Treasury Wine Estates (TWE), maker of Penfold’s, Wynn’s, Wolf Blass, Lindeman’s, Beringer and Rosemount premium wines, delivered what I consider the standout result and outlook of the large cap Australian reporting season. I remain of the view that TWE is a high conviction investment and will be further re-rated as the best premium wine play in the world.
TWE is now the 3rd largest wine maker globally. They are the only pure-play large-scale premium wine maker listed globally. All their large-scale competitors also produce lower margin spirits and/or beer.
TWE ticks every box of our investment process here at AIM. It has a stable of strong brands, it has strong management, it has a strong balance sheet, strong cash generation, strong margin growth, strong earnings growth, strong dividend growth and a global market place for its products. Even better, it was a spin-off from a big company (Fosters) and its Board also rightly rejected what now appear low-balled takeover offers from private equity.
I last wrote to you on TWE in mid-March after their strong interim result. TWE shares were $9.31. That was a bullish note on TWE and I hope many of you bought the stock (or invested in AIM), with TWE now $11.25 and cum a 12c final dividend.
Since then, our conviction has increased further in TWE and the AIM Global High Conviction Fund has an even larger investment in this stock (via stock price appreciation and further stock purchases). The FY16 results and outlook statement (management very bullish), which drove strong consensus earnings forecast upgrades, have played the main role in our conviction growing even further in TWE as a medium-term investment.
Back in March I wrote “I believe TWE is a classic example of a structural growth stock. I believe the macro tailwinds for Australian export wine will remain strong and TWE has the management team to deliver on the China opportunity. All things being equal TWE should be a core portfolio holding for the next 3 to 5 years as it delivers way above market (asx200) EPS growth and gets re-rated to a true global luxury brand stock”.
Fast forward to today and the vast bulk of large cap Australian stocks have experienced consensus earnings DOWNGRADES after reporting FY16 earnings, while TWE was one of a small group of stocks that experienced solid consensus earnings upgrades. That in itself makes TWE relatively more attractive for FY17 than its large cap Australian peers, who are broadly “ex-growth”.
To put the TWE upgrades into context, FY17 consensus EPS forecasts have risen from 36c when I wrote to you previously on TWE to 39c today. FY18 has been upgraded from 41c to 47c EPS. Both forecasts will prove too low in our view with TWE more likely to earn 41c in FY17 and over 50c in FY18 in AIM’s view.
Analysts, with the notable exception of David Errington at Merrill Lynch, have consistently UNDERESTIMATED TWE’s earnings growth and cash conversion power over the last few years. That continues to this day and we strongly believe that consensus earnings estimates for TWE will prove conservative and the earnings upgrade cycle, which has driven the capital growth in the share price, will continue. The chart below tracks FY16 TWE consensus earnings forecast (RED LINE) and the TWE share price. Unsurprisingly, earnings forecast were raised from 25.6c to 30.8c (+20.3%) over the period to June 30 and the share price rose around +50%, as the market added P/E multiple as growth was confirmed.
I see this happening again in FY17 and FY18, as consensus earnings forecasts get revised higher as time progresses. There’s a clear chance that FY18 consensus earnings could be -25% too low, and if that proves right, TWE’s share price will be significantly higher than what we see today.
It would appear that analysts and investors are underestimating the TWE transformation led by CEO Michael Clarke. TWE is transforming from an “order-taking agricultural company to a brand-led marketing organisation”. Clearly, the P/E differential between those two businesses is large and if TWE continues to execute this stock will go to a global luxury brand P/E rating as I have written previously.
The best way to confirm the move from an “order-taking agricultural company to a brand-led marketing organisation” is via looking at EBIT and particularly EBIT margin growth over the last three financial years. This trend will continue.
TWE confirmed they now expect to deliver “high teens” EBIT margins a full two years ahead of what they previously guided. This was the BIG news in the result and drove the consensus earnings upgrades.
To me sustainable margin increases are the true test of whether management is adding economic value. TWE’s sustainable margin increases are driven by portfolio “premiumisation”, supply chain savings and strong execution of brand building activities. All classic examples of management genuinely adding value.
You can also see clear evidence of management adding genuine economic value by the lift in ROCE, ROE and cash conversion.
So what is TWE doing better that is driving these significantly better returns in the business?
Answer? EVERYTHING.
However, the key answer is managing premium wine inventory far more commercially/profitably.
