Thursday, February 28th, 2019
On balance, Treasury Wine Estates’ growth potential and undervaluation make the stock an opportunity at current prices, though investors may choose to manage their exposure to the unique risks in this stock through a smaller weighting than for other large-cap stocks. The StocksInValue model portfolio recently purchased a position during the current share price weakness and we see upside of 15 per cent to our $17.20 valuation before dividends and franking, but we’ll limit the weighting to three per cent.
The few large-cap growth stocks on the ASX tend to trade on steep premiums to the market, and this used to describe Treasury Wine. Long an admirer of the company’s rapid earnings growth but deterred by the 30 times price-earnings multiple, we first became interested in the December quarter, when the multiple fell to its long-term average of 22 times during the macro-driven volatility. Today the multiple on 2020 consensus earnings is 20 times and for 2021, the year on which investors should focus given the sales volume momentum from recent strong vintages, the multiple is 17 times, only marginally more than the ASX 100 at 15 times. This relative multiple is at a five-year low. But Treasury should compound earnings per share by at least 15 per cent per annum over this and the next two financial years, which compares with EPS growth for the ASX 100 of low to mid-single digit over the same period. The stock is also inexpensive compared with its global wine peers.
Numerous reasons justify the market’s optimism on earnings. Treasury reports a high-quality and high-volume 2018 vintage with 2019 likely to be better still. These vintages should be ready for sale just as Treasury expands its distribution in China’s cities by more than 50 per cent over the next three years. The strategy to shift towards a more premium range in the Luxury and ‘Masstige’ categories is largely working, particularly in China and the Americas. Overall the execution of the company’s rapid growth has been impressive so far.
These culminated in guidance for growth in operating earnings of approximately 25 per cent in 2019 and 15-20 per cent in 2020. Not only are these some of the fastest growth rates available in ASX large companies, we are not aware of any other ASX 50 company giving guidance this confident for 2020.
The current share price softness both creates a value opportunity and points to why Treasury should be at most a medium-sized position in portfolios. The market is concerned about the poor 54 per cent cash conversion ratio (of operating cash flows to earnings) in the first half and the reduction in long-term guidance to 80 per cent from 80-100 per cent previously. The reactivation of the dividend reinvestment plan will be dilutive and is a response to the low cash conversion. The first half disappointment is largely explained by timing factors, changes in distribution from distributors to end customers like retailers, and currency movements but the longer-term deterioration possibly signals more difficulty collecting payment from end customers than distributors.
Cashflow pressures are also normal in a wine business. Growing wine grapes and bottling the finished product require substantial investments in working capital but customers typically don’t pay until years later when vintages finally reach the market. Shareholders have to fund the inventories of unsold wine in the meantime. Given the large size of Treasury’s 2018 vintage, this effect could intensify for a while given inventories are now over $2 billion. Eventually, this should translate to strong revenue growth but the market will still discount the stock for its capital intensity. The rising stock of inventory also increases the need to improve its mix or its average profitability.
Businesses which have to substantially scale up their sales and marketing teams to achieve high growth can also experience temporary margin compression until the revenue catches up with the higher operating costs. This happened to Treasury in its first half and will probably happen again at some point. As Treasury enlists dozens of second-tier distributors in China it will also have to be careful not to cause price discounting. In China, wine distributors sell the same portfolios with little differentiation on service, so price is how they compete. Distributors will have to be hand-picked.
Treasury admits it is stretching its existing key brands of Penfolds, 19 Crimes and Beaulieu Vineyard in coming years. While these are strong brands that have performed very well so far, Treasury needs to ensure their expansion outside what they are best known for does not reduce their relevance to consumers and ultimately their pricing power. At some point, Treasury’s volumes will grow so large that M&A will be necessary to sustain double-digit growth, and that is riskier than organic growth.
Finally, there are geopolitical risks from being a global business in today’s complex world. Treasury’s cash flows have already come under pressure once from delays at Chinese ports and the new, similar delays to Australian coal exports to China are a reminder this could happen again.
So whereas the earnings multiples for CSL and Cochlear are levelling out around 30 times, Treasury’s multiple will probably peak around 20 times. When deciding on the right weight for the stock in their portfolios investors should weigh the growth potential, the value and the risks.
Clime Group owns shares in TWE.