Treasury Wine bets on premium

Over the next six months or so David Dearie and his team at Treasury Wine Estates may pay closer attention to the sharemarket than has been usual in their group's relatively brief history as an independent listed entity. Circumstances, and their own decisions, have conspired to create a window of vulnerability for the former Foster's wine business.

This morning, ahead of the Treasury annual meeting, the company provided an update on its earnings guidance in which it said its expected constant currency earnings before interest, tax and SGARA in the first half of 2012-13 to be about 20 per cent below that generated last year before a second half recovery that would produce full-year constant currency earnings growth in the mid-single-digit range.

Last year Treasury produced constant currency growth in earnings (on an EBITS basis) of 18.6 per cent, although the strength of the Australian dollar reduced its reported earnings growth to 7.7 per cent.

While the magnitude of the anticipated first half slump in earnings appears to have taken the market aback, with Treasury shares falling sharply, the explanation for the downturn was already known.

The 2011 vintages in Australia and California were badly affected by weather. To protect the quality of its wines and brands, rather than respond by buying more lower-quality grapes Treasury took a decision to live with lower production but still incurred higher costs. So it will have less wine to sell this year but that wine has a higher cost base.

It also has to cope with one of the legacies of the 2011 de-merger, the need to build a new IT platform, and has also been affected by de-stocking by its distributors in the US. The outlook for the Australian dollar is also unlikely to be of much help.

Dearie's confidence about the second half, and more particularly the 2013-14 financial year, in which it expects to generate growth above the 15.8 per cent it has averaged in the past two years, relates to the 2012 vintage, which was exceptional in Australia and very promising in California.

Indeed he appears excited about the next couple of years because Treasury took a brave decision to take advantage of the 2012 vintage to grow its non-current inventory by 84 per cent to $362.5 million. It will have a lot of high-quality product to sell over the next few years, which should drive earnings growth.

The broad picture, however, is one where Treasury's earnings will dive in the first half of this year before, if its forecasts hold up, bouncing back in the second half and beyond. There is a potentially material mismatch between its immediate performance and what it believes it will deliver in the medium term.

That normally equates to vulnerability. The market has a short attention span and is far more interested in short-term profits than long-term prospects, although Dearie appears to have done a very good job of convincing the market that he is operating to a rational and disciplined long term strategy that will deliver growth.

With 20 per cent of Treasury's earnings already being generated within Asia, where constant currency earnings grew 40 per cent last year, he has quite an exciting growth story to tell.

Beyond that, Dearie has completely over-hauled his management team and operating model and tightened the focus on the premium end of the markets and on profit over volume. The early results have been promising.

An opportunistic player could, however, see this year as a window within which Treasury could be vulnerable, given that earnings will fall sharply before the ‘'hockey-stick'' rebound Dearie expects can occur, if it occurs.

There is some protection for the company in its nature. There are few major listed wine companies and no obvious industry buyers. The big brewers and spirits groups tend to steer clear of wine and its volatile combination of agriculture and consumer brands.

Private equity, however, has played in the wine space and, indeed, a private equity firm approached Foster's before Treasury was spun out, with an offered valued at between $2.3 billion and $2.7 billion which Foster's rejected. Treasury is valued at about $3.3 billion today, so Foster's rejection has been vindicated.

The scale of the Australian business and the centrality of the Australian dollar to Treasury's value probably complicates matters for any aspiring predator and Dearie has built significant credibility within the market already, which would make Treasury an even tougher target than it was within Foster's.

For a financial player, given that the group is well-managed, has a pretty clean portfolio and is already exploiting the Asian opportunity and being demonstrably successful, any tilt would have to be purely opportunistic rather than based on some conviction that the business could be re-engineered and value added.

Nevertheless, Dearie and his new team will be relieved if they can get through the next 12 months without someone knocking on their door and are able to pursue without distraction a strategy that they clearly believe is going to deliver quite an exciting future for a business whose performance over the years has been much maligned but which now appears to have been rebuilt on stronger foundations.