Hot Stock: Australian Vintage (AVG)

Thursday 9th June 2016

On track despite lower grape crush

What’s new?

As evidenced by Australian Vintage’s share price performance since the release of the 1H16 results, investors are becoming more comfortable with the changes that management has enacted over the last several years, and as a consequence are now more positive on the company’s future prospects. Sentiment towards Australian Vintage has also arguably been assisted by the progress that is being made by the company’s larger peer, Treasury Wine Estates.

While there are key differences between the two ASX-listed companies, one of the more interesting similarities is their respective focus on adding more value through its supply chain – Australian Agricultural Company (AACo)has also been an advocate of this growth strategy. Similar to Australian Vintage’s recent reported results, this strategy is delivering positive results for Treasury Wine Estates, which reported a 91 percent increase in 1H16 profit (+35 percent in constant currency).

Commenting on Treasury Wine Estates’ 1H16 results, management stated in mid-February that “the strong first half result demonstrates continued progress to transition Treasury Wine Estates from an agricultural, order-taking company to a brand-led, marketing organisation”. Sound familiar? In November 2015 management attributed AACo’s improved 1H15 results to “the transformation of the company from a production-led pastoral company into a vertically integrated beef business”.

This in our view is not dissimilar to Australian Vintage, with the recent improvement in the company’s operating performance and profitability attributable to three key drivers. The first was the overhaul of Australian Vintage’s capital position, with the key focus having been on right-sizing the company’s debt load. The second was Australian Vintage’s investment in operating efficiencies, which included rationalising the manufacturing footprint.

While the first two initiatives are now largely complete, the third driver, which is optimising Australian Vintage’s value chain, remains work in progress. This is not to say that the company is yet to extract value or incremental benefits from changes to its value chain, but rather that further upside exists. That said, significant progress has already been made, with the termination and re-pricing of grower contracts and focus on higher margin (i.e. branded) products both well progressed.

Further evidence of these benefits can be found in Australian Vintage’s trading update from last week. While the realities of being an agricultural company were also evident (grapes crushed from Vintage 2016 are down circa 13 percent on the prior corresponding period), we note that (i) grape yields from the company’s owned vineyards are up slightly, and (ii) the year-to-date revenue run rate of 8 percent growth reflects the higher proportionate growth in branded sales over bulk wine.

Outlook

While the lower tonnage of grapes crushed in Vintage 2016 will, all else being equal, put downward pressure on margins (i.e. increase unit cost of production), the net earnings effect from this appears to have been offset by (i) better yields (i.e. higher quality grapes), (ii) increased operating efficiencies, and (iii) management’s increased focus on branded wine sales – grape quality and lower grape volumes will no doubt assist in this regard.

At any rate, management has retained its earnings guidance for FY16. That is, management expects that “subject to no material changes to the current exchange rates, we remain confident that our 2016 net profit before one-off items will be up 10 percent to 15 percent on last year’s $7.1 million net profit after tax and before one-off items”. This suggests to us that management’s focus on operating efficiencies and higher margin sales is making the company’s earnings more sustainable.

Price

Australian Vintage is currently trading at 18.4 times the mid-point of the FY16 guidance, which in our view equates to near trough cycle earnings, and 0.75 times the reported book value for 1H16. This, in our view, is complemented by Australian Vintage’s positive technical setup, with the recent break through the 78.6% and 127.2% Fibonacci making way for the next upside target level of $0.67 per share, which is the 161.8% Fibonacci extension.

Worth buying?

Australian Vintage has reiterated its earnings guidance for FY16 despite having reported a circa 13 percent decline in its grape crush from Vintage 2016. While the lower throughput would ordinarily increase Australian Vintage’s cost per unit of production, the fact that the company’s guidance remains unchanged provides ample evidence in support of our view that management’s growth strategy is the right course of action for shareholders.

James Lennon is a senior analyst at investment research and funds management house Fat Prophets. To receive a recent Fat Prophets Report, CLICK HERE

Disclosure: Australian Vintage is held in the Fat Prophets Small/Mid-Cap Model.

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