EUR 850.00 For Business Accounts Only

Morningstar | Cheers to Treasury Wine’s Solid 1H, but Valuation Runneth Over

No-moat Treasury Wine Estates’ first-half 2019 results keep the firm on-track to meet our near-term projections. Performance was solid, with good execution on distribution changes in the U.S. and continued market premiumisation in China leading to strong top-line growth of 16% versus the previous corresponding period, or pcp. Alongside this improved top line, Treasury enjoyed further profitability expansion. Earnings before interest, taxes, and expenses associated with the valuation of self-generating and regenerating assets, or EBITS, grew 19% to AUD 338.3 million, a 22.4% margin versus a 21.9% margin in the pcp. Management reiterated its fiscal 2019 guidance of roughly 25% EBITS growth, tracking our forecast, albeit on a slightly higher revenue base than we anticipated, mitigated by some increased near-term costs associated with changes to Treasury’s altered U.S. strategy. We lift our fair value estimate to $12.30 from $11.70 to account for these changes and the time value of money, but our long-term expectations are largely unchanged. Shares still screen as overvalued, in our view.

The core of our thesis is that the blistering pace of EBITS growth Treasury has enjoyed will not continue over the longer term. Principally, we see more limited upside from a mix shift toward higher-margin luxury wine away from lower-margin commercial products, given the company’s already strong inroads in doing so. Highlighting this point, management offered an early outlook into fiscal 2020, forecasting 15% to 20% EBITS growth, bracketing our 18.3% projection. We expect Treasury will prove successful at reaching its aspirational 25% EBITS margin target--even surpassing it by fiscal 2022 to a 27% level, by our estimate, as recent strong Australian and Californian wine vintages are released from inventory in coming years--but we see the growth rate averaging mid-teens over the next three years.

Nonetheless, we applaud management for strong execution in the half, across all geographies. Asia remains Treasury’s primary growth engine, and with less than 5% market share in China, the company’s runway remains long, in our opinion. Revenue in the segment grew 32% versus the pcp, as Treasury further expanded its distribution in the region and concentrated on high-priced luxury and masstige wines. This strategy led to total volume rising just 1.6%, but average revenue per case jumping more than 30% as luxury and masstige wines grew volume more than 20%. We expect some softening of price increases as the firm continues to expand its offerings of midrange products, but nonetheless still expect revenue growth to average more than 25% over the next four years as the firm gains volume share. Moreover, given the focus on high-priced wines, the Asian segment’s margins remain Treasury’s highest, near 39%, which we expect to continue.

Treasury’s distribution and sourcing strategy in China supports its market share aspirations and our forecast growth rates. Unlike many competitors, Treasury does not use a national distributor, opting to instead work directly with wholesalers, retailers, and on-premises customers. This enables the company to capture a greater percentage of the end retail price of its wine, allowing greater reinvestment and competitive pricing, albeit with a greater amount of its own staffing and asset needs in-market. Further, the company has proven successful in launching new products, such as the French-sourced Maison de Grand Esprit, which it can bring to market more rapidly given a lack of conflicts of interest that other competitors may face with their distribution partners. Treasury announced that it is looking at bolt-on acquisition opportunities for additional French wine sourcing, which can then be routed into its core brands in China. While we expect the total wine market to continue to slow in the country, we believe Treasury is well-positioned to enjoy further geographic expansion and share improvement.

Treasury’s business in the Americas also appears to be back on track following some short-term hiccups in the prior six months associated with the route-to-market change-over. Revenue grew 20%, as the company captured greater pricing per case as a direct distributor in some regions under the new selling model, although EBITS margin fell to 18.5% from 19.9% in the pcp due to associated higher sales costs and one-time transitional expenses. As such, near term margins will be a bit lower than we anticipated, but we make no changes to long term forecasts, and see margins rebounding to nearly 24% within the next several years. Like its model in Asia, Treasury is self-distributing 25% of its business in the U.S., which offers many of the same benefits regarding product discipline and marketing controls.

Together, the Americas and Asia segments made up nearly 72% of Treasury’s EBITS in the half, and we expect this contribution to rise to more than 80% over the next five years. Volumes grew faster than market in Australia, tracking our expectations, but were flat in New Zealand following a shift in distribution in the pcp. However, we expect the top line to rebound in the second half of fiscal 2019 and grow at a mid-single-digit rate over fiscal years 2020 and 2021, while profitability continues to tick up given further favourable product mix developments. And Europe continues to chug along for Treasury, growing volumes in all major regions, although at a lower margin given a greater focus on lower-priced wines. As such, the contribution from this region is minimal, at only 7% of EBITS in the half.

One area to watch is Treasury’s cash conversion. Wine sellers typically must hold a very high amount of inventory on their balance sheets as the product ages, and this line item has increased markedly as the company has shifted its focus to higher-priced (and longer-aged) luxury wines. As a result, Treasury has not historically converted all of its EBITDAS--that is, EBITS plus depreciation and amortisation--to cash, estimating that through the cycle this conversion rate should average about 80%. Management noted that through the seven months ending Jan. 31, Treasury has converted 85% of its EBITDAS to cash, tracking our prior full-year 86% forecast. But the firm also outlined that continued luxury wine inventory investments in the coming months will likely push down this metric to between 60% and 70% for fiscal 2019. While one year of lower cash conversion does not upend our thesis for Treasury--we forecast the metric rebounding to average 87% over the next four years--the drop nonetheless highlights that greater revenue and profit growth than we forecast may also require a corresponding cash investment.

Treasury’s balance sheet should support these investments, however. The company finished the half with a lease-adjusted net debt/EBITDAS at about 2.0 times, within management’s cited comfort range of up to 2.5 times. The firm believes it can complete any planned French M&A in the normal course of doing business, without a need to raise additional capital.