Description

Thesis Summary

Treasury Wine Estates (TWE) is a short because a) US volumes are in decline while consensus believes they are growing, b) China growth is slowing down, and c) the underlying business is of worse quality than the market perceives.

1.       TWE operates a portfolio of weak brands, masked by a high growth China segment that is slowing down. Fundamentals in TWE’s US wine business (40% Revenue / 30% EBITS) are getting worse, as secular trends deteriorate and a strategic operational shift in TWE’s distribution strategy has gone awry

2.       Peeling back the onion, one finds that Treasury’s portfolio, especially within the US, consists of weak brands, with core US volumes declining. Americas margin improvement is proving increasingly difficult to achieve given new investments to support the company’s direct-to-retailer initiative and an unhealthy US wine sector backdrop for large commercial suppliers

3.       In addition, TWE has appears to have several accounting red flags and a history of channel stuffing (well-documented by the Australian Financial Review). FCF conversion has materially weakened in the last few quarters and we expect it will continue to be suppressed as the company invests in expensive inventory (wine vintages) that they cannot immediately monetize

4.       The Company is on its 4^th CFO in the last 3 years and fired its COO, Head of China (who then joined a competitor), and Head of Americas all during 2019

5.       At AUD 18.0/sh, on consensus estimates, TWE trades at 18x FY20E EBITS, 25x FY20E EPS, and 57x FY20E LFCF. Our base case price target is AUD 13.5sh for 25% downside with potential for 40% downside, which we find to be an attractive risk/reward

Company / Industry Overview

1.       TWE is a global wine producer with brands such as Penfolds, Berringer, 19 Crimes, and Wolf Blass. By geography, 40% of sales are in the US, 25% is in Australia/New Zealand, 25% is in Asia, and 10% is in Europe. TWE was spun off from Fosters in 2011 and has been a public company listed on the ASX since then. Over that time, the two key drivers for the business have been (i) premiumization (driving higher price points per bottle and margins) and (ii) the rise of the Chinese wine consumer (Asia has driven 45% of EBITS growth)

2.       US wine industry overview / value chain

a.       Major players / mkt share by ’18 revenue: E&J Gallo (20%), Constellation Brands (STZ) (15%), Wine Group (8%), Trinchero Family (6%), TWE (4%)

b.       Revenue growth algorithm (last few years CAGR)

                                                               i.      US wine industry: 3% sales growth (+0-1% volume / +2-3% price/mix)

                                                             ii.      Gallo/STZ: 1.5% sales growth (-50bps volume / +2% price/mix)

                                                            iii.      Note, there is a mix shift effect due to premiumization, as people trade up to masstige/luxury (>$11/bttl) wines and away from commercial (<$11/bttl). STZ in particular has been publically vocal about the poor trends in the commercial wine business (evidenced by their recent divestiture)

c.        3-tier distribution system

                                                               i.      Wine manufacturers sell to wholesale distributors, who then sell to retailers/local liquor stores (off-prem) and restaurants/hospitality (on-prem)

                                                             ii.      Distribution is a highly regional business, and the largest players (all private) are Southern Glazers, Republic, Breakthru Beverages, Johnson Bros, etc. Distributors are the most powerful players in the chain with near-monopolies in local regions

                                                            iii.      TWE embarked on a US distribution restructuring in large markets (FL and CA) starting Feb ’18, presumably in order to bypass the distributors who were not emphasizing TWE brands

3.       Fundamentals of the wine manufacturing business: Without a hit brand, wine manufacturing is a bad business that is notorious for generating returns that are less than the cost of capital

a.       Cyclical / capital intensive, resulting in low cash flow margins: One must not only invest in the vineyard/capital equipment but also invest in working capital. Profits generated today are plowed back into new vintages of wine that must be stored and aged over several years. Therefore, during good times, wine manufactures extrapolate volume growth into the future and heavily reinvest cash back into supply, hoping demand persists 3 years later

b.       Difficult to standardize and especially to scale: Vineyards are similar to ag businesses and are subject to bad weather/droughts that can destroy the yield of a vintage. Wine manufacturers are also subject to raw material constraints that limit growth. Even if one has a hit brand of luxury wine, it is very difficult to scale if the supply of high-end grapes is limited. We believe this supply constraint will result in a slow-down in Asia growth, as there is not enough Penfolds allocations to sustain historical growth.

