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Morningstar | Despite a Price Tumble, Treasury Wine Shares Still Look Expensive; Maintain AUD 12.30 FVE

Shares of no-moat Treasury Wine have retreated over the past several quarters, falling 25% since hitting a high in early September 2018. We’ve seen various concerns cited, including accusations of channel stuffing in China, executional issues in U.S. distribution changeover, and the ongoing international trade wars. Nonetheless, we view these issues as well-managed by the company. Treasury has noted inventory in China remains at appropriate levels, while the route-to-market changes in the U.S. are one-off and should lead to improved profitability over the long run. And while the tariffs put in place on American wine by China could damage Treasury’s exports from the geography, we see offsets from Chinese demand for Australian wine, which enjoy zero tariffs as of January 2019. Management recently reconfirmed its outlook for 25% adjusted operating income growth in fiscal 2019 and 15% to 20% in fiscal 2020, in line with our forecasts for 25% and 18.5%, respectively.

Despite the aforementioned risks being well-contained, we still view shares as overvalued versus our AUD 12.30 fair value estimate. We see other potential downside drivers, including slowing growth in the Chinese wine market, pricing challenges from a cyclical rise in global wine production, and cash flow degradation from new ACCC regulations.

The most substantial long-term risk we see is slowing demand in China. Asia is Treasury’s primary growth engine, and although we expect growth to slow from the white-hot 40% annual pace seen in the past four years, we still forecast a solid 25% annual top-line rate over the next four. Underpinning our outlook is a still-strong 11% volume growth in total Chinese wine demand, driven by rising per capita consumption rates as incomes lift and wine increases in popularity. But per the International Organisation of Vine and Wine, or OIV, Chinese volume demand dropped 6.6% in 2018, while Wine Intelligence reports that imports fell 8%--the first such drop in five years.

We’re encouraged that higher-priced wines continued to grow in China last year, as evidenced by total import value increasing 2.1% per Wine Intelligence, matching our expectation for market share opportunity for Treasury’s luxury and higher-end product. But a greater slowdown in the overall economy could challenge our volume growth assumptions or introduce greater competition, limiting the price increases we forecast. A downside case, in which revenue grows at a slimmer 18% annually, would trim approximately 12% from our valuation.

A key near-term risk stems from rising global wine supply coming at the same time as a fall in Chinese demand. According to OIV, wine production increased 18.5% in 2018, to 292.3 million hectolitres, following an 8.2% drop in 2017. This is the highest level since 297.7 million hectolitres in 2004. While Treasury’s high-end wines should remain relatively immune to pricing pressure, we expect the firm faces heightened competitive pricing pressure in its mid-range wines, where switching costs are low and consumers are more price-sensitive. Highlighting this risk, management noted in February 2014, following strong global production of 290.1 million hectolitres in 2013, that it was facing increased promotional pricing and competitor activity, particularly in midrange categories. While the firm’s product mix has shifted toward higher-priced wines in recent years, we estimate midrange “masstige” wines still represent the majority of Treasury’s revenue and operating profits.

Finally, the ACCC completed an interim report on the Australian grape-purchasing market, and proposed new rules in an effort to improve the price transparency at which wine producers buy grapes, and to lower the amount of time between delivery and payment to 30 days (from up to nine months in some cases currently). We’re less concerned about this risk than other issues; while the headline reads as negative for Treasury, we see a limited impact to the company in our base case. For one, the study focuses on warm-climate, primarily commercial-grape growing regions in the country, which we estimate make up less than 20% of Treasury’s Australian revenue and an even lower portion of operating profit. Any increased cost that would stem from greater price transparency would likely prove to have minimal effect on the firm’s consolidated results. And second, the firm is already a signatory to a voluntary Australian Wine Industry Code of Conduct, launched in 2009 to address these issues, meaning any new code mandated by the ACCC would likely not substantially change the firm’s business practices.

We also note that, despite a high headline reading of 175 payable days in fiscal 2018--well ahead of the 30 days suggested by the ACCC--the metric is a mix of many different arrangements, across the spectrum of grape pricing. This measure has widened from about 125 days in fiscal 2015, alongside rising days in inventory, as the firm has balanced its purchase agreements with the long receivables and inventory days required in higher-end wines. As a result, we view the total cash conversion cycle (receivables plus inventories less payables) as a more appropriate measure for comparison.

A short cash conversion cycle--which is good for the firm’s finances, but possibly bad for its suppliers--could be seen by the ACCC as Treasury abusing its market power over small grape growers. But Treasury’s 163 day cash conversion cycle appears reasonable to us and has remained relatively stable over the past five years, averaging roughly 154 days. This is similar to U.S. wine competitor Constellation Brands’ 175, although Constellation also owns a fast moving beer business and a capital-intensive spirits business, which makes a direct comparison difficult.

Nonetheless, if the ACCC becomes more aggressive across the grape-growing industry more broadly, Treasury could see some pushback on its recent endeavours to expand its payable days. But we see minimal valuation impact in this scenario. For instance, if this metric were to fall back to 125 days, we see only a negative 3% impact to our fair value estimate.