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Morningstar | Treasury Wines Sees Some Small Hiccups in FY18; Long-Term Forecast Intact and Shares Overvalued

No-moat Treasury Wine’s business remains a solid long-term growth engine, and we expect the business to enjoy further structural growth in China, market share gains from new product launches, and improving profitability from positive mix shift. But fiscal 2018 results show that the road could be bumpy along the way. Treasury saw underlying operating earnings in its Americas segment fall 1.5% from the year prior, as it works to restructure its go-to-market distribution strategy in the region. And with import clearance hiccups in China during the year, the firm saw a massive buildup of inventory on its books, leading to declining free cash conversion.

We expect these short-term issues to prove temporary, and Treasury’s results largely tracked our other expectations. However, shares still screen as substantially overvalued. We’ve lifted our fair value estimate to AUD 11.70 to account for better long-term profitability in Treasury’s Australian division, slightly better pricing in Asia, and a lower tax rate than we previously assumed (26% versus 27%). But we see little room for error in issues such as market expansion in China, competitive response from other global wine producers, or disruptions in global economic growth, on top of continued executional risk.

Treasury’s bottom-line results were in line with our forecasts. Operating margins were slightly better than we expected, at 21.8% versus 20%, but this was largely due to continued deliberate efforts to shed sales of low-margin commercial wine. As such, revenue growth of 1.1% for the full year trailed our forecast for 2.4% gains, leading to full-year operating income of AUD 530 million, only slightly ahead of our AUD 520 million forecast. Similarly, Treasury’s reported NPAT of AUD 360.3 million was ahead of our AUD 335 million projection but included a one-off tax benefit of AUD 20.9 million due to restatement of a deferred tax liability following the recent U.S. tax cuts; adjusted income was AUD 339.4 million.

We expect revenue growth to bounce back in fiscal 2019, owing to continued strong Asian end-market performance, share gains for Treasury given new product launches, and higher-priced luxury and midrange, or masstige, wine flowing from the balance sheet to the income statement as the ageing process completes. Management expects earnings before interest, taxes, and expenses associated with the valuation of self-generating and regenerating assets, or EBITS, to grow 25% this year, and continue to progress towards an EBITS margin of 25%. We agree, and forecast margins reaching 25% by fiscal 2021. Our updated projections also now expect the metric to reach nearly 27% by fiscal 2023, about a point higher than our prior assumption.

But we caution that this outlook suggests income growth will likely slow at some point from the torrid 25% annual pace seen over the past several years. We still think shares are priced for perfection in execution, end-market development, and consumer preferences, without a margin of safety to account for risks. For more information regarding our outlook for slowing top-line growth and these risks, please see our recently published special report, "In Vino Veritas: We Don't Expect Treasury Wine's Growth Will Live Up to its Inflated Share Price."

One of the key challenges facing Treasury, or any luxury wine maker, is cash flow management given a typically large amount of wine ageing on the balance sheet. The company generated muted performance in the fiscal year, with free cash flow, as defined by operating cash flow less capital expenditures, falling to AUD 101 million from nearly AUD 200 million in fiscal 2017 and AUD 300 million the year prior. And the company’s own cash conversion calculation, defined as underlying net operating cash flows before financing costs and taxes as a percentage of EBITDAS (that is, EBITS plus depreciation and amortisation), fell to 68% from 84% a year ago. We expect this metric to improve, however, given that there were one-time and timing-related issues, such as the U.S. route to market transition and customs clearance delays in China, that led to Treasury holding more inventory than anticipated. The adjusted cash conversion was closer to fiscal 2017 levels, and management expects this ratio to comfortably remain above 80%, in line with our five-year forecast for an average 87% conversion. However, we caution that free cash flow will likely remain below net profit after tax because of the capital requirements of holding an increasing amount of high-end wine on the balance sheet.

Another risk remains execution of Treasury’s Americas division, which has recently gone through a major structural change. As part of this strategic shift, the company will now self-distribute 25% of its business across two U.S. states--California and Washington--and will move 15% of its business to new distribution partners elsewhere. We anticipate this shift will lead to improved market share, profitability, and revenue growth over the long run, but the transition period has led to a decline in revenue and reduced operating earnings. Along with a continued intentional reduction in commercial wine sales, volume in the region fell 13% versus the prior fiscal year, while revenue dropped 11%. EBITS fell a slimmer 1.5%, owing to positive mix shift from a greater proportion of luxury and masstige wines, and supply-chain cost savings, leading to EBITS margins of 20.1% versus 18.1% in fiscal 2017. But overall, management estimated a sizeable AUD 25 million hit to operating income due to the changeover.

