Australian Vintage Ltd, inexpensive, but cheap?

On a recent post a reader recommended that I take a look at an Australian wine industry stock, Australian Vintage Ltd.  I've historically done very well investing in wineries and wine related stocks so it only made sense to investigate Australian Vintage Ltd (AVG.Australia).

I think it helps to invest in companies and businesses where the investor has no opinion of the product.  I am not much of a wine drinker, I will have a glass with relatives at a holidays, but that's about it.  I've had a variety of wine from the $2 bottles at Trader Joes to $150 bottles received as a gift.  As a consumer I have the ability to appreciate fine wine, but I don't have any strong tastes or preferences.

Our own preferences can be blinding with an investment.  If I only liked Pinot Noir I might hesitate to research Australian Vintage because they're renowned for their white wine.  If I were familiar with wine I might recognize the placement of their product at the liquor store, or have a thought on their product.  If I had a strong view of a company's products I might have trouble seeing what the numbers say about an investment.

Australian Vintage is a wine grower and producer in Southern Australia.  They have three main wineries and their products are shipped worldwide.  They crush 150,000 tons of grapes, and sell 85m liters of wine annually.  They grow their grapes on 11 vineyards, which are both owned and leased.  Their best known brand is sold in Australia and the UK under the name McGuigan.  In the US they market their own brands as well as sell bulk grapes to wineries such as Gallo, which produces affordable table wine.

The main attraction for this investment is their valuation.  They have a market cap of $82m and tangible equity of $172m.  Their book value is higher than tangible equity at $281m, but also includes goodwill, deferred tax assets and water rights.  The company is profitable, they earned $3.3m in the first half of 2014, and $7.1m in 2013.  Lastly management is very focused on paying a dividend, which was 2.6 cents fully franked (franked means the company paid the tax for shareholders, a non-franked dividend would be higher) per share last year.

The company's results started on a steady decline in 2006.  When I see a company with a low valuation and very marginal results I ask myself: "Is this a company problem, or an industry problem?"  Company problems are issues specific to the company that corrected would reverse their negative direction.  Industry problems are issues that all companies in a given industry are facing.  It's very easy to identify which sort of problem a company is facing, look at their competitors.  Australian Vintage is facing an industry problem along with other Australian wine producers.

The company's future and results are closely tied to their industry, the Australian wine industry.  Over the last five to seven years Australian wineries have struggled against a strong currency and over capacity.  These headwinds have harmed the industry as a whole eliminating profits and shrinking margins.  Conditions have somewhat stabilized as companies adjusted to the operating environment.  The companies still in operation have found a way to survive and are managing to produce small profits.

I've discussed investment pivot points in the past and I came up with two pivot points for this investment:

  1. Will the Australian wine industry remain depressed forever?  
  2. If it recovers will Australian Vintage be able to last long enough to enjoy a recovery?  
If I can answer both questions with a yes then it's worth investing in this company.

The answer to the first question is that I don't believe the Australian wine industry will remain in a slump forever.  While it might never return to the level of profits it achieved in the early 2000s it will recover.  That's because the industry has shaken out weak players and companies have reduced expenses.  Even a slight recovery will result in significant profits for everyone involved due to improved cost structures.  Unfortunately no one knows when a recovery might happen, and investors are notoriously impatient.  If something isn't a quarter or two away investors are often inclined to sell a stock and walk away.

Answering my second pivot question is tougher.  The company is earning just enough to stay in business under the current conditions.  They've reported very slight increases in profits and sales and expect that to continue.  The company has done a lot of right things to get their expenses under control.  They have reduced operational expenses and worked to increase their gross margin.  They're also working to upscale their brands.  The problem is all Australian wineries see upscaling as a solution.  Particularly troubling is that the company was heavily indebted and had a number of onerous contracts up until recently.  They raised capital through an equity offering to pay down their debt and re-negotiated their onerous contracts, both good things.

The company's debt ratio has been reduced to 39% of equity, and their interest expense is covered 5x.  It also looks like their results don't fully reflect the value of their renegotiated contracts.  What's been troubling me as I've researched Australian Vintage is their use of debt.  They don't have enough cash on hand to finance inventory, so they use debt to finance it.  In 2012 they had a very large vintage harvest which required a debt increase.  The concern is that they could have a large vintage that coincides with a reduction in demand, or negative currency movements.  In that case they would have financed a lot of inventory that they're unable to sell.  Beyond being able to sell the inventory they'd also have financing costs to worry about.

It's easy to get hung up on what the worst case scenario might be for a company.  I kept reminding myself that the company is already operating in a worst case scenario environment.  If someone would have asked their CEO to describe his nightmare operating conditions in 2003 he might have described what exists now.  An extended period of time with a strong currency coupled with a large amount of excess capacity and lagging demand for Australian wine.  In this worst case situation the company has managed to cut costs and turn a profit.  Things could easily get worse, but the company is already priced for bankruptcy.

