Is Treasury Wine Estates a logical fit for Pernod Ricard?

There has been recent speculation that Pernod Ricard is weighing an acquisition of Treasury Wine Estates, which has been caught in the crossfire of an Austral-Chinese trade spat.

In recent years Treasury has adopted a growth strategy that’s focussed on flagship brands leading growth in China, which has dragged them out of the dog days a decade ago, narrowly escaping bids from KKR and TPG in 2014.

Of the company’s $1.0 billion revenue growth since FY12, more than half has come from Asia and accounting for a little under a quarter of total sales in FY20.

However, the revenues from Asia have operating margins that are three times higher than other geographies, giving it an outsized portion of operating profit. So, it’s no wonder the stock has been punished as the company seems to have lost their golden goose.

Management has been scrambling to reallocate Penfolds ‘Bin’ and ‘Icon’ range into other markets (around 600,000 cases) while redirecting contracted fruit supply from the less desirable end of the China portfolio (Particularly Max’s blend and Rawsons Retreat – around 2 million cases) to other brands in the portfolio that they claim is supply-constrained.

Given the premium they were commanding in China, it’s unlikely they can attractively reallocate this volume elsewhere.

As part of Treasury’s strategic rethink, the company have guided that they will need to invest in marketing and distribution capabilities both at home, the US and in Asia ex-China markets. An overlooked and underestimated challenge will be transitioning from marketing an in-demand product ‘that sells’ to one which relies on prowess in distribution to muscle sales of less differentiated products in a more competitive space. To build out this footprint across multiple geographies will be more difficult and unrealistic to achieve under the current COVID travel restrictions.

Conversely, global drinks and spirits businesses are marketing and distribution machines of products that are often differentiated by just a brand alone. Pernod Ricard is a €9bn pa business (trailing only Diageo) of which almost half lies in Asia. However, the company’s wine offering is meagre compared to its spirits portfolio, with reported revenue of just $500m from Jacob’s Creek and Spain’s Campo Viejo the only notable wines brands beyond the Champagnes of Mumm and Perrier-Jouët.

Since wines make up such a small portion of total sales, there are presumably immediate opportunities for cross-selling across all of their markets without meaningful additional marketing spend. The local distributors could move the ‘masstige’ Penfolds and premium brands through the bar and restaurant channel with conceivably little effort.

In the longer-term, it is likely that China will return as a market for Treasury and the Penfolds brands. Either the snap tariffs will be reversed or they will ultimately find another way to market, like developing a suite of Napa products which makes me cringe but is already in the works. Making the most of either would surely be easier for Pernod, who describes China as a "must-win" market for them and has current hopes pinned on cognac, whiskey and vodka.

One can assume their investment in Chinese distribution and advertising would dwarf that of Treasury. As a point of comparison, Pernod has 684 employees in China compared to 126 to Treasury according to Linkedin.

Beyond the near-term flexibility, Pernod’s platform could afford Treasury’s hamstrung business, the most attractive part of the deal from the acquirers perspective would be the potential to cut corporate and marketing costs.

Treasury themselves are targeting $85m pa of corporate and supply-chain savings over the next two years through the restructuring of their US business alone. The $50m of those savings that are expected to be recurring represent less than 10% of the group total SG&A spend of $583m in FY20.

While Treasury’s fruit sourcing and wine-making capabilities will be of a high strategic value to Pernod who have failed to grow their Australian wine business since acquiring Orlando in 1989, I doubt that they will look equally favourably on the in-country marketing teams and support functions that would have a large overlap with their existing operations. Could further third of SG&A costs - around $200m - be saved there?

So, that leaves investors to ponder how much Pernod might be willing to pay for a company of strategic value that would swiftly add A$800-900m in EBITDA (including estimated synergies)...