The Chinese Ministry of Commerce decision to remove tariffs on Australian barley from 5 August 2023, has created an expectation that wine tariffs may also be removed in due course. Prior to the tariffs being imposed three years ago, China contributed about 32% of group EBITS ($209m) and was the strongest source of growth in the company.
The softening of China’s trade stance against Australia in specific industries and products could potentially extend to Australian wine following the barley decision. Our best estimate for the timeframe required to remove the tariffs on Australian wine is between 6 and 12 months from now.
What is the earnings upside?
TWE has been able to successfully redirect its Penfolds volume into other markets since being benched by China. The consequent decline in group EBITS for Penfolds has therefore been well handled (Figure 1) and perhaps not as detrimental to earnings as originally feared. Conversely, regaining entry into the Chinese market may not generate a jeroboam of volume uplift, but the likely price increases would play the major role in resurrecting earnings from China.
Assuming the timeframe is broadly correct, we think TWE can regain approximately $100m of EBITS in the first full year of trade with China. TWE would need to spend about $25m to reinstate its marketing and distribution capabilities and this would incorporate a reallocation of product from other markets. It is also relevant to understand the three year cycle for product to be grown and produced before it enters the market.
It could conceivably take three to four years before a full run rate of earnings is achieved. At this point, TWE would be selling mostly Penfolds premium wine to China at higher prices than before the tariff hike. We think TWE could then generate EBITS around $230m pa from China. This might be offset by the reallocation of Penfolds product from other markets although the quantum is difficult to estimate.
How meaningful is this to the TWE valuation?
TWE PE ratio peaked at 32x in April 2018 and averaged 26x through to 2019. As a growth stock, it attracted a premium to the ASX200 Industrials, but clearly the China interruption and the bumpy execution of the premiumisation strategy has punctured the PE premium. At 19x FY25e EPS, TWE is arguably cheap, and does not incorporate the scenario of regaining entry to China which is potentially now more realistic.
What about the rest of TWE’s business?
The positive message from the company’s Strategy Day in March set out the improving gross margins and potential for capital management, possibly in FY24. TWE is halfway to its 2025 goals including EBITS margin of 25%-plus, ROCE (return on capital employed) restored and growing, and for the dividend payout ratio to be maintained at 55-70% of net profit. But by May, TWE was reporting weak sales in its lower value brands particularly in North America and was forced to downgrade guidance for Net Sales Revenue (2-3%) and EBITS to between $580-590m.
TWE’s strategy of ‘premiumisation’ is the right one, but it is taking time to execute.
Investment View
The structural decline of cheap, low-end wines across the global wine industry has pushed TWE towards a premiumisation strategy across its portfolio. Fortunately, TWE has a premium brand in Penfolds that can more than compensate and indeed, position the company for future growth. The potential return of the Chinese market, which is biased towards premium wines such as Penfolds, would be a big fillip to group earnings and margins. Price increases in premium wines is a global trend and this adds to the story.
The prospect of wine tariffs being removed by China is gaining in probability, but the impact on earnings and valuation will be long-dated.
The market is not yet recognising this possibility for TWE, but it could trigger a PE re-rating for the stock.
For these reasons, we retain our Buy recommendation.
Figure 1: TWE EBITS
Risks to Investment View
Competition in the highly fragmented global wine industry is intense. Movements in the supply of wine can impact TWE’s profit margins. As was seen in China, tariffs can be imposed that can be damaging to earnings. TWE’s global earnings are exposed to foreign currency movements.
Recommendation
We have retained our Buy recommendation.
