TFF Group – Equity Research

Introduction to Tonnellerie Francois Frères

Tonnellerie Francois Frères (TFF) is a family-owned (71% ownership) dry material supplier in the alcoholic beverage industry, they supply casks and barrels for wine and Scotch and Bourbon whiskies (Wine is 43% of sales and Alcohol 57%). The oak barrels are the key value adding component to these beverages (flavor, aroma and body sources) and the quality of the barrel determines the quality of the beverage to a large extent (this is a very simplified overview).

TFF has a dominant position in all the segments they operate, their market share is 25% in wine, 80% in Scotch whisky and 18% in Bourbon. The Wine segment operates worldwide, while the Alcohol segments operate in their geographical denominations (US Midwest & East and Scotland).

Since 2016, TFF Group has enjoyed a staggering growth thanks to the excellent execution of the Bourbon Division (39% Revenue CAGR over the last 7 years). TFF’s investments are ongoing, with the goal of increasing the current Bourbon capacity by 85% over the next 2 years.

Nevertheless, the current situation is quite different. TFF has suffered a 41% drawdown during the last year (main reason we started to analyse in deep the company two months ago, as we were already familiar with the quality of its business) as TFF is suffering the reduced consumer demand and the inventory accumulation impact from the beverage makers and distributors. But unlike other players of the value chain, this impact on TFF’s economics has a lag (it takes longer for them to reflect the market demand) due to:

1. The product of TFF is used for long beverage maturing cycles (can last for more than 10 years in some whiskies)
2. The barrels is consumed further downstream in the beverage supply chain than the product of beverage makers or glass/cork manufacturers.

After the Q2 Earnings release last week, the company is trading at COVID lows. It is unusual to see such a compounder business with still runway for growth and a strong moat provide a good entry point. It is a moment of uncertainty for the beverage industry: the looming tariffs, the recent negative press around alcohol, the macro consumer trends and the noise of climate change potentially impacting the last couple of poor wine harvests…We analyze in depth each of these points.

There are many dynamics playing out in this company, and this week, we are sharing an analysis with all the attention to detail it deserves. We touch on:

• The beverage industry supply chain dynamics
• Business model of TFF and its detailed operations
• Breakdown of each one of the segments and the analysis of their macro and micro forecasts
• Analysis of its Capital Structure (Debt, Working Capital…), Capital Allocation, M&A, Management…
• Economics & Valuation including our downloadable spreadsheet
• A detailed risk analysis that matches the significance of the company’s situation
• Our Conclusion about the opportunity on TFF

The TFF Business

Before we delve into the specifics of each one of the beverages, it is worth explaining that, overall, the barrel and cask demand are result of various factors:

• Bourbon, scotch and wine consumption volumes and regulations: Different categories may require multi-barrel ageing or longer ageing. Government regulations around the requirements of Bourbon and Scotch, minimum alcohol % content in beverages that can be sold in grocery stores and tariffs, are some external factors that impact volume, beyond overall consumption trends.
• Inventories at their clients: Orders at their clients are subject to large YoY variations. Due to the multi-year period of ageing in some products, long-term forecasts guide the orders from their clients. These long-term forecasts are noisy and inaccurate, as predicting long-term beverage trends is not an easy task.
• Harvest quality: To a large extent, the better the grape harvest, the larger the produced wine volume. Good harvests deplete inventories at their clients faster, while bad harvests reduce the order intake.
• Availability of Bourbon barrels for scotch production: Scotch whisky is made with used Bourbon barrels.

Beverage Industry: Supply Chain

TFF Group is a supplier of the wet material processors in the beverage industry. Their clients are whisky makers like Diageo & Pernod and wine markers like our dear Italian Wine Brands. There are no pure publicly traded comparables to TFF. Other publicly traded companies that compete with TFF, only have barrel-making as a fraction of their revenues, such as Oeneo and Anora.

Ageing of the beverage inside the barrel:

The ageing of the beverage inside the barrel is the process that plays the most value-adding role amongst all the processes in the supply chain. Ageing inside the barrel is the main source of flavor, aroma and body.

It is interesting to understand the dynamics that play out during the ageing process: When it comes to the age of the barrel, think of it like a tea bag. The first time you use a tea bag, your tea has a lot of flavor. But when you use the same bag for a second cup of tea, it has considerably less flavor. It’s the same deal with a wine barrel. When a winemaker first uses a barrel, they usually get about 50% of the extract into the wine. On the second use, it goes down to 25% and diminishes even further after that. The same mechanism repeats with whiskies.

At the same time, the bigger the oak surface area/wine volume ratio during ageing, the stronger the influence of the oak and the faster the ageing process happens. In other words, smaller barrels have more of an impact on wine than larger barrels.

The Manufacturing process

High-level the barrel-making process has five steps:

1. Purchasing the wood: The supply dynamics differ depending on the geography. In France, 90-95% of the wood is purchased directly from the national forest authority. The government manages the stock of trees (oaks) better than private owners. Private companies do not always take proper care of their forests. They are not consistent in the offer (quantity and quality). It is difficult to manage tree inventory; It takes 250 years to have the oak ready. The government cuts the supply of wood to keep prices stable. That’s fine with for TFF, as long as TFF can find the wood needed at acceptable prices. A drop in lumber prices is not the direction of this market in the long term. Supply is limited, impacted by climate change. Prices will tend to rise.There is currently a good access to French wood. The process to acquire wood in France is transparent (no corruption). The wood goes to the player who pays the most for it. TFF pays handsomely, but they reflect their costs in their selling prices. France is in a very good situation as far as wood supply is concerned. It is possible to sign long-term contracts with the national forest authority, but only for sawmills. For this reason, TFF recently purchased 2 sawmills.

   In the USA, the dynamics are different compared to France. TFF buys mainly from private suppliers. There is a market price for wood. The price of wood depends on all the uses that are given to wood in the economy (e.g. construction, flooring, furniture). Prices are stabilizing and even falling. This might result in lower price of barrels. Especially in the US due to its diverse climate, the origin of the wood matters.