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The biggest test for Australia's most famous wine brand

Penfolds has a 176-year history but its resilience is being severely tested by the China trade row, and re-directing product to other markets isn't that simple.
Simon Evans
Nov 16, 2020

Penfolds is the most famous Australian wine brand and has been on a rollercoaster ride for the past four decades, having been through six different corporate owners.


It resides now as the crown jewel in ASX-listed Treasury Wine Estates, which had delivered immense riches to shareholders on paper after soaring to beyond $19 late last year on a China luxury wine sales boom. But it is now less than half of that, hovering around $9.18, because of the fear that the hardline approach from China's President Xi Jinping and senior leaders in the Communist Party could either block Australian wines from being sold into China, or impose punitive tariffs in a worsening trade spat.


The high-level "wolf warriors" of China, along with the COVID-19 pandemic which has hurt broader demand around the world in hospitality lockdowns, have combined to trash the share price of Treasury Wines. It plunged to a five-year low of $7.96 on November 5, but has made a partial recovery. The company is speedily working on a host of Plan B, C and Ds should the worst fears of investors occur and it becomes one of the highest-profile victims of the diplomatic row between China and Australia.


Penfolds has a history stretching back to 1844 when Christopher and Mary Penfold brought some vine cuttings to South Australia and planted them in the Adelaide foothills. The wines were originally intended as a medicinal aid for patients of Dr Penfold's ­medical practice.


Through the flagship Penfolds Grange, the most well-known wine from Australia, the "halo" effect has been in evidence as the entire range becomes more sought-after under a strategy by former chief executive Mike Clarke to elevate the brand into the luxury category in China.


It has been very successful. JP Morgan analyst Shaun Cousins estimates that China sales make up about two-thirds of Treasury Wines' total Asian sales, which amounted to $617 million in 2019-2020 and delivered earnings before interest and tax of $244 million.


The Asian business is the most profitable for Treasury, with margins of 39.5 per cent. Compare that with profit margins of 13.8 per cent in North America, where all players have been hit by a glut of cheaper wine which is now improving after a low Californian vintage, and 22.5 per cent in the Australasian market.


Trying to value Treasury Wines, which also makes Wolf Blass, Seppelt, 19 Crimes and Squealing Pig, is a nightmare for analysts and investors.


The unknowns around potentially hefty China tariffs on all Australian wine, or worse still a total ban on imports as retribution for the federal government speaking up on wanting an inquiry on how the coronavirus started, have the wine industry very nervous. The stance has also caused serious headaches in the lobster, coal and timber industries.


Other markets

JP Morgan's Cousins has a ''neutral'' rating on Treasury Wines and a 12-month price target of $9 on the stock. This assumes that the stock keeps trading on a price-earnings multiple of 19 times.


Cousins says the uncertainty around the outcome of the formal Ministry of Commerce anti-dumping investigation into Australian wine is a "risk that is difficult to price''.


Treasury Wines chief executive Tim Ford is working on mitigation strategies should the news be dire. One of the options is to pass on any extra tariff costs, while another is to reallocate wines to other markets.


Cousins says a ''reallocation'' strategy – where Treasury would rapidly shift to supplying wine destined for China to other countries – could limit some of the downside.


But the ''execution'' risk in pursuing this strategy is substantial, with other markets not growing nearly as quickly as China.


JPMorgan has crunched the numbers on a potential reallocation scenario and concluded that earnings before interest and tax and before the SGARA accounting standard could fall by 14 per cent in 2021-22.


A strategy embarked on by Clarke in 2018, of extending the Penfolds brand beyond its South Australian roots to become a global brand with a Californian version and a French version, potentially provides some minor salvation.


Wines from the US and France being sold into China presumably won't be hit by tariffs imposed by China.

A Californian Penfolds

Treasury Wines revealed in July 2018 that it would begin making the range of Penfolds red wines using premium grapes from California's Napa Valley. It also has a Penfolds brandy, a Penfolds champagne and red wines from France and a fortified shiraz called Lot 518, infused with Baijiu, a clear spirit that is hugely popular in China, under the Penfolds banner.


Ford signalled in early November that the range of Penfolds red wine from Californian vineyards would appear in the marketplace from March 2021.


The first batch of Penfolds red wines from France is earmarked to become available from late 2022 or early 2023.


Tribeca Investment Partners' lead portfolio manager Jun Bei Liu says the stock is very cheap given the strength of the demand for premium wine coming from the Chinese market.


She labelled it her top pick at the 2020 Sohn Hearts & Minds Conference, saying its valuation could be almost entirely supported by its inventory and property portfolio.


"Its valuation is pretty much supported by all those premium wines sitting in its cellar,” she says.


Highly resilient


She estimates Treasury has $4 billion of premium label wine in its cellar, which represents about 70 per cent of its market value.


UBS analyst Aryan Norozi has a 12-month price target of $8.80 on the stock and values the China business alone around $4 billion on an enterprise value basis. Treasury Wines in early November announced it had put on ice the work on a potential demerger of the Penfolds business into a stand-alone ASX company by late 2021, because of the China uncertainty.


The Penfolds brand has proved to be highly resilient through all manner of corporate machinations but the full force of the Chinese government's wrath is a huge test.


In the mid-1970s Penfolds was acquired by then NSW brewer Tooth & Co, and in the 1980s became part of the Adelaide Steamship Company, built up by corporate raider John Spalvins.


Spalvins’ empire fell apart after the 1987 sharemarket crash. Penfolds was sold off to a different beer company, SA Brewing, in 1990. SA Brewing, an ASX-listed company, subsequently changed its name to Southcorp in 1993, and then offloaded packaging and water-heater businesses to become a stand-alone wine business known as Southcorp Wines.


It then merged with privately owned Rosemount Wines in 2001 in what was effectively a reverse takeover, to become the world’s largest wine company. But things went on the skids under new management and in 2005 it was bought out by beer giant Foster’s Group, which had its own large wine business led by brands including Wolf Blass and Beringer in California.


Snoop Dogg


Foster’s was split into two companies in 2011. The wine company was rebadged Treasury Wine Estates and demerged as a debt-free wine company.


JPMorgan's Cousins says reallocating more than three million cases of wine now sold in China isn't simple.


Treasury Wines won't be the only company in Australia looking to diversify and this is likely to bring margins down for everyone.


There would be increased discounts and rebates, extra advertising and promotion in the Australian market, while volume growth is already ''modest'' in other big markets such as North America and Europe.


In North America, demand for luxury wine from Australia is ''expected to be weak given the perception of Australian wine and skew of leading brands'' is to more commercial price points. Cousins mentions 19 Crimes, which is a Treasury Wines brand with a strong marketing partnership with American rapper Snoop Dogg, and the big-selling Yellow Tail brand made by Griffith-based Casella Wines.


Cousins says Treasury has had a ''tumultuous'' last 12 months after first grappling with the commercial wine oversupply in the United States, bushfires in Australia which resulted in smoke taint for some smaller rivals in some wine regions, the COVID-19 pandemic and the China trade spat.


The share price has been volatile and the stock has underperformed the ASX.


But after all that, and the big hit to the share price, valuation support is emerging at around the $9.22 mark.


The Chinese Ministry of Commerce investigation is, however, a risk ''with significant potential downside''.


He forecasts EBIT margins across Treasury to fall to 19.9 per cent in 2020-21 from 19.8 per cent in 2019-2020, and rise again to 21.6 per cent in 2021-22.



This article was originally posted on The Australian Financial Review here.

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