-Macau's  earnings contribution accelerates
-Melbourne, Perth have modest upside
-Sydney's VIP market a key to future growth
 

By Eva Brocklehurst

Brokers took the opportunity to make some hefty upward revisions to the earnings outlook for casino operator Crown ((CWN)) in the wake of the FY13 results, but it's a small enclave in China which was really the main catalyst. The Macau high roller segment growth accelerated to 18% year-on-year in June, the strongest in about a year and a half.

Australian consumer sentiment remains soft but the company is considered well positioned to improve the earnings of Australian casinos, given cost reduction initiatives at Crown Melbourne and the expansion of the main gaming floor at Crown Perth. Melco Crown, the joint venture in Macau in which Crown has a 33.7% interest, will enhance this earnings growth. Citi estimates the JV will represent 46% of group profit by FY15, from 22% in FY12. Domestically, earnings upside will also come from a new Crown Sydney development, potentially opening in late 2019.

Key concerns for brokers from this result were the weak gaming floor revenues in Melbourne, down 1.9% in the June half, although these did not translate to declining earnings as Crown effectively managed the cost base. It has further initiatives in place in FY14, although Citi is one broker which still expects margins to fall. Perth is improving but will also cycle a lot of one-off costs related to the re-launch and branding in FY13. Citi notes the consumer environment in Perth has the potential to slow materially given lower mining investment. Nevertheless, the Perth property is yet to realise benefits from additional car spaces, new gaming capacity, new hotel and cost optimisation.

Macquarie believes there's scope for further margin expansion from the cost base changes implemented in Melbourne as well as the transfer of cost efficiency lessons to Crown Perth, which has been re-branded from Burswood in September 2012. Macquarie is of the view this heightened efficiency should boost casino margins in Australia by 90 basis points in FY14. Crown continues to invest in its domestic facilities, which are currently acting as a drag on free cash flow. There have been some delays to the capex profile at Crown Towers Perth, which will now have the majority of spending booked in FY16. FY16 will be the peak period for capex as the completion of Crown Towers Perth coincides with the ramp-up of spending for Crown Sydney, in Macquarie's view.

Credit Suisse thinks it should be business as usual in Melbourne by FY15 and incremental revenue growth is expected to be driven by further VIP play, but Credit Suisse does not think margins will expand significantly as the VIP segment is generally a low margin business.

Crown's valuation is highly dependent on the Melco Crown JV share price. Citi has upgraded Crown's FY14 earnings forecasts by 11% and FY15 by 5%, mainly because of lower interest costs and Australian dollar forecasts. Despite this, following the recent strong share price run, Citi has decided to downgrade the rating to Neutral from Buy. Macquarie also finds the strong share price reaction after the result a dampener and, with limited returns from current levels, maintains a Neutral rating.

Credit Suisse went the other way and upgraded to Outperform from Neutral, incorporating a full valuation of Macau's Studio City into the model. Studio City is expected to open mid 2015 with 500 gaming tables, 1,500 slot machines and 1,600 hotel rooms. Today, Melco JV has a market capitalisation of US$14.5bn with essentially no net debt. The asset base is two casinos, plus expansion options. The broker suggests that the larger of the two casinos, City of Dreams, might be worth US$11bn, acknowledging the valuation seems generous given the risks of operating in an emerging market such as China.

Yet, if demand for gaming continues to grow in the region, Studio City has a similar capacity to City of Dreams and may be destined to be another US$1.0bn earnings casino. On that basis, using a cost of capital that probably understates the long-term history of business volatility in China, Credit Suisse thinks Studio City may reach a perceived value of US$7bn. Construction costs have been flagged at US$2.0bn. The broker's new valuation reflects a US$700m annuity stream from Studio City. Melco Crown will have 60-67% interest in Studio City.

One other item of interest to Credit Suisse, was the growth in Singapore. Singapore is a key competitor to Australia's VIP market and has been growing VIP volumes at both Marina Bay Sands and Resorts World, owned by Genting Singapore. In the most recent quarter both properties posted VIP volume growth in excess of 25%. Despite this, the broker cautions, the Singapore market is volatile and Singapore has more stringent regulation than Macau regarding international marketing agents. In Singapore they can only source high rollers and cannot provide credit to or share commissions with players. These are the key incentives which are used by these marketers in Macau to secure VIP business.

