Acquisition of Diageo Business Set to Accelerate Treasury Wine Estates' Growth in the United States

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Equity Bottom-Up

<div class="content-highlight"><p style="text-align: center;"><em>Treasury's premium portfolio a boon, but shares look overripe.</em></p></div><p><a href="https://www.smartkarma.com/entities/710" target="_blank" data-smartkarma-citation="entities:710:1">Treasury Wine Estates Ltd (TWE AU)</a> has proved to be one of Australia's great recent turnaround stories, but the market's glass looks more than half full. We credit management for restructuring the winemaker's focus on the rapidly growing premium wine market since CEO Michael Clarke joined in 2014. However, the market has priced the stock at an increasingly high multiple to earnings, and shares now look substantially overvalued. We applaud the company for walking away from low-priced commercial bulk wine production that led to distributor inventory problems, write-offs, and wine destruction in prior years, focusing instead on higher-quality and higher-priced wine, which has improved profitability and returns on invested capital. But we expect earnings to slow and the high earnings multiple to ultimately collapse, and recommend a much lower price before considering long-term investment in Treasury Wine's shares.</p><p>Despite a rosy valuation, the future for Treasury Wine remains solid, especially overseas. Although many of the firm’s most well-known and highest-priced wines, such as the iconic Penfolds brand, are produced in Australia, the majority of earnings stem from Asia and North America. We expect these two regions to drive the bulk of income growth over the next five years, rising to 78% of operating income by fiscal 2022 from 68% in fiscal 2017. These gains will be driven by outsize economic growth in China, continued end-market premiumization, and positive profitability mix shift, albeit at a slower rate than the robust gains seen in recent years.</p><hr><h2>Key Takeaways</h2><ul><li>China has driven the bulk of Treasury's recent volume growth, and the company should benefit from rising imports, particularly from Australia. But the market overestimates the medium-term volume growth potential, which we expect to slow because of cultural limitations and more-limited GDP gains.</li><li>Treasury should enjoy the U.S. trend of increasing demand for higher-priced wines, boosting revenue growth and profitability. We forecast margins rising in this segment to 23% from 18% in fiscal 2017.</li><li>Despite rising margins and above-market top-line growth, we don't think Treasury has carved an economic moat. The firm faces competition from both larger, global players and smaller, fragmented wine producers. Meanwhile, customer switching costs are low, and consumers are often price-sensitive.</li></ul><hr><p><em>Analyst: Adam Fleck, CFA</em></p>

Treasury's premium portfolio a boon, but shares look overripe.Treasury Wine Estates Ltd (TWE AU) has proved to be one of Australia's great recent turnaround stories, but the market's glass looks more than half full. We credit management for restructuring the winemaker's focus on the rapidly growing premium wine market since CEO Michael Clarke joined in 2014. However, the market has priced the stock at an increasingly high multiple to earnings, and shares now look substantially overvalued. We applaud the company for walking away from low-priced commercial bulk wine production that led to distributor inventory problems, write-offs, and wine destruction in prior years, focusing instead on higher-quality and higher-priced wine, which has improved profitability and returns on invested capital. But we expect earnings to slow and the high earnings multiple to ultimately collapse, and recommend a much lower price before considering long-term investment in Treasury Wine's shares.Despite a rosy valuation, the future for Treasury Wine remains solid, especially overseas. Although many of the firm’s most well-known and highest-priced wines, such as the iconic Penfolds brand, are produced in Australia, the majority of earnings stem from Asia and North America. We expect these two regions to drive the bulk of income growth over the next five years, rising to 78% of operating income by fiscal 2022 from 68% in fiscal 2017. These gains will be driven by outsize economic growth in China, continued end-market premiumization, and positive profitability mix shift, albeit at a slower rate than the robust gains seen in recent years.Key TakeawaysChina has driven the bulk of Treasury's recent volume growth, and the company should benefit from rising imports, particularly from Australia. But the market overestimates the medium-term volume growth potential, which we expect to slow because of cultural limitations and more-limited GDP gains.Treasury should enjoy the U.S. trend of increasing demand for higher-priced wines, boosting revenue growth and profitability. We forecast margins rising in this segment to 23% from 18% in fiscal 2017.Despite rising margins and above-market top-line growth, we don't think Treasury has carved an economic moat. The firm faces competition from both larger, global players and smaller, fragmented wine producers. Meanwhile, customer switching costs are low, and consumers are often price-sensitive.Analyst: Adam Fleck, CFA

In Vino Veritas: We Don't Expect Treasury Wine's Growth Will Live Up to Its Inflated Share Price