Treasury Wine Estates: The China opportunity

Chief Investment Officer and founder of Aitken Investment Management
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Happy New Year! And what a new year we are in for.

When you have the leader of the “free world” tweeting economic policy, you can be absolutely certain of two things: volatility and opportunity.

My view is that the better investment opportunities lie outside of the USA. US equity valuations are high and there seems quite a lot of “hope” priced in. I don’t think President Trump can deliver change in the timeframe markets expect and I tend to think US equities will underperform other markets this year.

I think there are better investment opportunities in terms of value and growth in Europe, the UK and China. There are also better opportunities selectively in Australia.

While the “Trump Trade” has gathered all the headlines, and fair enough, quietly in the background all things China have been rallying. From commodity stocks, through to Macau casino’s, luxury goods stocks and the Australian dollar, they have all outperformed Wall St so far in 2017. For example, the Australian dollar itself is +5% already year-to-date and the S&P Global Luxury Index +3.3% year-to-date.

It would appear clear that the positive price action in all things China is trying to tell you something about the Chinese consumer and Chinese GDP growth. I clearly think that message is positive and one that Australian investors haven’t noticed or have ignored due to stock specific China facing issues such as Bellamy’s.

Bellamy’s, to me, is a clear one-off. I absolutely don’t believe BAL’s problems are a guide to anything other than BAL’s mismanagement. However, I do believe the BAL episode has weighed unfairly on other China consumer facing Australian companies and in that underperformance there is opportunity.

As we enter 2017, I continue to believe the investment case for Treasury Wine Estates (TWE) is very strong. However, the stock price has been marking time around $10.50, as investors wait for further earnings growth confirmation from the company at its February result. I also think BAL sentiment has unfairly weighed on TWE, as has the rotation from growth stocks to so-called value stocks post the US election.

TWE is in a multi-year earnings upgrade cycle, driven by excellent management execution. This is a global luxury brand stock that just happens to be listed on the ASX.

Morgan Stanley this week upgraded their recommendation on TWE to “overweight” and set a $13.00 12-month price target. That’s in line with my thinking and why I hold a large position in TWE. However, the broader TWE analyst community isn’t so sure, with four buys, six holds, and three sells. That reminds me that there is far from “universal bullishness” on TWE. That’s a good thing.

Let’s look at a few key bull points on the TWE investment case.

1. Market still underappreciates TWE’s China opportunity

The Morgan Stanley AlphaWise survey of alcoholic beverage consumers in China gives us greater conviction in TWE’s long-term opportunity. It is still early days in China for TWE but we turn more constructive given:

(i) the long term gradual shift from beer/baijiu to wine.
(ii) wine priced >Rmb1,000 has the highest expected consumption growth, according to Chinese consumers.
(iii) the increasing popularity of Australian wine at the expense of French wine.
(iv) a lack of availability of Australian wine, which we believe can be easily resolved; and
(v) TWE’s growth in China is broad-based.




2. Healthy pricing growth underwrites near-term earnings growth

In October 2016, TWE took 8-17% price hikes across its flagship Penfolds Bin range, which mostly falls to the bottom line. A comparison of retail prices in China, Hong Kong, and Australia shows a 20%-60% pricing premiums, assuming similar 25%-30% retail mark ups. To us, this illustrates the opportunity to realise prices by optimising inventory allocation.



3. Underperforming Americas business poised to turn around

A greater focus on ‘priority’ brands, more cost discipline, and divestment of commercial volumes should drive TWE’s Americas business. Our comparison analysis of US peer Constellation Brands’ (covered by Dara Mohsenian) financial metrics and TWE’s Americas business shows that TWE generates 17% higher sales/litre, but 37% lower profit/litre (FY16). Expressed another way, STZ is expected to generate a 28% FY20 margin vs. TWE Americas FY16 13.8%, FY20 MSe 23%.

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Valuation is cheap at 21x FY18 P/E

Continued strong growth from Asia and a turnaround in the Americas should drive EBITS margins well into the mid-20s. We lift our long-term (FY28) EBITS forecast from 23% to 26% vs. management aspirations of 30%, which drives our 20% FY16-21 EPS CAGR forecast and price target increase from A$10 to A$13. Relative to local ‘high growth’ companies and global peers we see valuation as cheap.

TWE is classic “structural growth at a reasonable price”. Instead of hoping ‘America becomes great again’, I believe the better investment strategy is to invest in China consumer facing structural growth stocks who now trade at reasonable valuations.

I wish you all a good year ahead but be ready for volatility and the opportunity it presents.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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