Would A Penfolds De-Merger Create Value?

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

Broker views differ on whether the separation of luxury brand Penfolds would create value for Treasury Wine Estates.

-Would create two businesses offering very different attributes
-Penfolds would likely take the bulk of costs and capex
-Weak Asian demand and wine over-supply in the US weigh
 

By Eva Brocklehurst

As brokers have speculated over many years, Treasury Wine Estates ((TWE)) is now contemplating the separation of iconic brand Penfolds, having dismissed the idea on prior occasions.

The company has also announced plans to reduce its commercial (less than $10 a bottle) portfolio, particularly in the US, and while brokers understand the reasons behind the revamping, views differ as to whether it is a good idea to separate Penfolds.

The separation of Penfolds would create two businesses that offer vastly different attributes for investors, Citi points out. Penfolds is a strong, globally recognised brand while the large commercial business would probably shrink, either because of loss of shelf space or divestment.

Treasury Wine intends to update the market in August about the progress on a potential de-merger and expects, if it proceeds, the deed will be done by the end of 2021.

UBS considers the decision to explore the de-merger positive, although was surprised by the timing given the current challenges. A de-merger would be value accretive, the broker assesses, assuming no adverse impact on the residual company's ability to maintain distribution and customer demand without the bundling and leveraging of Penfolds product.

The residual entity would have diminished appeal to major retailers without the flagship Penfolds brand, Macquarie agrees. Treasury Wine would also have difficulty continuing its US direct distribution model with a smaller portfolio, putting margins at risk.

Credit Suisse is rather hostile to the idea, believing it would not create value for shareholders. And it puts the company, or part thereof, in play.

The broker points out Treasury Wine as a whole is not constrained for capital and Penfolds actually had priority access to manufacturing and viticultural resources, which means a de-merger would benefit the residual business at the expense of Penfolds.

The broker suggests, as the pandemic passes, there will be opportunities to acquire brands that can diminish the influence of commercial wine within the portfolio.

Citi envisages upside if there is corporate interest in the Penfolds brand (although traditional multiples make it challenging) but also downside risk if the de-merger does not proceed and earnings weakness in luxury wines persists longer than 12 months.

Separation is by no means a source of immediate value creation, Citi ascertains. Without a decent value for the residual business of masstige and commercial wines it will not be rewarding for shareholders. Moreover, luxury sales are down around the world and revenue has fallen significantly in Asia.

Penfolds

Credit Suisse assesses the de-merger is also likely to add costs and capital expenditure. Penfolds' cost of capital will be higher and leverage capacity lower than the combined businesses today.

Penfolds could be appealing but needs to prove it can successfully create a French and/or US label that extends growth over the next decade, Citi adds. Also, operating costs appear too lean, and marketing expenses may need to rise to support a premium price position. The broker values Penfolds at $6.5bn, with an enterprise value/EBIT multiple of 17x.

Treasury Wine has indicated Penfolds accounts for around 10% of its volume and over half of earnings and anticipates excess luxury fruit is available in France, believing it would be well placed to accelerate the expansion of the French portfolio in Asia.

Macquarie poses the question as to whether a similar outcome around value transparency could not be achieved through a small change in disclosure rather than a company-changing de-merger.

The broker also notes it is unclear whether distribution would be independent and whether the shared global business services would continue. On this point, UBS also questions the ability to maintain points of distribution without a global shared services model.

Macquarie downgrades to Underperform, noting ongoing downside risk, particularly in the US and Asia. The broker assesses the issues surrounding the de-merger are more likely to impact the residual business negatively compared with Penfolds.

Moreover, it would be hard to maintain the current investment-grade rating without the earnings diversification of the larger group. Also, there are questions about the ability to continue the US direct distribution model without the Penfolds portfolio.

Morgans highlights significant uncertainty over the short term. The broker revises forecasts to reflect the over-supplied US wine market, and for the effects that the current coronavirus crisis is having on masstige and luxury wine sales, particularly in the high-margin Asian business.

Asian Demand

Treasury Wine is experiencing weak volumes in China while a decline in demand throughout Asia has been severe. Citi envisages a net drag from lower luxury sales in developed markets which will more than offset higher commercial sales.

Macquarie notes an important cultural difference in China. Wine consumption is heightened in the period September-January/February and done for "occasions". Without these events, the consumer is unlikely to consume wine and will save it for gifts. The broker also notes that exports to China from South Australia have not re-started.

Social isolation is also exacerbating the over-supplied situation in the US wine industry and Citi suggests the entity ex-Penfolds would have an uncertain outlook. Commercial wines would have 60% of volume, although the company intends to wind this back. The loss of Penfolds from the portfolio, too, would be a concern for customer perceptions of the other brands.

FNArena's database has one Buy (UBS), five Hold and one Sell (Macquarie) for Treasury Wine. The consensus target is $11.81, suggesting 11.4% upside to the last share price.

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