Inventory for a wine producer is the basis of future earnings. TWE has had a considerable lift in both short-term inventory sales and long-term inventory sales. Short-term inventory has increased by $200m to $904m, with $120m of this increase being in “luxury wine”. Long-term inventory has increased by $155m to $678m, with $135m of this increase being luxury wine. The mark of excellent management is this increase in inventory was achieved whilst cash conversion (cash realisation) was above 100%. The $200m increase in short-term inventory should deliver at least a $600m increase in FY17 sales and at a higher margin, given the richer mix of luxury wine.
TWE has also dramatically changed the relationship with distributors.
TWE has enforced with retailers to receive all sell-thru data (usually within two weeks) ensuring that there is no excess inventory in the system and margins are better for both TWE and retailer. By selling directly, they have prevented parallel shipments to China from excess inventory elsewhere.
They stated that Australian retailers had been deprived of excess Penfold’s volumes (sent to China) but had been treated as partners with a broader range of brands, so that profits by retailers were maintained. Prior to current management’s new structure, distributors had taken up to 50% mark-up and controlled the demand.
Highlights from the TWE investor conference call
My fellow AIM portfolio manager Angus Wright and myself have been on thousands of conference calls over the years. It is quite rare to be listening to a very, very bullish one where the CEO is showing complete confidence.
The TWE conference call was extremely bullish and I have selected a few quotes from the CEO himself for those of you who don’t have access to these investor conference calls.
General business conditions
TWE’s base business [i.e. excluding the acquired Diageo assets] reported EBITS of AUD 309 million, up 37% on a reported currency basis.
“Momentum across our business is accelerating. Sales growth is translating to even higher earnings growth as we optimize our brand building investment, and remain disciplined on managing costs… I am therefore very pleased to announce that we’ll now expect to deliver high-teens EBITS margin by fiscal 2018, two years ahead of previous guidance.” [This compares to a reported EBITS margin of 14.6% in FY16]
“Cash conversion of 123% in fiscal 2016”
Inventory
“For TWE, the 2016 vintage was at least as exciting in terms of size, yield and quality as the 2012 vintage. Total inventory has increased by AUD 344 million, of which AUD 255 million is luxury wine, delivered from the 2016 vintage as well as the acquisition of Diageo Wine. As at the end of the financial year, TWE now holds close to AUD 800 million of luxury wine on its balance sheet. Not only was it a terrific vintage but the two phases in the 2016 wines have been crafted under TWE’s now more efficient production and packaging network. In other words, the wonderful wines that we produce have gone into our balance sheet at lower production costs.”
Asian growth
“In fiscal 2016, we delivered EBITS growth and stable EBITS margin despite portfolio diversification and elevated investments in our brands and our people. We expect this momentum to continue in fiscal 2017. Depletions of our wine in China, which we see by customer each month tell us that we could still sell significantly more wine in China than we are today. TWE has the brand, the execution and the people to sustain our current trajectory. With less than 3% value share that total imported wine category in Asia, our growth and success in this region has still only just begun.”
“Wolf Blass revenue for last year went up more than 50% for the year in China.”
“We’re going to have a massive first half in Asia as we launch the American brands in Asia.”
FY16 clean-up and FY17 outlook
”After the first half, we knew that we were tracking to be potentially even well above the number that we quoted, the way that we’ve delivered for fiscal 2016. And so, we chose to use that back half of the year as an opportunity to just clean up everywhere around the world, which we’ve done. And I think people should hopefully be pleased with the quality of the results that we’ve delivered while at the same time, we’ve done a massive clean-up in our business… By the way, we’ve destocked the distributors, we’re destocking ourselves at the back end of the year.”
On the FY17 outlook: “I guarantee you’ll fall off your chair in February again.”
In summary, why would you doubt a CEO who delivered four earnings guidance upgrades in FY16?? He has genuine credibility but the analysts still don’t believe him. Therein lies the medium-term investment opportunity as consensus earnings forecasts remain too low for the short, medium and long-term.
We believe TWE earnings per share will grow by a minimum +65% over the next two reporting periods (FY17 +FY18). If everything goes right, that number could be +100% EPS growth over the combined coming two financial years. That is world-class earnings growth and will lead to a further share price re-rating.
I’ll finish today as I did in March in my first note on TWE…” TWE fits into our broader high conviction theme of the rising Chinese consumer. If this goes according to plan, and so far it has, TWE should be re-rated to a mid-teens share price over the years ahead and could also become a takeover target by another global alcoholic beverage major.”
The AIM Global High Conviction Fund owns TWE shares.
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