Australia | Dec 01 2020
Can Treasury Wine overcome the loss of a large part of its Chinese market and re-direct supply to other regions?
-May not be the end of the tariff story
-Treasury Wine to ramp up marketing across other regions
-Oversupply likely to be largely directed to Australasia
By Eva Brocklehurst
It will take time for Treasury Wine Estates ((TWE)) to overcome the loss of its important and growing Chinese market for prestige wines. Can the company find redress in simply redirecting supply to other markets? To some extent, maybe, but unlikely is the chorus.
Provisional tariffs were implemented by the Chinese government on Australian wine imports to China from November 27. The rate, 169.3%, was materially ahead of most expectations.
Morgan Stanley assumes, at this point, that the legacy China business is largely untenable and sales from Treasury Wine into the country will essentially cease. The main priority will be the reallocation of luxury wines previously sold in China.
The broker assumes none of the company's commercial and masstige wines are reallocated and 70% of luxury wines sold into other markets will be at a -10% reduction in returns per case, calculating, all up, just 25-30% of volumes and 50% of current profits could be recovered from FY22.
Macquarie expects the tariff will effectively close the Chinese market to Australian wine imports for its duration, which is unknown at this stage. These provisional tariffs do not include any stated measure relating to the investigation of dumping and Morgans suspects another tariff may be forthcoming. Yet the company has indicated further tariffs are unlikely to change its plans.
To put this in perspective, Treasury Wine will still have some sales in China, likely at the higher end customer base that is not price conscious. Its Penfolds branded baijiu sales will not be affected as this is not standard red wine. Morgans suggests over time Treasury Wine may even look to bottle and package bulk wine in China. Bulk wine is not subject to the tariff.
Citi, downgrading to Sell from Buy, believes it will be difficult to maintain any presence in China and the turnaround in the Americas will become the driver of the share price. The broker expects marketing costs will have to rise and and also anticipates an earnings margin dilution of -10 percentage points in the markets where wines are re-allocated.
On the positive side, Credit Suisse believes the news is unlikely to get worse now that China has announced the provisional measures, upgrading Treasury Wine to Outperform, assuming heavy tariffs remain in some form through to FY23. The broker anticipates the Asian business will return to pre-pandemic, pre-tariff levels in FY24.
UBS considers the risk/reward now balanced, assuming around 10% of earnings from China can be recovered. Value is there as, ex China, valuation is assessed at 14x earnings. Nevertheless, with heightened uncertainty and few upside catalysts the broker downgrades to Neutral from Buy.
To put perspective on the scale of the reallocation, around $1bn of Australian industry wine exports need to be reallocated, along with existing export markets worth $1.3bn and the $5bn domestic wholesale wine market.
A mitigation strategy is expected to take 2-3 years and profitability in FY21 as well as cash flow may be affected by the need to reinvest. That said, Treasury Wine has signalled it has plenty of liquidity and will ramp up marketing across other markets that were previously under-supplied with the Penfolds brand.
In terms of China, Treasury Wine will also accelerate its multi country-of-origin wines, particularly from the existing asset base in France, the US and even China, as well as strip out costs. A globally standardised margin structure will be applied.
Morgans notes the first Penfolds release from France is not available until FY23 while a range of Penfolds red wine from Californian vineyards will be made available from March 2021.
The broker removes expected earnings from China from its forecasts but stresses it is extremely difficult to make forecasts given the multiple mitigating strategies now being put in place. The main unknown is how much additional investment will be required to promote Treasury Wine's brands in less well-known markets.
Moreover, the resulting oversupply of masstige/commercial wine in the Australian market will affect the Australasian business. The main upside risk the broker envisages is the removal, eventually, of the tariff. Given the strength of Penfolds in particular the possibility of corporate action also persists, Morgans adds.
Macquarie conservatively brings Chinese volumes to zero for the next 2.5 years and re-allocates some volume to other regions. Downside risk for the short term is on margins, although the broker assumes the company can scale its Asian cost base appropriately.