Is There Any Value In Treasury Wine?

This story features TREASURY WINE ESTATES LIMITED. For more info SHARE ANALYSIS: TWE

-Need to divest, create alliances
-CEO's strategy considered positive
-But many challenges remain
 

By Eva Brocklehurst

Treasury Wine Estates ((TWE)) has ended discussions with the two private equity concerns stalking the stock. After an eventful six months or so of due diligence, negotiations foundered as Treasury Wine's board rejected proposals from both parties. Treasury Wine's major shareholders concluded that the $5.20 indicative offer undervalued the company, whilst the private equity groups could not structure a deal at a high enough price for regulatory and financing reasons.

Credit Suisse describes the speculated takeover of Treasury Wine as a "hypothetical fiction of investor imagination" but believes CEO Michael Clarke has validated his business improvement plan. He remarked that one of the firms started out with a different idea about how to improve the business and eventually aligned its vision with that of management. Credit Suisse concludes the saga confirms the impracticality of breaking up the company to create value. It also reflects an urgent need to divest underperforming brands and engage in alliances. Two key areas in this regard will be Asian distribution alliances and commercial wine exposures. Nevertheless, Credit Suisse does not envisage any single potential transaction will dramatically change the value of the company.

Treasury Wine will now look for merger and acquisition opportunities and alliances to grow its Asian and European operations and focus on improving its "lazy" balance sheet. It will make more targeted marketing campaigns, cut overheads, separate the commercial wines from the luxury and masstige brands, invest in premium wine inventories and adjust vintage release dates. UBS cannot fault this strategy but does not believe it will be easy.

Macquarie was impressed by some of the initiatives the CEO outlined, particularly the focus on tighter marketing spending, more effective release dates for Penfolds and better earnings form the commercial end. Considering commercial wine accounts for around 70% of group volumes, lifting the profitability of this segment could be material. Macquarie was unsurprised at the inability of the bidders to come to a formal offer, noting that regulatory issues in the US would have been an obstacle.

US regulations require a three-tiered system of manufacturing, wholesaling and retailing alcohol and, in the case of Kohlberg Kravis Roberts, existing ownership of a retail business means it would be unable to buy Treasury Wine's US manufacturing operations. TPG was unable to proceed because a $5.20 price meant it was unable to obtain an acceptable level of debt funding. Macquarie believes further bids are unlikely to surface, so the focus is back on the challenging fundamentals.

The premium built into the stock on the anticipation of a successful offer is likely to take some time to wash out in JP Morgan's view. The broker remains concerned the share price is again being based on overly optimistic expectations regarding the timing and quantum of a turnaround. The broker could become more positive on the stock below $4.20.

The impact of the Australian dollar may also be overstated as the market fails to take into account the amount that is competed away, because of similar benefits accruing to other wine producing countries. The proportion of the benefit that Treasury Wine is able to retain from the fall in the currency comes down to the change in margins relative to its competitors. JP Morgan observes there is no cost advantage relative to other Australian wine producers from a falling Australian dollar. Again, the broker believes the market dynamics are difficult and there is much uncertainty around the near-term earnings outlook for Treasury Wine.

The private equity firms failed to proceed because, in Credit Suisse's view, there was no silver bullet to unlock significant value and rapidly retire debt, or partially fund the transaction. Divesting brands would not realise significant value because of their low margins, or declining revenue profiles, and divesting geographies would probably have resulted in complex licensing and distribution arrangements. Credit Suisse maintains Treasury Wine must be valued on cash flow, especially in a highly leveraged private equity situation where debt obligations, rather than investor perceptions, are the reality.

In looking at the last five years the broker finds there has been no financial improvement, as cash flow peaked in 2012 and has fallen since. The share price has appreciated 30% while earnings power and debt obligations have not improved. Credit Suisse observes investors seem to be valuing the company above its cash flow generating potential and this may relate to valuations of other luxury goods stocks.

So, Credit Suisse is also discarding a discounted cash flow valuation in favour of a comparative rating, for now. The argument for this approach is that the emphasis on the luxury end of the portfolio should ultimately yield luxury goods margins at a group level. Also, Treasury Wine's balance sheet is under-geared and this has potential to add around 10% to earnings. For the moment the broker is not arguing with those investors it calls optimists, but retains an Underperform rating.

Interestingly, on FNArena's database the above four constitute the Sell ratings and the remaining four have Hold ratings. There are no Buys. The consensus target price of $4.74 is down from $4.93 ahead of the news. It suggests 8.9% upside to the last share price.
 

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