In terms of Australia's fledgling VIP market, Deutsche Bank notes turnover disappointed at both properties, up just 1.4% in the second half. This is an extreme contrast to the growth in the Macau and Singapore VIP markets. Melbourne was up just 0.5% and Perth was up just 3.9%.

It's not just about the glittering competitors offshore. Crown lost share in the second half and it is apparent to Credit Suisse that Echo Entertainment's ((EGP)) Sydney outfit, Star, is using its VIP tax-rate advantage to offer more attractive commission rates to VIP players. Players choose venues for a variety of reasons but price is one. Before Crown Sydney becomes a competitor, Echo is expected to double turnover with existing capacity. Crown has not revealed how it will deal with the price disadvantage other than continuing to invest in venues. Over the medium term, Credit Suisse expects growth under 10% in Crown's VIP business, which will get a renewed focus when Crown Sydney eventually opens for business.

On the FNArena database there are five Buy ratings and three Hold. The consensus price target is $15.30, suggesting 3.2% upside to the last share price. This target has increased from $13.99 ahead of the results. Crown plans to change its name from Crown Limited to Crown Resorts Limited, pending shareholder approval at the AGM on October 30.
 

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-Strong Aust growth in main brands
-UK Sage starts off well
-Growth despite margin contraction in America
 

By Eva Brocklehurst

Amid an earnings season beset by weak consumer confidence and retailer woes, Breville Group ((BRG)) has stood out. It is not often in the current climate that Australian operations are the highlight of the results. Even less so when it's consumer oriented merchandise. Breville hit the spot in this regard, as there was strong growth in both Breville and the discount Kambrook brands.

The small appliance manufacturer reported FY13 net profit of $49.7 million, up 8%, well ahead of guidance, and a final dividend of 12c. The results included $800,000 in restructure expense after the loss of the Keurig contract, and resulting from the downsizing of the Canadian operations, as well as $2m in start-up losses from the Sage brand launch in the UK. JP Morgan estimates a further $4m will be taken in costs in the next year.

North American margins are falling heading into FY14, with the loss of the Keurig distribution contract, but core revenue growth in the region remains strong, up 32% for FY13, and brokers see little cause for alarm. It may be early days for the UK business, having launched in May, but UBS also sees no reason why it won't be a success. The broker notes management commentary has been limited but early consumer reports and press coverage have been positive for the select items making up the Sage range.

More products are also rolling off the production line to assist growth in FY14, including the Oracle automatic manual coffee machine (automatic manual?). Yes, it's clever. There's also the QuickTouch microwave and the Crispy Crust pizza oven!

Macquarie notes the stock has rallied hard and is now above where it was before the loss of Keurig earnings. While Breville appears fully valued near term the broker was very encouraged by the strong momentum in international sales throughout FY13 and continues to believe in the international growth prospects of the brand. Macquarie also compares the result with competitor brand Sunbeam. The second half revenue growth of 8% and further margin expansion were in complete contrast to the performance of Sunbeam, which reported double digit sales and earnings declines. Breville has continued to outperform Sunbeam in the Australian market through its increased investment in its brand and growth in premium products. The Nespresso deal is expected to ramp up its contribution in the first half of FY14 after retailers run down existing ranges.

Breville is trading at a premium to small industrial peers at 17 times. While near-term upside is limited, valuation is justified, in UBS' view, given brand value, US momentum and the Asian and European opportunities. A Buy rating is therefore retained. In fact, on the FNArena database it's Buy nearly all the way. There are four Buy ratings and one Neutral (Credit Suisse, yet to update). The consensus target is $7.23, signalling 5.1% downside to the last share price. The target has moved from $7.11 ahead of the results. Targets range from $6.02 to $8.20.

UBS has raised earnings forecasts for FY14 by 0.4% and FY15/16 by 2.5%, largely the result of increased Australian/US revenue growth assumptions. Management has not provided guidance for FY14, but the broker expects more clarity on an earnings range later in the year. The results beat JP Morgan's forecasts. The broker has now included the UK in revenue growth assumptions, albeit conservatively, and expects 20% revenue growth over the next couple of years and similar earnings margins to North America ex Keurig (16%). JP Morgan maintains this is highly conservative if the success the company has had in North America is anything to go by.

