Clouds clear for a Treasury Wine harvest

Competition from Asian consumers, French crop failures... the good-time glut is over for American drinkers and, with a falling Aussie, the supply-demand equation is finally improving for Treasury Wine Estates.

At face value the Treasury Wine Estates result didn’t look too flash, with reported earnings halving as a result of the write-offs flowing from the decision to get rid of excess inventory in its US distribution system. There is, however, quite a lot occurring within the business and the markets in which it operates for David Dearie to be starting to get excited about.

Had it not been for the disfigurement created by the $154.7 million of losses related to that excess inventory – mainly old commercial stock – within the US system and the continuing impact into this financial year that it will have on shipments in the first half as Treasury gets its supply into balance with demand, the result would have looked pretty solid.

The Treasury business outside of the US reported 17 per cent growth in its earnings before interest, tax and SGARA (EBITS), with a 35.6 per cent increase in EBITS from Asia highlighting the growth potential of the region. The US result, down 14.5 per cent at an EBITS level before the writedowns, was the underperformer.

The reason Dearie would be increasingly confident that the longer-term underpinnings of the business provide encouragement, however, is that the macro settings for the sector and for Treasury in particular are becoming increasingly favourable.

The wine industry, obviously, is affected by agricultural conditions and cycles as well as by the behaviour of the participants within it.

For the past decade and a half, if not more, the industry has been plagued by overcapacity. It isn’t a coincidence that Foster’s entered the wine industry back in 1996 – when it acquired Mildara Blass and Rothbury Estate – during the tail-end of the last period when supply and demand was broadly balanced. It added Beringer in the US in 2000 and then Southcorp in 2005, by which time the market was heavily oversupplied.

It isn’t, therefore, surprising that Treasury struggled to deliver attractive or consistent returns ahead of its demerger from Foster’s.

For a variety of reasons, some of which relate to decisions taken by the producers within a more consolidated industry to reduce their supply bases, some of which relate to weather – France, for instance, has had two successive poor weather-affected seasons – and some of which relate to increased demand in Asia and in a rebound in demand in the US, for the first time since the 1990s the market is close to balance.

Treasury, for much of its recent history, has been on the wrong end of currency relationships given that its core production is within Australia. A one cent movement in the dollar relative to the US dollar impacts its EBITS by about $2.5 million and a 1 per cent movement against the UK pound by $3 million so the strength of the dollar has hurt earnings.

This year, of course, there has been a significant and positive change in the value of the dollar and an easing of the acute pressure it imposed on the group’s earnings while it was above parity with the US dollar. It is also about 18 per cent of its peak earlier this year against the pound.

Dearie has also heavily restructured and repositioned Treasury since he became chief executive in mid-2011, aiming to position the group more towards the premium and ‘masstige’ segments of the global industry. In Treasury’s non-current inventory – and it has $446 million of non-current inventory – 90 per cent of the wine is now classified as luxury and masstige.

If the market continues to shift into balance, that inventory, which Dearie has deliberately built (and which would have been added to by the flow-on effects of the reduced US shipments) will become more valuable and profitable.

A recent, quite discernible pick-up in demand at the higher-price points in a US market that had been impacted heavily by the US recession also augers well for the prospects of extracting value from that inventory (Treasury Wine Estates hits a cellar floorJuly 15).

The first half of this financial year will be affected by the continuing impact of the action taken on the US inventory position, which Treasury says will cost another $30 million and push first-half earnings lower that for the same half of the 2013 financial year, although it is providing full-year guidance of $230 million to $250 million of EBITS.

Dearie’s confidence in the outlook, however, is reflected in plans for a major investment in his brands, including a 70 per cent increase in investment across Asia ahead of anticipated volume growth.

The wine industry is one of those industries, like aviation, where nothing can ever be taken for granted. But for the first time since shortly after Foster’s big wine-buying spree began, the industry fundamentals are lining up in a positive fashion for the global wine business Treasury has built.

For Treasury shareholders, however, there will be at least one other piece of news they probably won’t like to digest in the near term.

At the time of the demerger there was uncertainty about the tax implications, with some proposed changes floating around at the time which would have required the group to retain the historical costs of its assets at the point of demerger for tax purposes.

The changes weren’t made, Treasury is now required to reset its tax base using relative market values and it would appear it will be entitled to tax refunds for the 2011 to 2013 years.

That’s actually good news for Treasury, given that the group will be able to use the tax offsets it will receive against future tax liabilities. It means, however, that the 2013 final dividend and probably the next two years of dividends won’t be franked, which probably won’t be regarded as good news by shareholders.