Treasury Wine Crushes China Worries

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

Brokers are relieved at how Treasury Wine Estates dealt with speculation that inventory was building up in China. Nevertheless, they disagree on valuation.

-Customer depletions in China have more than doubled and all brands show growth
-Main issue in China is sustaining volume growth and extending reach beyond Penfolds
-Outlook less clear for FY20 as 2017 was an inferior vintage
 

By Eva Brocklehurst

Treasury Wine Estates ((TWE)) has hit back at speculation regarding excess inventory in China, outlining the rigorous audit process that allows it to take action should distributors not play by the rules.

Most brokers were relieved with how the company dealt with the speculation that inventory was building up in China. The company has recently cut off supply to a number of customers after they failed to appropriately sell through the full portfolio of wine.

CLSA suggests these customers were not impressed with the move and are trying to manoeuvre their way back into accessing the company's wine. Treasury Wine has emphasised that picking and choosing wine by distributors/customers will not be tolerated and they need to sell the full portfolio.

Meanwhile, customer depletions in China have more than doubled in the last quarter and all brands are showing growth, so the company suggests there is no inventory problem. The response makes CLSA much more comfortable. The broker, not one of the eight stockbrokers monitored daily on the FNArena database, upgrades to Buy. Target is $21.

Morgan Stanley agrees that, even if the company is playing hard ball in China, in the long-term it will strengthen the stable of brands and, if Treasury Wine gives in to distributor demands, it would not be in full control of its marketing.

The broker believes the company's US wine is important to the expansion in China, estimating Treasury Wine generates $20m in annual sales of US product to China, or 8% of its sales to China.

Citi takes a different view. The broker is encouraged by the company's assertion that depletions grew 100% in the year to date in China, as this suggests any build up in inventory is not widespread, but questions why the company's lower-end wines are increasingly being discounted in e-commerce channels in China.

The price premium paid in China versus Australia for Rawson's Retreat was 30% last year and has been observed at 5% recently. The broker forecasts price per case for Treasury Wines Asia to fall -7% in FY18, the cause being a shift towards lower-priced wines.

Citi has a Sell rating and does not believe the pace of growth justifies the stock's P/E ratio, and there is downside risk to volumes as demand for brands other than Penfolds grows more slowly.

Distribution Centre

The company has acknowledged slower volumes in China since April because new labelling laws have specifically affected those with warehouses. Citi suspects this action is quite targeted and a reminder of the regulatory risks of dealing in China.

The Chinese government has cracked down on exports to Treasury Wines' Chinese distribution centre but the company is able to export directly to wholesalers and retailers, as Morgan Stanley understands it.

The distribution centre was established in 2017 to serve small customers and the financial impact of shipments being curtailed appears limited to the broker. Credit Suisse suggests the company can, for example, increase shipments to customer warehouses rather than its proprietary warehouse but ascertains that, for most investors, such situations are rather opaque.

Regardless, the main issue for the company in China is sustaining the pace of volume growth and extending reach beyond Penfolds, in Citi's view, and sustaining a healthy price per case would be the best evidence.

Moreover, because sales of premium Penfolds product is formally tied to sales of Rawson's Retreat and other brands like Wolf Blass, the broker considers this situation unsustainable and suggests consumer demand must ultimately determine sales.

Morgan Stanley calculates that excess quantities of brands outside of Penfolds, which is estimated to be 70% of the company sales in China, are unlikely to affect earnings significantly and is now more comfortable with the outlook.

The company reiterated guidance for operating earnings (EBITS) of $524m in FY18 and $655m for FY19, which Morgan Stanley believes underscores an unchanged outlook and signals the sell-off in the stock is overdone.

Credit Suisse asserts that the media reports were old news and exaggerated, noting that as far back as July last year there were issues in China around the Rawson's Retreat brand and the company had begun to rectify the situation.

Outlook

FY19 guidance for 25% growth in operating earnings is considered achievable and the issues are small enough to be contained. Nevertheless, FY20 consensus estimates are too high and the broker expects the stock to be range bound.

There is potential for an accretive acquisition but, unlike when the uncontested Diageo deal was done, interest rates have risen and the multiple the company is likely to pay for quality will be higher. Credit Suisse upgrades to Neutral from Underperform until there is more confidence surrounding FY20 estimates.

Also, the 2017 vintage was inferior to 2016 so the company may not have the uplift in luxury volume that will benefit FY19. 2018 is envisaged as a high-cost vintage which the company is now likely to defray with a new cost reduction program.

Ord Minnett is confident that the company is executing well, and having optimised the route to market for the wine in China is now doing the same in the US. The broker believes Treasury Wine is well-placed to access the structural growth drivers of the Asian wine market, despite recent customs issues in China.

The company has a disciplined approach to capital, which in the broker's view provides potential for strong earnings growth on a multi-year basis. While acknowledging the multiple is high, Ord Minnett suggests growth in earnings per share is also very high and maintains an Accumulate rating.

There are three Buy ratings, three Hold and one Sell (Citi) on the database. The consensus target is $17.13, signalling 0.6% upside to the last share price. Targets range from $13.30 (Citi) to $20.00 (Morgan Stanley, Ord Minnett).

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