Sounds good. Are there risks? Yes, Breville is attempting to start a new brand from the ground up in the UK but JP Morgan thinks the endorsement of Heston Blumenthal will be instrumental in smoothing the way. The UK retail market is lacklustre but then that has been the case for some time. In the two months since the business started revenue has equated to $2.1m. The company incurred $3.6m in start-up costs but JP Morgan observes it generated significant publicity and media support as a well as a strong backing from premium retailers.

Looking into FY14, the fall in the Australian dollar and the corresponding increase in production costs have the potential for a negative impact on margins. Given the large US dollar earnings and cash repatriated to Australia there is a partial natural hedge. The company has taken out forward cover for $30m of purchases at US95.5c which will afford time in which to adjust prices and ranges and minimise margin impact, in Macquarie's view.

See also, Breville Marked Up For Growth on June 14 2013
 

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-Good potential in Japanese acquisition
-Costs subdue European earnings
-Australasian profits strong
-Store roll-out, online offers growth
 

By Eva Brocklehurst

Domino's Pizza Enterprises ((DMP)). The name tells the story. Takeaways from the latest result? JP Morgan is excited, especially about the acquisition of a 75% stake in Domino's Pizza Japan. Key to the broker's optimism is the company's record of executing on acquisitions and boldly taking market share.

JP Morgan cites the fact the company turned around a loss-making European business to generate $6m in earnings within 18 months. FY13 results were affected by weakness in Europe. Profit rose overall but it was the Australian and New Zealand businesses that contributed the strength. The company expects FY14 earnings will grow around 15%, and helping this along will be the acquisition of the Japanese stake. The remainder of the Japanese business will be retained by the vendor, Bain Capital. The price paid equates to a multiple of 10 times trailing 12-month earnings versus the 18 times on which Domino's is currently trading. Brokers think the price is inexpensive, when coupled with the 15% growth expectations. JP Morgan thinks it's time to be Overweight.

Credit Suisse also believes the acquisition is sound. It is already a profitable business and there is growth ahead in store numbers. Domino's can leverage current expertise to improve services and deliver margin expansion, the same way it did locally. Nevertheless, the acquisition is only marginally adding to forecasts because of the downgrades from the European division. Credit Suisse does expect European profit margins will recover in FY14 but growth will be challenging. It's a matter of the company meeting guidance, rather than materially exceeding it as has been the case in the past.

FY13 sales were up 11.3% and underlying earnings 16.2%. European sales growth was a strong 25.2% but there was significant cost escalation and this reduced earnings growth to 7.3%. The reason costs grew in Europe was the significant roll-out of corporate stores in the Netherlands which, in Credit Suisse's view, led to poor cost management in food and labour sourcing and a reduction in margins. There ware also increased logistics cost from the French commissary being unable to supply the new stores in an efficient manner. Add to that legal costs from the Speed Rabbi Pizza proceedings and a restructure of the European management team.

Credit Suisse thinks Europe is a longer-term proposition and the Japanese expansion should diversify growth and reduce the focus on Europe. JP Morgan expects the European disappointment is short term. Issues are being addressed and, coupled with roll-out of digital ordering platforms, earnings and margins should improve. Macquarie is in much the same camp, viewing the new region as preferable to an acquisition in a related sector. It provides a scale entry, significant earnings accretion and should more than offset Europe.

Increased scale, improved product mix, increased online ordering and the continued sell-down of corporate stores drove margin growth in Australasia. The company should be able to improve margins given the roll out of digital technology and the global POS (Pulse) system in Europe as well. In March 2013, an iPhone application and mobile website were launched in France. Online has now reached 25% of sales in France. The Pulse system has been rolled out to 50% of stores in The Netherlands with the remainder expected to be completed by October 2013.

Domino's is the third largest pizza delivery chain in Japan with 259 stores, comprising 216 corporate stores (83%) and 43 franchise stores (17%). It commenced operations in 1985. Bain Capital acquired the business in 2010. The market has had relatively flat growth potential but JP Morgan thinks the company's strategy will be to gain market share off competitors. This is similar to what was achieved in Europe, where the company entered as the number two or three player. Europe was a loss-making business when acquired, and yet the company was able to quickly gain number one share and turn around the business and post profits within a year.

