KKR waits for a window of opportunity on Treasury

What will Kohlberg Kravis Roberts do next in its pursuit of Treasury Wine Estates? In the near term, probably not much.

After its approach to Treasury proffering a $3.1 billion takeover bid was rejected earlier this week, it is unlikely that KKR will simply accept the rebuff and disappear quietly from the scene. But given that a core element of its DNA is that it doesn’t make hostile offers, it is improbable that the private equity group will dial up the aggression.

Given that no-one’s first bid is their best bid, it is likely that KKR would be prepared to offer something more than the indicative offer of $4.70 a share that the Treasury board said did not reflect the fundamental value of the business, particularly if that gave it access to the due diligence that private equity firms and their financiers generally require in order to make a firm offer.

From its perspective, however, there is no present need to rush.

The obvious strategy for KKR would be to sit back and watch the market. It will wait for it to settle after the initial big spike in Treasury’s share price as the market responded to the disclosure of its proposal. The shares have traded up about $1 above their levels before that announcement on relatively heavy volumes.

Some of that would be short-covering -- there were some quite big short positions in the stock -- and there would also be an element of takeover arbitrage activity. The former will be a temporary phenomenon, but KKR would be watching the arbitrageurs closely. A big build-up of holdings by arbitrageurs has the potential to destabilise a register and make the target more vulnerable.

Both KKR and Treasury would also be monitoring the market for any signs that a third party is trying to build a strategic position, although that is considered unlikely.

Once the market settles and it gets a better understanding of what Treasury shareholders would regard as a compelling offer, KKR would have the option of making a revised approach. It would be conscious that while the Treasury board dismissed its initial offer, neither the company nor its new chief executive, Michael Clarke, have slammed the door on further engagement.

The private equity giant would have been very conscious that in his conference calls with analysts and media earlier this week, Clarke studiously avoided confirming the revised guidance for the full-year earnings Treasury issued in January, when it revised down its guidance for earnings before interest, tax and SGARA by $40 million to between $190m and $210m.

If Treasury were forced to issue another downgrade in an environment where consumer confidence and spending is falling away rapidly, KKR’s prospects of acquiring the business would improve significantly.

There is an option of playing a longer game. Treasury will release its full-year results on August 21. With them, Clarke is expected to produce a much more detailed strategic plan for the group than he has been able to do in the short time that he has been in charge.

While he did detail a $35m cost-out program, the market is waiting for a deeper insight into Clarke’s strategy for turning around the group’s performance. The credibility of his plans and the extent to which they can create value within a reasonable timeframe could be crucial to shareholder perceptions of the value of the shares and to the success or failure of any further KKR approaches.

A key element of that strategy will be how Clarke plans to unlock the latent pool of earnings within the near-$500m of inventories the group has accumulated over the past two years.

Merrill Lynch’s David Errington has estimated that the earnings of the Penfolds business alone could nearly double from about $180m to $350m over the next two or three years as Treasury releases its store of luxury wine holdings.

It is that big pool of prospective profit as well as the backdrop of an improving supply-demand balance within the global industry that Treasury could argue makes the timing of KKR’s approach opportunistic. Errington has put a break-up value on Treasury of $6.50 a share.

For KKR, there is a risk in waiting for the results and strategic plan because it gives Clarke, who has only been in the CEO’s chair since March, more time to develop a convincing strategy and win the confidence of the market.

That would suggest it will be waiting for any window of opportunity to force Treasury to engage (or to convince Treasury’s institutional shareholders to pressure the board to engage) that opens between now and then.