EUR 850.00 For Business Accounts Only

Morningstar | Treasury's Premium Portfolio is On-Trend, but Valuation Still Too Rich for Our Taste

No-moat Treasury Wine has proven to be one of Australia's great recent turnaround stories, but the market's glass looks more than half full. We credit management for restructuring the winemaker's focus on rapidly growing premium product since CEO Michael Clarke joined in 2014. However, shares now look substantially overvalued. We applaud the company for walking away from low-priced, commercial bulk wine production that led to distributor inventory problems, write-offs, and wine destruction in prior years, instead focusing on higher-quality and higher-priced wine that has led to improved profitability and return on invested capital. We raise our fair value estimate to AUD 10.50 per share from AUD 10.10, recognising the continued solid growth potential in Asia and profitability expansion in North America. But we expect earnings to slow and the high earnings multiple to ultimately collapse, and recommend a much lower price before considering long-term investment in Treasury Wine's shares.

Despite a rosy valuation, the future for Treasury Wine remains solid, especially overseas. Although many of the firm’s most well-known and highest-priced wines, such as the iconic Penfolds brand, are produced in Australia, the majority of earnings stem from Asia and North America. We expect these two regions to drive the bulk of income growth over the next five years, rising to 78% of operating income by fiscal 2022 from 68% in fiscal 2017.

Treasury's outlook remains especially bright in China, with further wealth creation likely leading to continued strong gains in wine consumption, and imports rising at an even faster clip. But we caution that growth rates look to slow from recent levels--a view the market doesn’t seem to fully appreciate. We expect Treasury’s volume in its Asian segment to grow at a 21% CAGR over the next five years, substantially slower than the 40% seen in the past three years.

While the company imports wine to many countries in Asia, China is the main driver of the segment’s future. The country has helped to drive substantial top-line growth for the company, as consumers have flocked to brands such as Treasury's Penfolds and other high-end wines. We estimate roughly a third of the segment’s volume stems from sales in the country, and we forecast nearly 25% annual volume growth for Treasury over the next five years, outstripping the country’s total wine market gains of 11% yearly as the company picks up share. However, while we see the near term as particularly strong, we expect slowing GDP growth, increasing competition, and a cultural limit to the upside of wine consumption as factors that will lead to more-muted gains in the latter years of our five-year forecast.

Treasury's future in North America focusses on product premiumisation and profitability expansion. We expect total wine consumption in the U.S. to grow at roughly 2.5% to 3.0% annually, continuing recent trends. However, we expect luxury volume growing high single digits (we estimate 8%) and masstige growing mid-single-digits (6%). This implies commercial wine grows only 1% through 2021. We anticipate Treasury should be able to hold on to its market share in luxury and masstige wines, despite a fragmented and competitive market.

However, while this increasing portion of higher-end wine should benefit average revenue per case sold, we don't see much pricing power at the individual product level in most of Treasury's product portfolio. Wine pricing is extremely competitive at the low-end to mid-range price points, per industry commentators, and as a result, we forecast the majority of Treasury's higher price per bottle going forward stemming from positive mix shift rather than substantial price hikes on each individual brand. The firm's luxury wines—particularly those priced from about USD 50 per bottle—are the exception, in our opinion. We believe consumers in this category are less price sensitive, more brand loyal, and often purchase with intent to store long-term or collect, enabling Treasury to pass through price hikes at a considerably higher rate. But we estimate these luxury products make up less than 10% of North American revenue.

Still, the positive product mix shift from selling higher-end wine should benefit Treasury's operating margins in the United States. Treasury generated roughly 18% operating margins in its North American segment in 2017, but the profitability profile across different wine price points differs materially. We estimate that Treasury's luxury wine currently garners EBITS (that is, earnings before interest, taxes, and expenses associated with the valuation of self-generating and regenerating assets) margins of about 35%, masstige around 20%, and commercial wines a slim 5%. We expect continued stronger growth in luxury and masstige wines, along with margin expansion within each category, to drive EBITS margins to north of 23% by fiscal 2022.

Our primary qualm with potential investment in Treasury comes down to valuation. In our opinion, the market has already recognised Treasury's strong future earnings growth, and then some. A more-bullish scenario that arrived at the current market value would need to assume Treasury to both gain share in luxury and masstige wines, while also being able to lift price at a faster rate than competitors and further leverage marketing expenses in North America--a combination we view as less likely than our base case. Similarly, the market appears to be pricing in an upside case in Asia, suggesting revenue growth in the segment would need to climb at a 31% average annual clip, versus 25% in our base case, while operating margins increase to 45%, substantially outstripping most luxury wines' profitability and smashing management's own forecast for 32% to 37% margins.

These optimistic cases in North American and Asia, together with a more-optimistic view of Treasury's Australian and European businesses, lead to a bull scenario valuation of AUD 14.70. To arrive at the current market price near AUD 16.60, we'd also have to assume that Treasury has carved a wide economic moat, extending the period over which it can enjoy economic profits to 20 years versus fewer than 10 years we assume in our base case. While we forecast a sharp improvement in return on invested capital over the next five years, rising to nearly 13% by fiscal 2022, we don't yet have the confidence that these ROICs will remain above the cost of capital for a full decade.

Our opinion is built upon two main factors. First, we don't think Treasury's global scale sufficiently separates it from other major wine producers. We applaud the company for its improving financial results and refocused activity on high-end wines, but Treasury isn't the only winemaker pursuing premiumisation of its portfolio, multi-regional sourcing, or enjoying economies of scale. Second, the wine industry is highly fragmented outside of these large players, and consumers face minimal switching costs between brands. although we think the upper end of wine is a true luxury good with substantial pricing power, we expect most wine consumers at the lower-end tend to be more brand-agnostic, and much more devoted to price rather than label. We estimate that by fiscal 2022, luxury wine will make up roughly a third of Treasury's consolidated operating income, suggesting the majority of earnings will still stem from these competitively challenged, and almost commoditised, sources.

In all, we think shares are priced for perfection in execution, end-market development, and consumer preferences. The current market valuation leaves little room for error in issues such as market expansion in China and challenges with local wholesale partners, competitive response from other global wine producers, or disruptions in global economic growth.
For more information, please see our recently published special report, "In Vino Veritas: We Don't Expect Treasury Wines’ Growth Will Live Up to its Inflated Share Price."