Domino's aims to grow the Japanese business to 600 stores, which equates to a 28% share of chained pizza stores. This compares to Australia, which is currently at 28%, and in Europe, where the company has 23% of chained stores.Traditionally Japan has been a delivery model and most of the sites are in back streets, which are low cost but have low visual impact. Since April 2012, there were nine re-locations and the Japanese entity was able to generate good returns on these. Domino's expects more than 25% of the existing network can be relocated. This is assisted by supply coming onto the market with a large number of convenience store retailers, such as 7/11, upgrading to larger floor spaces. JP Morgan expects the increase in supply will help keep costs low and there is a less onerous regulatory environment in Japan - it is as easy to open a store in Japan as it is in Brisbane.

There are four Hold and two Buy recommendations on the FNArena database. The consensus target price is $11.69, signalling 1.1% downside to the last share price. It compares with $10.90 before the result.
 

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-Overall sales trend improving
-Price deflation eases for now
-Will gross margins hold up?
-Higher margin sales and scale are key
 

By Eva Brocklehurst

It's all about discounting in retailing these days. In a highly competitive environment how much margin-crushing discounting can be avoided? In the case of electronic - and recently home - goods retailer, JB Hi-Fi ((JBH)), what's ahead for margins makes or breaks a good report.

JB Hi-Fi reported an 11.2% increase in FY13 profit and declared a 22c final dividend. Sales rose by 5.8% to $3.3 billion. Gross margins increased by 43 basis points to 21.5%. So far so good. Cost of doing business as a percentage of sales increased to 15.1% from 14.9%, not so good. Like-for-like sales eased back 0.6% over the year. Not good. The improvement in first half gross margins expanded into the second half as positive comparatives contributed to the numbers. Margin expansion seemed to be reflecting better prices rather than the mix of sales, in Macquarie's view. Will it last? Price is still a major focus for the company but depth and frequency of price deflation has slowed, for the time being.

Traditional categories are still underperforming. Australian visual sales were down 11.9% and software down 2.6%. New sources of revenue were from online and digital channels and products from the new HOME segment. Online sale are now around 2% of sales. There's still some way to go for these new categories, in Macquarie's view. Management expects 6-8% revenue growth in FY14 but home and digital strategies might require more time to generate earnings growth. Macquarie thinks all the positives are factored into the share price now, anyway, and has decided it's time to downgrade to a more Neutral view on the stock.

UBS takes a different tack, believing the stock is well placed to outperform in the medium term. This is reflective of  the forecast earnings and good inventory and cost control. Sales momentum is also improving in growth categories such as telecommunications and seen stabilising in visual segments. Guidance includes contributions from online, commercial and home and UBS, adjusting for this guidance, finds this implies like-for-like growth of 0-2%. This may be light but the broker thinks it could prove conservative because of new gaming releases and improving trends in audio visual software, as well as rising prices. UBS notes the trial of the HOME store format has proven successful in delivering incremental sales and there's been no negative impact on the existing offering.

Citi retains a Sell rating. The company may have restored its growth trajectory and stepped up the focus on sales but the broker thinks there will be some gross margin erosion as lower margin categories drive overall growth. Pressure from competitors will continue to feature, given the high sales productivity of the JB Hi-Fi stores. For Citi, it's about lower long-run earnings margins. Margins are expected to drop 170 basis points over the next four years as growth in sales per store fails to keep up with the growth in costs per store. What stands JB Hi-Fi in better stead in this regard is that, at a long-run margin of 3.8%, the earnings per square metre for JB Hi-Fi is still higher than any other discretionary retailer under the broker's coverage because of the sales productivity per store.