c.        Numerous substitutes, SKU proliferation: There are a massive number of wine choices (e.g. wine aisle at a grocery store), and wine manufacturers have not built brand loyalty among mainstream consumers as labels have proliferated over the last decade. This has also made wine ripe for private label disintermediation, as retailers hire a manufacturer and slap a pretty label on the bottle (e.g. Costco, the largest US wine retailer and a veteran in the PL wine business). The heavy level of competition and lack of brand power is one of the key factors that makes wine a worse business than Spirits / Brewers for example

d.       Irrational competition: Competitors are often family vineyards in the business for personal reasons other than driving economic profit

How did we get here today?

1.       A weak Australian currency, the rise of the Chinese wine consumer, and a promotional CEO have transformed the market’s perception of TWE from a cyclical agricultural stock to a luxury brand business that gets comp’d to global spirits companies like Pernod Ricard and Diageo

a.       In the last 5 years, TWE’s multiple has re-rated from 10x NTM EBITDA / 18x NTM EPS to currently 16x NTM EBITDA / 25x NTM EPS, and consensus believes TWE can continue to grow EBITS by 17% CAGR over the next two years

b.       To further illustrate the evolution in market perception, sellside reports back in 2011 from TWE’s spin-off showed the market valuing TWE on a multiple of tangible book value or ~7x EBITDA at the time

2.       What caused TWE stock to grow 4x since 2015?

a.       Massive FX tailwind creates illusion of fundamental growth: Since FY12 (AUD peak vs USD/GBP), the devaluation of AUD has led to a reported financial gain of A$325M Revenue and A$96M EBITS, which represents a massive 18% of Total FY’18 EBITS. FX tailwinds drove 40% of Revenue growth and 30% of EBITS growth since FY12 (the USD and GBP significantly devalued from ’12-’15)

b.       Penfolds China Story: TWE’s Australian wine brand Penfolds (translates to “Ben Fu” in Chinese or ‘marching towards wealth’) is a major hit in China (#1 premium wine label). Penfolds is the golden goose, driving TWE’s Asia business to grow 40% Revenue & EBITS FY15-18 CAGR, playing to the dramatic rise in the Chinese middle-class/consumer. Given Penfold’s success, TWE has used this asset to bundle lower quality commercial wines to drive extraordinary growth in the region. Clearly, no investor in 2014 saw this inflection coming

c.        New CEO Mike Clarke: Mike Clarke joined the company in 2014, after the last CEO departed following the channel stuffing incident. Clarke has done a great job revamping the product line, refocusing the company across their 4 geographies, and investing behind the China business. Every bull attributes the strong management team to his/her thesis

Short Thesis

We believe that TWE is a poor underlying business contrary to what the market perceives, and that consensus expectations are too high, especially for the Americas segment. Consensus models Americas revenue growth with margin expansion, while we believe Treasury’s US volumes are in perpetual decline and margins will remain stagnant. Consensus expects a turnaround in the US business or ~30% of TWE’s EBITS growth to come from US. When we speak with sellside, Analysts give credit for US growth that is overly optimistic. If the US doesn’t deliver, we think numbers will come down materially and the multiple will de-rate.

1.       Nielsen US wine data over the last several qtrs have shown significant weakness (negative growth) across the industry, especially in commercial wine (<$11/bttl)

a.       STZ (one of the largest industry players) just sold a large portfolio of their US wine business to Gallo (largest wine manufacturer in the US) at a cheap multiple (6-7x EBITDA) and has been vocal about weakness in US commercial wine. It’s a strong tell when one of the nation’s largest players wants out and exits at a cheap multiple

b.       Management markets the Americas business as a masstige/premium business, though Nielsen data shows ~90% of volumes are <$10/bttl. Management refuses to disclose their Americas mix

