Equity Fund

An under-the-radar ASX beverage bargain

By 7 April 2022April 12th, 2022No Comments

Two decades ago, I started my career as head of European beverages in London for a large Pan European Investment Bank. Over the several years of cutting my teeth in London as an equity analyst, I would spend a lot of time covering quality stocks such as Heineken and Diageo and learned to appreciate their cash generative attributes. Stocks like this did a good job posting consistent organic revenue growth as well as increasing their margins by focusing on a select group of ‘power brands’. The managers of these brands need to keep promoting, advertising, and innovating to keep the brands fresh and relevant, however in time it becomes harder to make incremental profit as their markets become saturated.

It pleases me greatly to reflect on my old hunting ground. Although the overall returns on premier league beverage companies have been excellent over the last decade, I also noticed a distinct lack of ‘old fashioned’ consistent organic growth over this same period. At the same time, the price to earnings multiples of these entities has increased by ~50% thanks to a collapse in interest rates. Very good companies with iconic brands, but buyer beware as the trajectory of interest rates has changed! We have also seen this story with other well-known large, listed stocks elsewhere.

I believe it is more difficult for branded wine producers to ever reach the economies of scale and consistently high returns on equity generated by some of the better spirit and beer alcoholic beverage manufacturers. Typically, the asset base is far larger with significant investments in inventories, some owned vineyards, and manufacturing & storage assets. Additionally, wine producers face higher agricultural risk inputs from one year to the next – think droughts, fires, and floods. In Australia, we have faced all of these in recent years.  Nevertheless, there are some outstanding wine manufacturers with excellent high-margin brands that help protect and grow profits over time. Think of Moet Chandon and other champagnes with their clever constrained supply narrative and Penfolds in the Treasury Wine Stable in Australia.

Enter Australian Vintage Limited (ASX:AVG), one of Australia’s largest wine producers, and very well known in the industry, but still a relative unknown under-the-radar stock on the ASX, although this is changing. As value investors, we don’t buy stocks when they are popular and priced for all the good news. We initiated our position on AVG several years ago when the company was still growing out of their bulk wine producer roots, with expensive grape supply contracts and an enormous debt pile. However, at the same time we could see potential in their brands. The strategy to grow into a branded wine business made sense and looked achievable over time with a competent management team. Additionally, we knew the onerous grape supply contracts would run off in time. We started purchasing shares at a price representing one-third of the company’s net tangible assets.

Australian Vintage today is a success story under the excellent CEO Craig Garvin. We see a bright future for the company with further gains for their shareholders in the years ahead. The four-pillar brands of McGuigan, Tempus Two, Nepenthe and Barossa Valley Wine Company are distinct from each other, clearly positioned for their target markets and offer international growth potential. Already in their target segments, the brands command leading market share positions both domestically and in the UK with growth significantly outpacing their competitors.

With regards to innovation, Australian Vintage is leading the non-alcoholic trend in the wine industry with the McGuigan Zero range. The company had the foresight to invest significant capital in zero alcohol technology a few years ago and this is paying off now in a big way. Their leading position in lower alcohol wines has been further strengthened recently with the launch of Sevenly, the new range of lower alcohol wines, with fewer calories, made in collaboration with Sarah Jessica Parker and Coles Group. Additionally, as another example of innovation, we expect the company to make use of all the excess alcohol they are generating from the zero range by launching a gin spirits brand in a partnership arrangement.

The financial accounts over the years speak for themselves but are best illustrated in the charts below.

Figure 1: AVG gross margins 2016 to 2021

Source: Australian Vintage Limited financial accounts

The successful development of Australian Vintage brands over the past 5 years has resulted in a significant improvement in the company’s gross margins from 25% in 2016 to 31% in 2021. It’s doubtful the 40% gross margins of Treasury Wine Group are achievable, but a 35% gross margin looks like a realistic target over the medium term. This improvement in margin over time will have a significant impact on the group’s profitability.

Figure 2: Net debt 2016 – 2021

Source: Australian Vintage Limited financial accounts

Despite paying dividends each year along with a special dividend and capital return, the reduction in the Group’s net debt highlights the company’s ability to generate strong cash flow over time.

Figure 3: Return on Equity 2016 – 2021

Source: Australian Vintage Limited financial accounts

Historically the company struggled to generate an adequate return on capital and therefore the share price trading at a discount to net tangible assets was warranted. We took the view that if the company was successful with their branded wine strategy, we would begin to see an improvement in the return on equity over time, and indeed that has turned out to be the case.  The current 8% return on equity is respectable but far from the best in class. We expect to see further gains in the years ahead.

 Figure 4: Equity / Net tangible Book Value 2016 – 2021

Source: Australian Vintage Limited financial accounts

As a rule of thumb for these asset-rich investments, we would anticipate them trading at or around their net tangible asset value once they achieve a respectable return on equity ratio of approximately 8%.

Interestingly, the Company today is still trading on over a 30% discount to their net tangible assets despite reaching a respectable return on equity. This discount is even more surprising considering Australian Vintage is likely to grow at higher rates of return in the years ahead, as they are well on their way to becoming a well-respected listed beverage company with international brand recognition in some important geographies around the world.

As an interesting side note, the much-loved larger listed peer, Treasury Wine Estates, generates a return on equity today of around 7% (down from ~10% two years ago) and trades on a price to their net tangible assets of 3.9x. That’s almost a 400% premium to their net tangible assets.

Please click here to see the Wentworth Williamson interview with the Australian Vintage CEO, Craig Garvin, and see for yourself why we continue to back this company and its management team.