As the company has made it clear the focus is on sales, not margins, Citi thinks there will be a negative mix impacting on FY14. Accelerating cost growth will also be a challenge as staffing and contracted lease costs are growing 3-4% per store - a problem when comparable store sales growth is less than 3%. Other negatives in the mix for FY14 are the more costly gaming consoles, where margins are less than 10%. This may be improved by attached software but it's still a low margin category. Software categories such as CDs and DVDs are nearer to a 30% gross margin and the decline in sales of these categories in FY13 hurts. What's positive on Citi's score card? Increased scale. JB Hi-Fi is a top retailer in computers and has a growing share of other sectors. It can squeeze suppliers harder. The other is reduced discounting activity, given the rumours that Dick Smith Electronics may be up for public offer.

Compression of gross margins is the concern for JP Morgan as well. Sales trends may be improving and, importantly, profits but the medium term outlook for margins worries this broker, as a result of changes in the sales mix and the industry challenges. The long-term sustainability of like-for-like sale growth is questioned because underlying growth is soft. It's not enough to change JP Morgan's viewpoint (Neutral) while earnings momentum is improving. Yet.

On the FNArena database the consensus target price of $16.75, signalling 11.4% downside to the last share price, compares with $15.20 ahead of the results. There are two Buy, three Hold and three Sell ratings. On FY14 consensus earnings estimates the dividend yield is 4.0%, on FY15 it is 4.2%.
 

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-Inventory build strategy questioned
-US commercial cycle may be turning
-Strong lift to Oz high-end sales expected
 

By Eva Brocklehurst

Treasury Wine Estates ((TWE)) has taken a few hits on the chin recently, none the least being a hefty inventory write-down. Some brokers think the stock may be a little punch drunk and have reviewed its value. After all, the company does have some nice product for which demand is always there. Macquarie put the thesis about some months back that Penfolds was by far the most valuable of the assets and the rest of the brands were just complicating the story. More on that later.

Deutsche Bank took a look at Treasury Wine's inventory recently, assessing the merits of accumulating wine inventory for sale at a later date. That is, seeing whether the price appreciation for vintages of premium wines over several years delivers a return to shareholders if inventory is held back from sale. The trigger for this re-assessment is that non-current inventory has lifted materially over the second half of FY13, driven by an impressive 2012 vintage.

Deutsche Bank's analysis suggests that, in most cases, it is better to sell the wine. Price appreciation in Treasury Wine's premium wines has been insufficient to justify the accumulation of inventory for later use. There are some merits to accumulating inventory in a good year because it can smooth earnings in the event of a bad vintage but, to the broker, this is the process of normal business and should not be a driver of the stock price. To that end, Deutsche Bank retains a Sell rating, given the stock's stretched valuation and poor return profile.

Treasury Wine will write down around $200m in FY13 in inventory and lost revenue. Credit Suisse summed up the initial reaction to the news by noting the decision avoided the issues of strategy, governance, accountability and brand equity. The lack of investor confidence in these issues was expected to put pressure on the share price in the medium term and it did.

Subsequently Citi decided to be more positive, upgrading the stock to Neutral from Sell to incorporate a cyclical upturn in the US wine industry. The Americas business will benefit from a growing shortage of US wine grapes and this should drive Treasury Wine's margin higher, by 970 basis points from a trough in FY14. US commercial wine has the most upside for Treasury Wine, in Citi's opinion. While high end wines are enjoying solid growth, low end wines continue to face intense competition caused by excess supply. For Treasury Wine, this commercial segment accounts for 70-80% of volume, but only 30-40% of earnings. The flagship Penfolds brand - Penfolds Bins, RWT, St Henri and Grange - make up only 0.2% of US volume. While the commercial segment faces current hardship, this is where Citi sees the best opportunity if the wine cycle turns.

Treasury Wine is also the price leader in Australia and is raising prices on higher end wines, while discounting some of the foundation brands such as Wolf Blass and Lindemans to maintain market share. Citi thinks this should continue, and expects the market will be surprised at how strong second half FY13 earnings are. Citi is still not getting carried away. The industry is tough, with more producers, fewer retailers and greater competition for Australian wine. In the US business the fight is still on to retain market share. Moreover, the broker suspects Treasury cannot achieve a return on investment capital above the cost of capital.

Away from the US business, BA-Merrill Lynch has also turned more positive and thinks the high quality of the Australian asset base is not getting enough attention. Sure, Australia has not been flavour of the month for a few years overseas but the broker sees a chance that sales of high quality wines could nearly triple by FY15/16. This should be sustained through Treasury Wine's ability to replenish the higher volume of sales via increased production rates.

