market should underpin margin growth.

America and Asia poised to lead long term growth as product supply, and the mix is oriented towards a focus on ‘premiumization’.

Shares trade at reasonable levels relative to its underlying earnings growth profile.

Treasury Wine Estates is embarking on a multi-faceted strategy to improve market share and drive margin growth. Management has reiterated FY20 EBITS growth of 15-20%, but subsequent years are expected to accelerate above 20%. This comes as the company diversifies its product supply and shifts its mix towards higher-margin premium wines. TWE is also investing in its route to market, which will lower distribution costs, improve cash conversion and allow it to expand in China. Measures are in place to mitigate a cooling UK market, and outsourcing business functions will harness economies of scale to lower costs. With an undemanding P/E valuation (in line with peers at ~25x) relative to anticipated EBITS growth, for shareholders, TWE's latest efforts could serve as a key catalyst for future earnings and share price appreciation.

Aligning products to drive margins

TWE is intending to diversify product supply and realign product mix to hone its focus on premium wine with higher margins.

For instance, TWE's activity in the Chinese market is set for a strategic shift, with numerous efforts in place to drive future growth. The entire wine market in China is 140 million cases in size; however growth has been weighed down by competitor de-stocking. TWE has managed to defy this trend, leveraging its fully stocked retail shelves - helped by the 2016 vintage - and accelerating depletion growth.

TWE has reaffirmed its desire to expand the overall wine category and become the number one French wine importer in the market through its new Penfolds wines.

Source: Pg 40 of TWE Investor Day Presentation 2019

One risk to be wary of, however, is the integration of the new French wine products into the (Australian) Penfolds brand, especially as part of a streamlined product range. Offsetting this, the 2018 Australian vintage is expected to contribute strongly towards growth in FY21.

Considering 59% of wines sold in China are produced domestically, with French wine trailing behind at 14%, the company's connection to a premium brand portfolio via Penfolds will be imperative to make quick progress in the market.

Source: Pg 65 of TWE Investor Day Presentation 2019

Elsewhere, the company has earmarked strong brand investment to build TWE's profile, tighten compliance measures for distributors engaging in cross regional sales, and expand its warehouse strategy. The warehouse model is expected to improve cash conversion, as customer credit times are set to be halved to 45 days, with delivery lead times also cut significantly. Eventually, this model will handle over half of China's volume. In 2H19, TWE doubled its in-country sales staff, supporting its plan to double its presence to around 200 cities across the country, including 40 'focus cities' as shown below.

Source: Pg 65 of TWE Investor Day Presentation 2019

Finding the right balance in the US

Management has articulated a clear target to grow EBITS (earnings before interest, tax, material items, and self-generating and regenerating assets) margins to 25% from the current level of 19%. While I have my doubts as to the feasibility of this goal in the near-term, the strategic outline proposed by TWE has strong merit.

Source: Pg 50 of TWE Investor Day Presentation 2019

Supporting EBITS growth is a shift in the product mix towards premiumization. Currently, the product mix between luxury and masstige products, to commercial products, is 50:50. This compares unfavorably with TWE's global profile, where the ratio is 70:30. Nonetheless, within the masstige category, there is scope to increase sales to the retail channel, thereby increasing margins.

The other key initiative to underpin margin growth involves addressing the route-to-market model, as shown in the map below. Having already invested US$20mn in 2017 to improve its luxury wine supply, and also grown its points of distribution by 4% - including 11% for the luxury segment - approximately 25% of TWE's US sales are now handled through a self-distributed model. The changes are yet to reach their potential, with California and Washington noticeably lagging. I think the upside, however, is the ability to harness scale and realize network efficiencies in the long run.

Source: Pg 59 of TWE Investor Day Presentation 2019

In addition, the 2018 US vintage (Napa) will deliver a boost to earnings in FY22. The product mix will incorporate Penfold's premium position and afford TWE scope to grow margins. And while the broader US wine market has seen discounting at the budget end, for the $8 and above wine segment, there has been above-average market growth over the last six months. As such, TWE will continue to mitigate its exposure to declining margins as its product mix re-aligns to its global level.

Weathering the storm in ANZ and EMEA

The challenges in Australia are somewhat cyclical, but concerning in any case. Higher grape costs have impeded margins, which meant FY19 performance was subdued. Management has set a goal to reach 25% market share, despite currently sitting at 21.8%.

Source: Pg 83 of TWE Investor Day Presentation 2019

The path to realizing this will rest with portfolio premiumization, small acquisitions, and a quick payback on its Penfolds Bilyara luxury winery development.

The European segment is also under strain as UK wine volumes remain in decline, and Brexit approaches.

Source: Pg 100 of TWE Investor Day Presentation 2019

I find comfort, however, in TWE's risk mitigation strategies, which includes working with retailers to manage inventory, as well as TWE's decision to maintain a separate supply chain for the UK from that of continental Europe.

Despite this, rising grape prices in Australia are resulting in higher COGS and squeezing margins. TWE has signaled that EBITS will move from 15% (FY19) to "mid-teens," however, exchange rates have helped soften this blow.

Source: Pg 102 of TWE Investor Day Presentation 2019

Adjusting the corporate direction

One of the most prolific tailwinds supporting TWE's future earnings growth is its move to outsource central processing functions to a global business service. Although there are up-front costs, which will skew the FY20 earnings profile towards the second half, this measure will help reduce overheads in the long run. Cash conversion also remains a compelling and stable indicator for the company's sales outlook, which has been reaffirmed at around 80% for FY20 despite significant inventory investment.

Source: Pg 9 of TWE Annual Results Presentation

Management has also cooled somewhat on the proposed de-merger of the commercial segment. The scarcity of material opportunities that would fit the growth and premium product profile of TWE has likely contributed.

Valuation

With respect to TWE's anticipated earnings growth profile in future years, the company's current valuation would seem undemanding. While EBITS is expected to grow at an encouraging 15-20% in FY20, an acceleration in the years thereafter is set to see it exceed 20%. For consistent growth of this nature, a forward P/E ratio for FY21 around 25x earnings (in line with peers) seems reasonable.

Given the various initiatives that are set to restore cash conversion toward ~80%, and the likelihood that TWE can optimize its route-to-market to surpass this target, a premium is warranted on account of upside potential. Risks largely extend to business strategy execution, a rise in the AUD, and local market sentiment.

Conclusion

After a challenging year, where economic setbacks in key markets all but inhibited growth, Treasury Wine Estates is setting the course to realize sustainable growth over the long term. This growth is set to be led by America - target 25% EBITS margin - and China. In these geographies, management have made it clear that investment to redefine the route to market, introduce new product supply, and 'premiumize' the product mix, all of which will help drive earnings growth. There is also significant expansion set to unfold in China, which affords scale to the business.

Notwithstanding the challenges affecting its UK market, including higher grape costs and the implications of Brexit, the company has measures in place to mitigate this. At the corporate level, Treasury stands to leverage outsourcing efficiencies, while retaining a vastly improved commercial sector will diversify its earnings profile in difficult trading conditions. Considering its plans to accelerate EBITS growth in future years, and its current fair P/E valuation with respect to peers, TWE shares could offer good upside to long-term investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.