Can Treasury Wine overcome the loss of a large part of its Chinese market and re-direct supply to other regions?

-May not be the end of the tariff story
-Treasury Wine to ramp up marketing across other regions
-Oversupply likely to be largely directed to Australasia
 

It will take time for Treasury Wine Estates ((TWE)) to overcome the loss of its important and growing Chinese market for prestige wines. Can the company find redress in simply redirecting supply to other markets? To some extent, maybe, but unlikely is the chorus.

Provisional tariffs were implemented by the Chinese government on Australian wine imports to China from November 27. The rate, 169.3%, was materially ahead of most expectations.

Morgan Stanley assumes, at this point, that the legacy China business is largely untenable and sales from Treasury Wine into the country will essentially cease. The main priority will be the reallocation of luxury wines previously sold in China.

The broker assumes none of the company's commercial and masstige wines are reallocated and 70% of luxury wines sold into other markets will be at a -10% reduction in returns per case, calculating, all up, just 25-30% of volumes and 50% of current profits could be recovered from FY22.

Macquarie expects the tariff will effectively close the Chinese market to Australian wine imports for its duration, which is unknown at this stage. These provisional tariffs do not include any stated measure relating to the investigation of dumping and Morgans suspects another tariff may be forthcoming. Yet the company has indicated further tariffs are unlikely to change its plans.

To put this in perspective, Treasury Wine will still have some sales in China, likely at the higher end customer base that is not price conscious. Its Penfolds branded baijiu sales will not be affected as this is not standard red wine. Morgans suggests over time Treasury Wine may even look to bottle and package bulk wine in China. Bulk wine is not subject to the tariff.

Citi, downgrading to Sell from Buy, believes it will be difficult to maintain any presence in China and the turnaround in the Americas will become the driver of the share price. The broker expects marketing costs will have to rise and and also anticipates an earnings margin dilution of -10 percentage points in the markets where wines are re-allocated.

On the positive side, Credit Suisse believes the news is unlikely to get worse now that China has announced the provisional measures, upgrading Treasury Wine to Outperform, assuming heavy tariffs remain in some form through to FY23. The broker anticipates the Asian business will return to pre-pandemic, pre-tariff levels in FY24.

UBS considers the risk/reward now balanced, assuming around 10% of earnings from China can be recovered. Value is there as, ex China, valuation is assessed at 14x earnings. Nevertheless, with heightened uncertainty and few upside catalysts the broker downgrades to Neutral from Buy.

To put perspective on the scale of the reallocation, around $1bn of Australian industry wine exports need to be reallocated, along with existing export markets worth $1.3bn and the $5bn domestic wholesale wine market.

Strategy

A mitigation strategy is expected to take 2-3 years and profitability in FY21 as well as cash flow may be affected by the need to reinvest. That said, Treasury Wine has signalled it has plenty of liquidity and will ramp up marketing across other markets that were previously under-supplied with the Penfolds brand.

In terms of China, Treasury Wine will also accelerate its multi country-of-origin wines, particularly from the existing asset base in France, the US and even China, as well as strip out costs. A globally standardised margin structure will be applied.

Morgans notes the first Penfolds release from France is not available until FY23 while a range of Penfolds red wine from Californian vineyards will be made available from March 2021.

The broker removes expected earnings from China from its forecasts but stresses it is extremely difficult to make forecasts given the multiple mitigating strategies now being put in place. The main unknown is how much additional investment will be required to promote Treasury Wine's brands in less well-known markets.

Moreover, the resulting oversupply of masstige/commercial wine in the Australian market will affect the Australasian business. The main upside risk the broker envisages is the removal, eventually, of the tariff. Given the strength of Penfolds in particular the possibility of corporate action also persists, Morgans adds.

Margins

Macquarie conservatively brings Chinese volumes to zero for the next 2.5 years and re-allocates some volume to other regions. Downside risk for the short term is on margins, although the broker assumes the company can scale its Asian cost base appropriately.

The mix of wine sold in Asia is at much higher margin than the rest of the company's portfolio and China, in particular, had an appetite for the luxury wine range. Macquarie believes there is further downside risk to the share price from falling margins, particularly if disruption remains in place for an extended period of time.

Ord Minnett anticipates luxury and masstige wines could pass on some of the tariff by way of higher prices while commercial wines will struggle. These accounted for 18% and 16% of Australian wine exported to China in 2019 and 2020, respectively. The broker cuts its rating to Lighten from Hold.

UBS suggests that the company's aspirational 25% earnings margin in the Americas is not without risk. The target is to be driven by reduction in commercial volume mix to 15% and a halving of volumes. The broker envisages some earnings upside if the company is successful.

Credit Suisse assumes the lost volumes from China will spark discounting in Australia and the UK, particularly in the commercial and premium categories, and estimates Treasury Wine will reallocate 400,000 cases of Penfolds Bin and Icon ranges. The company has signalled this volume represents 25% of these ranges globally.

The broker calculates China averages a price that is 1.6x higher than other markets for these two ranges. Given that the company attempts to harmonise pricing around the world about half of this differential stems from mix.

This is important, because Australia, the other large Penfolds market, consumes a different mix to that purchased by Chinese consumers and consumer preferences among the two countries are different.

Where Will The Wine Go

Australia may be able to take 100,000 cases of Penfolds but Credit Suisse doubts this would be the top end of the range. Treasury Wine will reallocate some of its luxury grape sourcing to its other premium brands, which Morgans notes have been significantly supply-constrained over recent years.

Macquarie suggests reallocation of excess wine to the Australian market could mean a supply/demand imbalance that affects price and providing a negative volume risk to those producers that don't adjust prices.

The broker suspects Australasia and Asia will be the main recipients of the reallocated wines, assuming Australasia can absorb additional volume and that Europe, Middle East and other near regions can take some as well. In the UK, the world's second-largest wine importer, growth is predominantly coming from the value end.

In reallocating to other Asian markets Treasury Wine is looking at Hong Kong, Vietnam, Singapore and potentially the China Free Trade Zone. If international travel rebounds strongly, which it is expected to do, the global travel retail segment may help the situation.

Credit Suisse regards reallocation to the US as unlikely to have a meaningful impact. The brand needs development in that region. Macquarie assumes Treasury Wine is successful in exiting the commercial wine business in the Americas and also notes the US market is keenly competitive and oversupplied.

Macquarie points out global consumption of wine is expected to drop significantly in 2021 as a result of the socio-economic impacts of coronavirus and global supply may well increase because of favourable conditions in the major northern wine producing regions.

This would indicate the gap between supply and demand could expand to 21%, higher than it has been for the last 10 years. FNArena's database has two Buy ratings, three Hold and two Sell. The consensus target is $9.43, suggesting 10.5% upside to the last share price.

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