If the company were to declare bankruptcy, the worst case for stock investors, they could pay off their debt with their fixed assets.  Their fixed assets were recently assessed at $120m against the company's borrowings of $107m.  That would leave investors with the company's working capital which is $157m, still double the current market cap.

I don't love this company, but I love their valuation.  At 28% of book value almost nothing needs to go right for investors to realize a return.  If the company can continue to survive they will eventually gain the benefit from a tail wind.  The company doesn't even need to be worth book value for investors to benefit.  If the market suddenly believes they're worth 60% of book value an investor here doubles their money.  The icing on the cake is that while investors wait for a recovery they can collect a 6.2% dividend.

As I looked at this I re-assessed Treasury Wine Estates (TWE.Australia), the larger and more well known Australian wine producer.  Treasury Wine Estates is trading for 80% of book value and is facing the same industry headwinds.  They've been making changes to their business in an effort to thrive in the current environment as well.  If Australian Vintage were to trade at 80% of book value like Treasury Wine Estates they'd be worth $224m.  If Australian Vintage were rewarded the same P/E as Treasury Wine Estates they'd trade for book value.

Disclosure: Long Australian Vintage

22 comments:

  1. I share the same opinion, I think that we have here a bargain, although the financial struggling

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  2. I was probably the one that mentioned this to you. I am long this stock and think it will take 2-3 years to see that value at least partially realized.

    Just a couple of comments: Tonight is budget night in Australia where the reveal the new budget. The new government has promised to end corporate welfare. I am hoping that they end the crazy wine equalization tax which in short is where they take money from big wineries like Treasury and AVG and hand it out to small wineries which are structured to operate at a loss so as to claim a $500,000 annual welfare payment. This is a big cause of the wine glut which has hurt legitimate wine companies like AVG. So, lets hope something happens on that.

    I think to be profitable in this industry in the future branding is essential. The Treasury wine brands are right now in disarray and that company needs to be bought out and broken up for its parts. McGuigan on the other hand just increased sales of its Mcguigan brand 29% as announced in their half year results.

    If you are not branding then you are competing with low margin private label supermarket brands which sell this cheap wine (from the wine glut) at very low margin. AVG actually makes Tesco brand wine for Tesco. It is a good business to utilize the excess production from our vineyards but very cutthroat and low margin. The wholesale price of cheap wine in Australia is between 60-80 cents per liter now due to government tax policy subsidizing this. It is crazy and hard to obtain decent margins in this type of market. Let's hope the new government addresses this....

    Also, if the wine glut ever goes away I think AVG will benefit more due to their proportionally greater ownership and long term leasing of vineyards. They are grape growers as opposed to asset light industry model like Cassella Wines which makes the "Yellow Tail" brand that you see everywhere. In the asset light model you don't grow any grapes. You just buy them from farmers often below cost (due to the wine glut and wine equalisation tax)

    These asset light wine makers are not hurt like the farmers and vineyard owners by low grape prices. But this will reverse and benefit AVG is the wine glut ever goes away. This is my understanding. But I am not expert and could be wrong.

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    1. Great information on budget night in Australia, I did some searching and it appears that the wine tax wasn't reduced. It's a shame the government is propping up unprofitable wineries with this tax. Their market manipulation has affected the entire industry.

      Great points on the McGuigan growth. I agree that Treasury needs to be sold. They're below book as well and might be worth a position again just on that alone. I know they were shopping themselves in China a few years back, although nothing happened.

      I'm content holding and waiting until something happens, we'll see when that is!

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  3. Hi Nate,

    Franked dividends mean you get back a tax credit (called franking credit or imputation credit) for the corporate tax the company has paid. An Australian can use this tax credit to offset his taxable income. e.g. if a company's tax rate is 30% and declares a 70cents fully-franked distribution, an Australian investor will get $1 notational taxable income, 70cents in cash and 30cents in tax credit. Effectively, what it means is, if your marginal tax rate is lower than 30%, you will get tax refund.

    But it may not work for foreign investors.

    There are tax treaties between US and Australian. I get tax credits for the 15% withholding tax US gov taken from . I guess the treaties will in it have something similar working the other direction.

    re: AVG, FCF looks scary over the last 10 years....

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    1. John,

      Great thoughts on the dividend. The company has paid the tax alright right? The point I was trying to convey is that if one were to compare what the company pays out to other companies worldwide it should be 30% higher. This is because they've already paid that tax for individuals.

      It appears that US investors claim the dividend received by Australian firms as the dividend plus the tax credit.

