- TWE writes down US inventory
- management still operating on blind faith
- value lies only in corporate action

By Greg Peel

Celebrated British wine expert and TV personality Oz Clarke unwittingly launched Australia's highly successful export wine industry back in the 1980s, according to a recent documentary on the history of Australian wine. A bold young Australian winemaker approached Clarke at a tasting in the UK and asked him what British drinkers would like in a good table red and what they would be prepared to pay. The winemaker took the answer home and a year later returned to the same annual tasting, with bottle in hand. Clarke loved the wine, and the days of Ben Ean and Cold Duck were over. Welcome chardonnay and shiraz. The French were livid.

Australian wine boomed, and Britain and the US couldn't get enough of the stuff. Eventually the large corporate players cottoned on to the sort of earnings growth the fledgling winemakers were posting, and decided it was time to move in. The pinnacle was reached in 2005 when beer-maker Foster's acquired wine conglomerate Southcorp for a hefty price. By then, Australian wine's global honeymoon was over. Foreign drinkers had moved on to new wine fads and styles. Australian wine hit the discount bins.

Thereafter followed an Australian grape glut, around about the time the GFC curbed consumer spending across the globe. America had begun to develop its own successful winemaking industry, once again highlighted on a television program by Oz Clarke and his mate James May. Even British wine hit the restaurants. In 2011, a desperate Foster's spun off the old Southcorp into a new listing, Treasury Wine Estates ((TWE)). The remaining beer division was soon swallowed up by global brewing giant SABMiller.

While wine had brought Foster's almost to its demise, in 2011 analysts largely agreed that the upside value was contained in TWE and its iconic brands and not in the mature beer business. Initial hopes were high that TWE could improve from a low base, as long as nature was compliant, and as long as management adopted a realistic and sensible strategy. In 2013, nature is forever unpredictable but analysts suggest TWE management has manifestly failed, relying solely on blind faith.

The issue has been one of unsold inventories building up with US distributors. While other wine suppliers discounted prices in the GFC fallout to clear stock, TWE failed to do so and relied instead on a belief that not only would consumer spending cycle back up again, but that Americans would fall in love with Australia's tired old brands all over again. Yesterday, TWE bit the cork and wrote down its excess US inventory. "The fix is long overdue," says Citi. But there remains an element of denial in the manner in which management has gone about the write-down. Says UBS:

"TWE [has confirmed FY13 earnings] of around $216m bit if we consider that some of the profit generating volume has been effectively brought back and written off below the line (channel stuffing) the number appears meaningless".

Credit Suisse was less polite in suggesting:

"TWE's ASX announcement flagging $200m in inventory write-offs and lost revenue avoided the big picture issues of strategy, governance, accountability and eroding brand equity...Years of trade loading allowed management to avoid truly confronting the brand equity issues in the business, in our view".

The truth is, as Credit Suisse points out, TWE's market share in the US has roughly halved over the past six years. The influence of Beringer, TWE's major US distributor, in the wine trade is now greatly diminished. The Macquarie analysts have pointed out in the past that the story being told by management of building exceptional brands and driving top line growth have failed to manifest on the profit and loss statement. TWE has continually failed to match demand-based forecasting estimates with actual underlying demand for its brands. The company is blaming distributor business models, Macquarie notes, when lower sales are obvious in consumer data.

Underlying conditions in the US and UK remain tough, notes Deutsche Bank, "brand Australia" is out of favour and TWE's US inventory base is too high.

How hard can it be to sell Grange? Well therein lies the conundrum. Hidden behind the dust-gathering cases of vin-very-ordinaire is a little gem called Penfolds, about which both a couple of brokers have a specific opinion.

CIMB has downgraded its rating on TWE to Sell in the wake of the write-down announcement, bringing to six from eight the number of FNArena database brokers with Sell or equivalent ratings on the stock. An inventory write-down has long been expected by analysts, but none are much amused with the way it was implemented.

TWE will take a $160m provision against US inventories in FY13, made up of a $35m for the destruction of aged inventory, $40m in discounts to distributors to clear excess current stock, and $85m associated with carrying excess bulk and bottled wine and onerous contracts for grape purchases. In order for TWE's FY13 profit guidance of $216m to be maintained, the profit from selling excess wine to US distributors is taken above the line and the cost of clearing it from distributors is taken below the line. What this all means is that reduced shipments in FY14 mean FY14 earnings will start $30m below FY13. Or put another way, FY13 earnings will really be $176m, not $216m.

Analysts were expecting a write-down, but they were not quite ready for neither the extent nor the accounting smoke and mirrors. And while analysts welcome the long-awaited inventory consolidation, they are not yet sure that management has had the epiphany it needs to be able to successfully exploit this new starting point. TWE is still attempting to promote a "luxury wine" story when inventory is failing to move. There is potential for further downside, analysts suggest, and despite yesterday's 11% share price thrashing the market is still over-valuing the company, ascribing a high multiple to a stock beholden to the vagaries of not just global fashion, but also to the weather.

"We continue to believe that the share price is factoring in optimistic assumptions," says JP Morgan, "regarding both the quantum and timing of the impact of TWE's investment in sustainable luxury wine supply. In addition, we think consensus earnings forecasts fail to incorporate the balance sheet expansion required to fund TWE's luxury wine expansion".

Analysts have now cut earnings forecasts and reduced price targets, dropping the consensus target to $5.20 from $5.47 previously. That doesn't seem like much of a cut under the circumstances, and with the stock trading around $4.70 today the raft of Sell ratings seems misplaced. But if we take Merrills' target out of the mix for a moment, the consensus target falls to $4.51. And if we take Macquarie out as well, it falls to $4.30.

In Merrills view, TWE's US wine business is worth $1bn, with the vineyards alone worth $600-800m. But the analysts don't believe that value can be realised under the current structure. They believe the asset would need to be sold to realise the full value for shareholders.

Merrills is sticking to its $10.00 price target and Buy rating.

Macquarie's target, also unchanged, is not as ambitious at $5.75, but the analysts have upgraded to an Outperform rating on yesterday's share price drop. Macquarie, too, believes the current business strategy is not creating value for shareholders. The current business is too big and too complicated, and more personnel changes are likely within management. TWE needs to look at a corporate strategy, the analysts entreat. Bring on The Penfolds Wine Company.

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