2.       TWE’s Nielsen data suggest the portfolio is in far worse health than that of the industry. TWE’s volume growth rates are highly negative over the last year and continue to be negative through 1H19

a.       The Company makes several arguments as to why the data is noisy and not representative of core fundamentals

                                                               i.      In 2017, TWE appeared to be intentionally ‘burning’ volumes that were ‘unprofitable’ in order to right-size the portfolio

                                                             ii.      In Feb 2018, TWE announced a US RTM (route-to-market) restructuring, where they began selling directly to large grocery chains in some areas of states like CA/FL (big wine states), allowing TWE to bypass distributors and keep a portion of the margin. That resulted in heavy temporary losses as they navigated through the change

                                                            iii.      The data is sell-through while TWE revenue is sell-in so there is a timing mismatch

                                                            iv.      However, a year later, volume trends continue to be negative, even after the distribution change has been lapped

b.       TWE’s wine label ‘19Crimes’ has been a big hit in the US, which has masked the deterioration in the core. However, 19Crimes is dramatically slowing down, as gains have been driven by increased distribution rather than SSS

                                                               i.      When looking at Americas historical volume growth in the filings, numbers don’t actually look that bad because a) TWE did a big acquisition in FY16 buying Diageo’s wine portfolio and b) 19Crimes has been offsetting the heavy declines in the core. However, 19Crimes’s growth has now meaningfully slowed

c.        We believe the company may be looking for an acquisition to keep pushing the appearance of growth, though there are not many scale acquisitions available that are masstige/luxury and big enough to move the needle

d.       All of our calls have come back negative on TWE’s Americas portfolio and their ability to turnaround their business amid a backdrop of distributors with significant scale and bargaining power

3.       China growth is slowing down

a.       While sell-through data is a black box in China, the latest Wine Australia data show Australian wine exports to China have slowed materially. On an LTM rolling basis, wine export volumes in 1Q19 was -15% yoy, albeit 1Q18 was abnormally elevated

b.       Hours after the Wine Australia data was released, TWE put out a press release arguing that the export data is misleading and reiterating guidance

c.        Several days later, a filing was released showing the CEO sold 50% of his shares on that same day, netting him $7M personally. He also seems to have top-ticked the mkt, selling those shares at AUD 17.25/sh (he also sold ~$7M of stock in summer 2018, while the Company was buying back shares at 30x P/E) before the stock drifted down to 15

d.       While we don’t have visibility into TWE’s underlying China business given lack of data and transparency, we are skeptical that the Asia segment can continue CAGR’ing revenues at 20%+ levels

e.       It’s worth noting that unlike typical Food & Beverage companies, TWE’s Asia business is especially sensitive to the health of the Chinese economy. Around 50% of luxury wines in China are used for gifting rather than everyday consumption. Furthermore, we’d expect consumers to trade-down amid economic weakness

4.       Poor FCF conversion / Accounting Red Flags

a.       FCF conversion has increasingly deteriorated over the last year, driven by a) receivables growth / worsening customer collections, and b) inventory growth. Management initially guided to 80% FCF conversions, and in Feb ’19 earnings, reduced the guidance to 60-70%. During this last half, TWE beat on FCF conversion, but upon deeper inspection, one realizes the beat was entirely due to delayed inventory timing (for when TWE buys their commercial grapes) rather than a genuine improvement in cash conversion

b.       Buried in their annual report was disclosure that they ran a meaningful ~$26 mm gain on a sale of a US vineyard through their EBITS line which allowed management to hit their EBITS guidance. Without it, they would have missed. Incredibly, this has not received attention from the sell side. Note: Americas EBITS for 1H19 was $107 mm

c.        In FY18, TWE also changed their depreciation policy in order to hit their EBITS target

Why does this opportunity exist?

1.       TWE is covered entirely by Australian sellside analysts who are not in touch with the idiosyncrasies of the US market

2.       Underfollowed stock: we have spoken to consumer retail specialists at hedge funds who have never heard of this company, despite its AUD 13bn mkt cap

3.       Management has delivered on expectations over the last few years, so bulls have been conditioned to believe, and extrapolate historical results into the future

Management

Mike Clarke joined TWE in 2014 assuming the CEO role, after a stint as CEO of UK publically traded company Premier Foods. He and his team have done an admirable job over the last 4 years right-sizing the ship and capitalizing on growth, particularly in Asia. The team has executed several route-to-market changes in most of their regions, refocused the portfolio, and generated substantial growth over the last several years.