Treasury Wine has iconic assets in Australia that are seen as largely irreplaceable. Also, there's little debt on the balance sheet and Merrills lauds the investment strategy to increase the availability of high-end wines via vineyard expansion and inventory build up. This increase in long-term inventory has been achieved via investments made in the past three years. To Merrills this build up is not detrimental. Within a year or two, the broker expects nearly $700m of long-term inventory to underpin the company's ability to sell three times what it currently sells in high-end wines. Merrills estimates that around 90% of Treasury Wine's current earnings are sourced from its Australian wine production capability.

The company is expected to generate $275m more earnings in FY15 than in FY13. All of this growth is expected to be sourced from Australian production. The earnings contribution to the US is expected to grow by around $40m, but this should come from Australian exports. Merrills does not factor in Treasury Wine's US business - US wines for the US market. The current low share price is seen offering a good buying opportunity and the broker stands out on the FNArena database with a $10 price target. Minus this outlier the target range is $4.10 to $5.75.

The softening of the Australian dollar has helped export margins but JP Morgan suspects it has quickly been factored into the share price. The broker also thinks consensus earnings are not properly factoring in the balance sheet expansion required to fund Treasury Wine's luxury wine expansion. The broker thinks this expansion will undermine the valuation over time. This will make the stock look increasingly expensive once rising debt lifts the enterprise value.

Macquarie also does not believe the current strategy is creating value. The business is too big and complicated to be successful. Despite this negative, Macquarie has recently upgraded the rating to Outperform from Neutral. The Penfolds Wine Company is the key and Macquarie thinks creating value out of that business alone is the way to go.

On the FNArena database Treasury Wine has five Sell, one Hold and two Buy ratings. The consensus target price is $5.34, up from $5.20 at the end of July and suggesting 7.8% upside to the last share price.

See also, Treasury Wine's Future Red Or White on July 16 2013
 

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- TWE writes down US inventory
- management still operating on blind faith
- value lies only in corporate action

By Greg Peel

Celebrated British wine expert and TV personality Oz Clarke unwittingly launched Australia’s highly successful export wine industry back in the 1980s, according to a recent documentary on the history of Australian wine. A bold young Australian winemaker approached Clarke at a tasting in the UK and asked him what British drinkers would like in a good table red and what they would be prepared to pay. The winemaker took the answer home and a year later returned to the same annual tasting, with bottle in hand. Clarke loved the wine, and the days of Ben Ean and Cold Duck were over. Welcome chardonnay and shiraz. The French were livid.

Australian wine boomed, and Britain and the US couldn’t get enough of the stuff. Eventually the large corporate players cottoned on to the sort of earnings growth the fledgling winemakers were posting, and decided it was time to move in. The pinnacle was reached in 2005 when beer-maker Foster’s acquired wine conglomerate Southcorp for a hefty price. By then, Australian wine’s global honeymoon was over. Foreign drinkers had moved on to new wine fads and styles. Australian wine hit the discount bins.

Thereafter followed an Australian grape glut, around about the time the GFC curbed consumer spending across the globe. America had begun to develop its own successful winemaking industry, once again highlighted on a television program by Oz Clarke and his mate James May. Even British wine hit the restaurants. In 2011, a desperate Foster’s spun off the old Southcorp into a new listing, Treasury Wine Estates ((TWE)). The remaining beer division was soon swallowed up by global brewing giant SABMiller.

While wine had brought Foster’s almost to its demise, in 2011 analysts largely agreed that the upside value was contained in TWE and its iconic brands and not in the mature beer business. Initial hopes were high that TWE could improve from a low base, as long as nature was compliant, and as long as management adopted a realistic and sensible strategy. In 2013, nature is forever unpredictable but analysts suggest TWE management has manifestly failed, relying solely on blind faith.

