The hazard of driving profits with Chinese drinkers – Treasury Wine gets tested

Crown Resorts experienced the perils of operating in China – and more particularly the risks of relying on China as its growth engine.

It became badly unstuck when 19 of its staff were arrested for breaking gambling laws in late 2016. The China market took years to even begin to recover and thanks to COVID, our current toxic relationship and likely regulatory restrictions being placed on junket operators that facilitate Chinese gamblers playing in international casinos, this market now barely has a pulse.

Unlike Crown, Treasury Wine had done nothing to make itself a target of Chinese authorities. It was just a victim. However, like Crown, Treasury had relied on China to propel its growth.

Given the China wine trade will now all but evaporate it will cut a 30 per cent hole in the company’s earnings leaving it in damage control mode. Until last weekend 25 per cent of Treasury Wine’s top quality Penfolds range went into China.

So it’s understandable that since Friday when China announced the wine tariff, Treasury Estates’ share price has been in freefall. It is hard to imagine that Treasury Wine’s executive team has been sitting flat footed all year hoping for the best.

It would have been irresponsible not to have planned for the worst at the same time. And this is as bad as it could get.

How well Treasury Wine tackles this challenge will be a gigantic test for its new chief executive, Tim Ford, who within minutes of being appointed to run the company early this year was hit with the COVID curve ball that decimated sales derived from restaurants and pubs.

While in-premises consumption in Australia is starting to improve as the economy opens up, it could be some time before other markets such as the US return to pre-COVID levels.

The good news is that the threat to the China market has now become a certainty – albeit a difficult one. Ford now knows what he has to work with.

The other big positive is that Treasury Wine’s premium brands are sufficiently sought after that replacing the China exports with new markets or increasing sales to existing markets outside China may well be achievable over time.

Ford understands that when dealing with wines in the premium end this process can’t be hurried along by discounting. And the good news is that counterintuitively the best wines can increase in value over time – rather than suffer from a limited shelf life.

Even if it finds new markets to replace China over the next couple of years, it will still be missing its growth engine.

This is where Treasury Wines’ strong balance sheet will come into its own because this where the inventory will need to be parked.

Ford told investors on Monday there is unmet demand in various geographies including South East Asia and the US, so this is where its efforts will be initially focused.

The management has to mobilise the plan to immediately get the marketing and distribution costs out of China and redirect them to new markets. This may involve increased costs because the company has no distribution infrastructure in new markets.

Thus Ford will need to find ways to shave costs in other areas. Execution of this strategy is something over which Treasury Wine has control.

But the challenge extends beyond finding new markets for its luxury brands of which the Chinese were so fond. China also imported the lower end commercial wine from Treasury Wine and this is the product that analysts think will now end up in Australia and New Zealand.

This is the cheaper and lower margin plonk that will probably be further discounted for sale in bottle shops.

Even if Treasury Wine executes its recovery strategy brilliantly, its earnings will be hit in 2021 and 2022. And even if it finds new markets to replace China over the next couple of years, it will still be missing its growth engine.