Nonetheless, this segment is on-track to meet our long-term expectations. We’re not too surprised by the short-term hiccups seen this half; we had noted such risk in a note on Jan. 31, 2018, and management estimates the transition should be fully completed by the end of fiscal 2019. We expect further profitability uplift from rising luxury and masstige volumes as these products continue to gain share in the American market, and additional margin captured by Treasury self-distributing its product, leading to mid-single-digit top-line growth, along with margins improving further to 23.5% over the next five years.

However, management commentary in the period highlights our no-moat rating for Treasury. Net sales per case were up sharply in the U.S., but mostly due to positive mix shift. The company noted that while it captured price increases on some luxury brands, this was offset by discounting and price cuts in other products. We think the firm will continue to enjoy success in bringing new products to market, including a planned Italian wine launch in fiscal 2019 and U.S.-sourced Penfolds Napa Valley wine over the next several years, but nonetheless expect competition to remain fierce. As a result, we anticipate marketing spending rising to 5% of revenue in fiscal 2019, from 4.6% this year, and any future positive net pricing to result primarily from positive mix rather than per-product price realisation.

Asia also remains a critical growth driver for the company, and we expect a rebound in Chinese volumes following a slight slowdown as Treasury moves past its recent challenges with import delays in the country. We’re further encouraged that management believes the issues with Rawson’s Retreat--cited as a concern a few months ago due to potentially heightened inventory in the channel--has been rectified, with inventory cover still broadly in line with last year’s results. And despite slightly lower volume than we had anticipated, revenue per case rose sharply, given continued growth in luxury wine. 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 20% over the next five years, slightly ahead of our prior forecasts.

Treasury’s Asian profitability also remains a leading earnings driver for the company. EBITS margins were a bit lighter than we expected, at 37.5% for the fiscal year versus our 38.5% assumption, as the firm made greater investments in advertising and promotional expenses. Nonetheless, the segment remains on track to meet our long-term 40% forecast, owing to continued increases in luxury and masstige wine and returns on the supply-chain investments made. Management’s new outlook for margins to remain above 35%--versus a prior specified range of 32%-37%--further supports our projection.

We were admittedly surprised by Treasury’s strong Australian and New Zealand profitability in the fiscal year, as margins ticked up to more than 22%, ahead of our 20% forecast. The firm’s supply-chain investments and cost savings have seemingly led to greater benefit than we anticipated, and the company is targeting further margin accretion in fiscal 2019 from continued efficiency savings and positive mix shift. We’ve raised our long-term projections about 170 basis points, to more than 23%, to account for this continued success. We also agree with management’s target for Treasury to capture 25% market share in Australia, and our forecast for 1%-2% volume gains, and mid-single-digit total revenue growth, outpaces our industry outlook. However, we expect the Americas and Asia to make up the lion’s share of Treasury’s future earnings, at 79% combined in fiscal 2023, up from 68% in fiscal 2018. Conversely, we forecast Australia and New Zealand making up a slimmer 15% of consolidated EBITS.

We similarly expect Europe to remain a minimal earnings driver for Treasury. Volume in this region fell 7.5% in the fiscal year, reflecting Treasury’s exit from commercial wine sales, but net sales per case climbed 4.4% as luxury and masstive volume grew substantially. This positive mix shift also drove a 310-basis-point jump in EBITS margin, to 15.4% versus 12.3% in fiscal 2017 and ahead of our 15% forecast. Nonetheless, we think the geography is on track to hit our long-term 16% margin forecast. Still, faster growth and greater profitability gains in other regions will likely limit Treasury’s European exposure to only 5% of EBITS over the long run, by our estimate.

Beyond the core operating performance, Treasury also recapitalised a portion of its balance sheet during the fiscal year, pushing net debt/EBITDAS, adjusted for operating leases, to 1.9 times from 1.5 times in fiscal 2017 to complete AUD 300 million of share repurchases. While we think the firm’s debt metrics remain healthy--interest cover is still a solid 16.1 times, for instance--we’d prefer to see a greater emphasis on accretive acquisitions or increased dividend payouts rather than buybacks at the current market price. Management completed this year’s repurchases at an average price of AUD 15.41 per share, and while it’s hard to argue that these transactions look attractive versus the current market price of over AUD 19 per share, we think time will prove that these were a low-return option for redeploying capital, given our lower valuation.