The issue has been one of unsold inventories building up with US distributors. While other wine suppliers discounted prices in the GFC fallout to clear stock, TWE failed to do so and relied instead on a belief that not only would consumer spending cycle back up again, but that Americans would fall in love with Australia’s tired old brands all over again. Yesterday, TWE bit the cork and wrote down its excess US inventory. “The fix is long overdue,” says Citi. But there remains an element of denial in the manner in which management has gone about the write-down. Says UBS:

“TWE [has confirmed FY13 earnings] of around $216m bit if we consider that some of the profit generating volume has been effectively brought back and written off below the line (channel stuffing) the number appears meaningless”.

Credit Suisse was less polite in suggesting:

“TWE’s ASX announcement flagging $200m in inventory write-offs and lost revenue avoided the big picture issues of strategy, governance, accountability and eroding brand equity…Years of trade loading allowed management to avoid truly confronting the brand equity issues in the business, in our view”.

The truth is, as Credit Suisse points out, TWE’s market share in the US has roughly halved over the past six years. The influence of Beringer, TWE’s major US producer, in the wine trade is now greatly diminished. The Macquarie analysts have pointed out in the past that the story being told by management of building exceptional brands and driving top line growth have failed to manifest on the profit and loss statement. TWE has continually failed to match demand-based forecasting estimates with actual underlying demand for its brands. The company is blaming distributor business models, Macquarie notes, when lower sales are obvious in consumer data.

Underlying conditions in the US and UK remain tough, notes Deutsche Bank, “brand Australia” is out of favour and TWE’s US inventory base is too high.

How hard can it be to sell Grange? Well therein lies the conundrum. Hidden behind the dust-gathering cases of vin-very-ordinaire is a little gem called Penfolds, about which both a couple of brokers have a specific opinion.

CIMB has downgraded its rating on TWE to Sell in the wake of the write-down announcement, bringing to six from eight the number of FNArena database brokers with Sell or equivalent ratings on the stock. An inventory write-down has long been expected by analysts, but none are much amused with the way it was implemented.

TWE will take a $160m provision against US inventories in FY13, made up of a $35m for the destruction of aged inventory, $40m in discounts to distributors to clear excess current stock, and $85m associated with carrying excess bulk and bottled wine and onerous contracts for grape purchases. In order for TWE’s FY13 profit guidance of $216m to be maintained, the profit from selling excess wine to US distributors is taken above the line and the cost of clearing it from distributors is taken below the line. What this all means is that reduced shipments in FY14 mean FY14 earnings will start $30m below FY13. Or put another way, FY13 earnings will really be $176m, not $216m.

Analysts were expecting a write-down, but they were not quite ready for neither the extent nor the accounting smoke and mirrors. And while analysts welcome the long-awaited inventory consolidation, they are not yet sure that management has had the epiphany it needs to be able to successfully exploit this new starting point. TWE is still attempting to promote a “luxury wine” story when inventory is failing to move. There is potential for further downside, analysts suggest, and despite yesterday’s 11% share price thrashing the market is still over-valuing the company, ascribing a high multiple to a stock beholden to the vagaries of not just global fashion, but also to the weather.

“We continue to believe that the share price is factoring in optimistic assumptions,” says JP Morgan, “regarding both the quantum and timing of the impact of TWE’s investment in sustainable luxury wine supply. In addition, we think consensus earnings forecasts fail to incorporate the balance sheet expansion required to fund TWE’s luxury wine expansion”.

Analysts have now cut earnings forecasts and reduced price targets, dropping the consensus target to $5.20 from $5.47 previously. That doesn’t seem like much of a cut under the circumstances, and with the stock trading around $4.70 today the raft of Sell ratings seems misplaced. But if we take Merrills’ target out of the mix for a moment, the consensus target falls to $4.51. And if we take Macquarie out as well, it falls to $4.30.

In Merrills view, TWE’s US wine business is worth $1bn, with the vineyards alone worth $600-800m. But the analysts don’t believe that value can be realised under the current structure. They believe the asset would need to be sold to realise the full value for shareholders.

Merrills is sticking to its $10.00 price target and Buy rating.

Macquarie’s target, also unchanged, is not as ambitious at $5.75, but the analysts have upgraded to an Outperform rating on yesterday’s share price drop. Macquarie, too, believes the current business strategy is not creating value for shareholders. The current business is too big and too complicated, and more personnel changes are likely within management. TWE needs to look at a corporate strategy, the analysts entreat. Bring on The Penfolds Wine Company.

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