However, along the way, TWE has lost 3 CFOs - Gunther Burghardt (left 2018), Noel Meehan (left 2017), Anthony Reeves (left 2015), their COO Rob Foye (left Jan ‘19) who was leading the US route-to-mkt restructuring, the Head of China Peter Dixon (left Feb ’19, the day after TWE announced earnings), and President of Americas Victoria Snyder (left Aug 2019). We find this rate of senior departures alarming and especially the two most recent.

Valuation (FYE 6/30)

The market focuses on TEV/EBITS and Fwd P/E. At AUD 18/sh, on consensus estimates, TWE trades at 18x FY20E EBITS and 25x FY20E EPS. However, we note that both metrics significantly understate valuation, given the level of capex and high working capital (cash plowed back into inventory) that go into a wine manufacturing business. If you look at P/LFCF, TWE trades at ~60x FY20E Adj LFCF.

We arrive at a base case price target of AUD 13.5/sh, using 18x FY20E 72c/sh EPS. We assume significant Americas EBITS slow-down (2% ’19-‘21E CAGR, giving some credit for distributor margin capture from distribution restructuring) and modest China slowdown (19% CAGR) vs Consensus (25% CAGR).

We also look to a SOTP to help us frame intrinsic value. A base case 20x EBITDA multiple (international spirits multiple) for China (assuming 80% of Asia), 14x EBITDA for Australia/New Zealand, and 7x EBITDA multiple for Rest-of-Company yields an AUD 14/sh estimate. Note STZ just sold the majority of their wine portfolio for <7x EBITDA.

Recent Developments

1.       Constellation Brands (STZ) missed badly in their US wine business (US wine volumes continue to decline)

2.       The COO who was in charge of the US restructuring was fired

3.       Head of China business Peter Dixon left to join Accolade Wines (backed by Carlyle), a competitor

4.       Large scale players are getting out of the industry e.g. Constellation recently announced the divestiture of a portfolio of wines (mostly commercial but also some premium) at <7x EBITDA

5.       5/1/19 Wine Australia data shows significant China slow-down (inflect neg)

6.       5/1/19 TWE releases 8K rebutting negative Wine Australia data and reiterates guidance

7.       5/7/19 Filing shows TWE CEO sold half his shares between 5/1 and 5/3, avg sale price of $17.25 seemingly top-ticking the market

8.       8/7/19 GMT Research publishes a short report alleging TWE inflated profits post their acquisition of Diageo Wines

9.       9/4/19 Head of Americas Victoria Snyder leaves TWE after 14 years

Risks

1.       China growth story continues to CAGR at historical rates and/or greater-than-expected Asia performance outweighs worse-than-expected Americas performance

2.       China macro could improve due to 1) significant monetary/fiscal stimulus and/or 2) a trade agreement with the US

a.       Note: there are no trade war tariff issues here though the China growth story is significant enough that the stock will move based on China consumer/economic sentiment

3.       Promotional CEO; management knows how to play the accounting game

4.       Overall business continues to grow, so TWE can engineer earnings expectations (e.g. releasing excess allocations/working capital timing)

5.       Management could successfully execute on the US distribution restructuring

6.       Management execution on new products in the portfolio leads to a hit brand; distribution expansion in China is successful

7.       The fundamentals of the wine business improve (asset light, emergence of global brands) to the point where they should be comp’d to the global spirits business, justifying the current trading multiple

8.       Short interest at 5% of shares outstanding / 10 days to cover

Catalyst

Catalysts

1.       Earnings results show weakness in underlying fundamentals, poor cash flow conversion. TWE announces twice a year (half year results). Next earnings are Feb 2020

2.       China and US wine trends show weakness

3.       Accounting investigation

4.       If CEO Mike Clarke leaves / further executive departures