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