Why Treasury Wine closed the lid on KKR and TPG

The protracted stalking of Treasury Wine Estates over the past two months appears to be over, with the perhaps surprising outcome that for the moment Treasury retains its independence.

From the moment Kohlberg Kravis Roberts & Co (subsequently joined by Rhone Capital) emerged and was subsequently joined by another private equity group, thought to be TPG, it appeared the indicate offers of $5.20 a share would see ownership of the perennially challenged Treasury change.

Instead, Treasury announced today that after discussions with the prospective bidders it had become apparent that they wouldn’t be able to put forward a transaction on terms and at a price acceptable to the board.

The board had also canvassed the views of its own shareholders, talking to shareholders representing more than 50 per cent of its capital, and came out of those discussions with “clear feedback” that there was a near-universal view among them that the $5.20 a share level undervalued Treasury.

The failure of the process to produce an acceptable bid wasn’t only due to Treasury’s view of its own value.

Treasury referred to one of the private equity firms facing potential regulatory obstacles and another financing issues.

TPG, with casino interests in the US, would have had to navigate post-Prohibition “tied house” rules in the US that dictate the separation of supplies, distributors and retailers of alcoholic products. The financing issues related to the amount of leverage one of the bidders wanted or needed to make the numbers work for them at $5.20 a share.

One of the problems confronting the private equity players is that it has become apparent that both the market -- and the bidders themselves -- have bought into the strategy and tactics that have been introduced by Treasury’s relatively new chief executive, Michael Clarke, to the point where it was probable he would have been retained even if there had been a successful buy-out.

Clarke, who became CEO in April, hit the ground running with a program of reducing costs, significantly increasing marketing support for the group’s premium brands, radically changing the release dates for the group’s core Penfolds brand and building stronger relationships with retailers. He has also structurally separated the group’s commercial wine and “masstige” portfolios as part of a strategy of “premiumisation.”

There were early signs in the results for the last financial year that his changes were gaining traction, and Treasury said today that year-to-date performance -- results for the first three months of this financial year -- were tracking ahead of plan.

Clarke said volumes, revenues, gross profit and earnings before interest and tax were all tracking ahead of the group’s plan and that the performance was being driven across all four of its major regions.

The private equity players are unlikely to return soon, given that they need board support for the schemes of arrangement they use to guarantee the 100 per cent ownership required for their leveraged bids.

With Clarke saying they could make the numbers work for a leveraged buyout at $5.20 a share, it would appear reasonable to conclude that they won’t come back at a higher level in the near term, although no doubt they will continue to monitor Treasury in case it stumbles again.

The appeal of Treasury to private equity -- and its own shareholders -- is that beyond the kind of basic management-driven improvements in the business Clarke is trying to engineer, there are some latent profit pools within the group and some upside from changes to the external settings.

The most obvious of the latent profit pools lies within Treasury’s inventory position. It has been building a reserve of non-current luxury wines -- there’s around $500 million of inventory that represents high-margin future profitability to be unlocked.

There’s also an opportunity, which Clarke is pursuing, to better leverage the Penfolds brand, the jewel in the Treasury portfolio, by distancing it from the commercial wine portfolio and ensuring the timing of its releases is better aligned to the “events” seasons.

Clarke has learned something from the private equity firms’ plans to leverage Treasury, saying that the group does have a lazy balance sheet. He could slightly dial up gearing to leverage returns to shareholders without creating an overly-risky financial structure.

He could also use the balance sheet to bolt on some acquisitions.

One of the most misunderstood aspects of Treasury’s disappointing US results and the big write-downs that have occurred over the years is that its former parent Foster’s knowingly over-paid to acquire Berringer in 2000 -- it publicly acknowledged that at the time -- to gain a beachhead in the US.

It knew that to justify the acquisition and improve the economics of its US business it would need to add to its presence through incremental acquisitions, which for a variety of reasons didn’t eventuate. Clarke appears to understand that he can generate synergies and improve Treasury’s US position over time through selective acquisitions.

For most of the time Treasury has existed, within Foster’s and without, it has had to face adverse external influences that have impacted its performance. For a decade and a half there has been a significant glut of supply over demand in the wine industry. That is changing, particularly at the masstige end of the market.

Treasury has also had to deal with the strength of the Australian dollar, particularly in the post-crisis period. It is particularly sensitive to the $US:$A and British pound:$A exchange rates, both of which have improved markedly in the past month. If sustained, the depreciation of the Australian dollar could add close to $20 million of earnings before interest and tax over a full year.

Clarke said today that Treasury’s shareholders regarded the overtures from private equity as “opportunistic and inadequate”.

Those shareholders have presumably looked closely at Clarke’s game plan, and at the external environment, and come to the same conclusion that the private equity firms did -- there is a lot of upside to Treasury if Clarke can (finally) unlock the group’s potential.

The pressure is now on Clarke to deliver. Treasury has been the source of so much disappointment and so many unpleasant surprises over the years that it can’t afford any more. Clarke has bought it time and opportunity. It is doubtful it will be given either again if it stumbles yet again.