Australian Wine Set To Cycle Back Up Again?

This story features AUSTRALIAN VINTAGE LIMITED. For more info SHARE ANALYSIS: AVG

– One stockbroker has gone contrarian on prospects for Australian wine producers
– BA-ML is predicting a long lasting upcycle
– Change in industry dynamics should benefit Treasury Wine Estates

By Greg Peel

We recall that the Australian wine industry underwent a significant boom beginning from around the late eighties as the world discovered just how good a drop the stuff from downunder was at a reasonable price. The boom lasted more than twenty years and encouraged significant growth in Australian wine growing acreage. But just as the industry was resting on its laurels, two things happened around the same time – wine production gluts locally met a wearing off globally of Australian wine novelty, to be replaced by offerings from South America to Eastern Europe. The US wine industry began to expand rapidly and even the Poms now like to think they can produce a decent drop.

Just as the Australian wine surge was peaking, Foster's ((FGL)), frustrated by a lack of growth in the Aussie beer market, acquired Australia's biggest conglomerate winemaker Southcorp. The move was to become a corporate case study in disastrous acquisitions. Foster's rode the Australian wine cycle back down from peak to trough before finally ditching its wine division in a spin-off last year. The spin-off ended an era and gave birth to a standalone Treasury Wine Estates ((TWE)). Maybe you could call it Southcorp II.

Initially stock analysts were reasonably well disposed towards TWE given it appeared the only way was up, as long as the company did not let its debt get too out of hand. Foster's remained less of a growth proposition in a local market now embracing less beer in general and more boutique offerings when consumed. But there was a high possibility of takeover by a global player and indeed SABMiller brought a tear to Paul Hogan's eye late last year.

In 2012 however, TWE has been battling subdued demand in both of its prime markets of Australia and the US. Of particular concern has been high levels of inventory and that's what caught Foster's out in 2009 when it still owned the wine division. Today the FNArena database shows no less than four Sell ratings among the seven brokers covering the stock, with two Holds and one lonely Buy. The Buy rating comes from BA-Merrill Lynch – avid critic of the Southcorp takeover and often a contrarian to the popular market view.

JP Morgan updated its view on TWE yesterday, as well as that of listed peer Australian Vintage ((AVG)). The review was prompted by a trading update from AVG that noted vintage 2012 was set to be a low yield year.

In response to previous high yield, or glut, years, TWE has cut back on its own wine production such that only 25% of requirements comes from TWE-owned vineyards with 30% coming from purchases of bulk wine. The ploy has worked to some extent, given supply has tightened up which is supportive of prices. But in a low yield year, TWE will be forced to buy in more outside wine and this will increase costs, notes JP Morgan. In the meantime, an easing of the Aussie dollar has provided some relief on the export front but only marginally.

JP Morgan thus believes AVG is better positioned to benefit from a tighter supply market than TWE and hence the broker rates the former a Hold (Neutral) and the latter a Sell (Underweight).

However while JPM is looking at tighter wine supply as a near-term problem for TWE, Merrills is taking a wider view. 

“There has been evidence emerging over the last six months that the US and Australian wine industries have tightened,” note the Merrills analysts, “and we believe we are now in the very early stages of a long duration up-cycle”. Grape supply has lessened and some wine producers have started holding back inventory, they point out.

Early in April it was Credit Suisse (Underperform) in particular who was worried about TWE's inventories, citing the earlier FGL experience. However the analysts did acknowledge that near-zero US interest rates provide for minimal carry costs. Merrills is a lot more keen on the concept of retained inventories given the opportunity to increase shareholder returns. If wine is held back while supply tightens, not only should subsequent pricing be more favourable but aged wine draws a greater price premium.

In short, Merrills is now prepared to stick its neck out and play the contrarian card. The analysts have put their money where their mouths are, lifting their target price on TWE by a solid 27% to $5.75, further supporting their existing Buy rating. That target now becomes a clear outlier, with the remaining database targets ranging from $2.80 (Credit Suisse) to a neutral UBS on $3.75.

Merrills points out that in 2002, TWE's predecessor Southcorp was trading on an enterprise value multiple of 17x which by today's standards “seems outrageous”. And that was before Southcorp acquired Beringer and Wolf Blass. Using in-house forecast earnings, Merrills has TWE's multiple at 7.3x.

At today's share price, TWE is not among the highest yielding stocks, with an FY13 consensus forecast yield of 3.5%. That's a tad under the current Aussie ten-year bond yield. But as the last few years of difficult share market trading have shown, the big winners have been dividend paying growth stocks – those with growing earnings expectations offering both capital and yield return and the potential to lift dividends.

As noted, Merrills is the lonely contrarian here, but Merrills was also pretty lonely in absolutely trashing Foster's Southcorp acquisition several years ago.
 

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