      Yes, FCF and cash flow in general isn't great. They have a slide in their capital raising presentation discussing all the levers of cash flow, it was very illuminating.

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    2. For US investors, the franking credits attached to dividends don't do very much. Essentially, if a dividend in 100% franked, that reduces Australian withholding tax to nil. (To the extent a dividend is not franked, then the tax treaty allows Australia to impose withholding tax of 15% on dividends paid to US residents.) Got that?

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  4. Nate,
    Have you considered Chinese adr's listed in the US that are going private? Do you have any thought on this...
    Don

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    1. Don,

      I never have. I recognize that I am missing out on value by ignoring these Chinese companies, but I believe they're too much of a gamble.

      Nate

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    2. Take a look at SGAS... A group of buyers (including Morgan Stanley Private Equity Asia) are in advanced talks to take the company private via a merger by Q2 2014.
      Here is the link to an article:
      http://seekingalpha.com/article/2211303-sino-gas-international-holdings-5_7-percent-gross-profit-in-1_5-months

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  5. Australia's currency is causing problems, not just in this industry but their whole economy. It can't really continue like this forever or their businesses will really suffer - but who knows when it will reverse. I own Emeco Holdings which is a similar Aussie company trading below liquidation value.

    Unfortunately that's the price you pay for not being a 'problem' economy like Europe or the US.

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    1. One storyline was that China was going to crash and bring down the value of the AU currency with it. That would have supercharged some Australian stocks, but so far it hasn't happened.

      Currencies never stay high or low forever. I'll take a look at Emeco Holdings, I like things below liquidation value!

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    2. Yes, the high currency is a problem, Australia-wide.

      Part of the problem is that interest rates in Australia are higher than many other countries, which attracts a low of "hot money". That position might reverse in future.

      A bigger problem is that there are a number of giant resource projects that have recently started or will soon start producing soon. For example, on current projections, Australia will soon become the largest gas exporter in the world (bigger than Qatar or Russia). This factor is likely to keep an upward pressure on the exchange rate.

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  6. Interesting write up thank you.

    I know very little about this business but do the $82m of operating lease commitments change the way you value the business? I am assuming in a liquidation scenario these commitments would have to be honoured.

    All the best,

    Mike

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    1. Mike,

      In a liquidation they'd need to be honored you're right. But it's also likely if they liquidated they'd be able to sub-lease them or sell them so the hit wouldn't be full.

      When thinking about liquidation I want to make sure I get my money back. Even if the company were to liquidate there's a greater chance I'd get my money verses not getting it.

      Nate

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  7. Hey Nate,

    Do you understand this provision for onerous contracts they keep reversing (I think) into income?

    Love your work!

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    1. their provision for onerous contracts went from nothing in '08 to 26m in '09 and according to someone from AVG they have reduced the provision each year as they incur the cost of the contracts. so they have written it down by about 20m since '09. based on that i assume soon the provision will be completely written down.

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  8. Hi Nate,

    Cheers again for the blog.

    I have had a positions in AVG twice before. Most recently I had a good run - it looked like cashflow was improving but then I got out when the financials deteriorated - unexpected rise in debt, after they had been paying it down for a year or so.

    I'm not sure how much you can rely on book value as a measure for this sort of business - there's always scope for a massive writedown.

    The other point I would raise on branding is that wine in the UK (AVG's biggest market) is largely commoditised. If you walk into any supermarket there is abundant oversupply and not much in the way of differentiation - there are shelves and shelves of wines from everywhere. I don't think it's just an Australian problem - i think it's global. In the UK most people won't pay more than 6 pound for a bottle. McGuigan has decent shelf space in Sainsburys (volume) but none in Waitrose (high end supermarket). Difficult to see any wine company setting itself apart in a supermarket (see if anything stands out next time you visit your local Walmart (or wine store)).

    That said, if cashflow turns up over a longer period I could be interested again.

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  9. http://dealbook.nytimes.com/2014/05/20/australian-winemaker-rebuffs-2-8-billion-takeover-bid-by-k-k-r/?_php=true&_type=blogs&module=BlogPost-Title&version=Blog%20Main&contentCollection=Mergers%20&%20Acquisitions&action=Click&pgtype=Blogs&region=Body&_r=0

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  10. How does one buy shares? Via OTC AUVGF?

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    1. They are available at Saxobank or interactive brokers (IB)

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  11. I got their market cap as 46m rather than 82m (.35cent/share x 132m shares) or (7.1m net income/132m shares= 0.053eps)

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  12. Anyone knows why the volume was huge yesterday (6,633,632 shares traded) , comparing with a normal day of 30k, 60 k? I didn´t find anything on google, The only announcement on August 11th is that the full year results will be released on August 27th. Is there any relation between the announcement and the volume ?

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