Vital Southcorp And Foster's Both Get It Right On Wine
The Age
Thursday August 19, 1999
There is an emerging conventional wisdom within the wine industry that the more successful a wine business becomes, the less appealing it is an investment.
That is a view of the industry and its investment characteristics that is being challenged by the two major premium-wine producers, Southcorp and Foster's. Their response to the investment implications of growth, however, is quite different and should produce very different companies in the long term.
It isn't necessarily the case that only one of them will be proven right. There is enough growth in the industry - and such massive opportunities for local wine makers outside Australia and the strategies are sufficiently different - for both to be successful. Given their scale within the domestic market, along with BRL Hardy, it is indeed vital for the industry that both strategies are successful.
The view that successful wine companies are inherently incapable of producing adequate returns, at least in terms of the way those returns are currently measured, has some validity.
Southcorp yesterday produced another strong result, built on a surge in revenue and earnings in its wine division, which accelerated towards the end of the year.
The description of the wine-division result was one of a high-growth business. Revenue was up 10.4 per cent and earnings before interest and tax was up 20.2per cent. Second-half EBIT leapt 31per cent as the big increase in red wine capacity and production in recent years started to kick in. Margins edged up from 19.1per cent to 20.8per cent over the year, but exceeded 25per cent towards the end of the period.
And yet the return on investment from that business was flat - 11.2 per cent (EBIT to investment) versus 11.1 per cent in the previous year.
That would tend to support the thesis that there is tremendous growth potential in the wine industry but that growth doesn't deliver competitive returns.
The reality is somewhat more complicated. Southcorp is at the tail end of a massive investment in vineyards and wine-making facilities to lift its red wine production. It has spent $150 million on that program and there was an associated $100 million increase in stock last year as the production increase started to kick in.
Southcorp made a major investment in non-income-generating assets. The effect of that investment on its financial returns was compounded by the nature of its output - premium red wine takes from three to five years to mature before it can be turned into cash.
If Southcorp now sat on its hands, the value added now sitting unrecognised in its cellars would eventually flow and drive a surge in its performance and its return on investment. The business is, of course, too dynamic and the longer-term implications of a pause in investment too unpalatable to contemplate such a course.
There is, however, enough of a one-off, structural element to the recent investment to suggest the program will taper off and returns will rise as stocks are sold.
In a different accounting and tax environment, the increase in the value of stocks could be brought to account over time and both margins and returns would rise.
Southcorp's famous Grange, for instance, is cellared for five years. It is accounted for at its historical cost of about $6 or $7 a bottle but has a market value over $100. If that latent profit could be recognised as it builds up, the accounting and tax obstacles to pursuing greater investment and larger long-term revenue and returns would be overcome.
Whether those returns would be truly competitive with those available elsewhere is a moot point. An integrated wine-making business is highly capital-intensive and the elapse of years between the making of the investment and any return exacerbates the impact.
In the long term, the listed wine companies may, if they want to fully exploit their potential, have to consider structural change to shift the bulk of their vineyards off their balance sheets.
In the medium term, the objective for both Southcorp and Foster's Mildara Blass division is to lift their returns on capital from their low double-digit levels towards 15per cent.
It should be noted that Southcorp and Mildara are two of the world's larger, more profitable and efficient wine companies.
The Foster's strategy is somewhat different to Southcorp's successful plunge into greater red wine production.
This week, Ray King, who played a pivotal role in establishing wine as an attractive public company investment proposition, convincing the sharemarket that it was possible to generate adequate profits from wine, announced his retirement.
King will be succeeded by Terry Davis, now managing director of Cellarmaster Wines. Foster's acquired Cellarmaster in 1997 and has subsequently bought wine clubs in Holland and Germany.
The appointment of Davis signals strongly the Mildara strategy - there is going to be increasing emphasis on expanding the wine-club business.
There is a great opportunity in the clubs, where Foster's is already the world's second-largest operator in a highly fragmented, largely privately owned sector. The clubs involve minimal capital and generate extraordinary returns on investment - Foster's bought into the German club on a price/earnings ratio of five. That business was producing a return on funds employed of 100 per cent!
Expansion of that business will clearly lift Mildara's overall return on capital and, because the market values wine-club earnings on much the same basis as traditional wine making, ought to create substantial shareholder value.
Both Southcorp and Foster's believe that continuing efficiency improvements and focus on scale, and perhaps some creative approaches to the ownership of their vineyards, can lift returns from traditional activities towards respectable levels.
The real issue is whether they can produce superior returns, commensurate with the growth rates and the margins they are generating.
In Southcorp's case, the question will be answered by its success in shifting its production up the value curve towards the high-margin, premium end of the market, and extracting more value from its intellectual capital.
For Foster's, the answer, for the moment, probably lies both in that same focus - Ray King's long-standing focus - on premium brands as well as the future mix of traditional and wine-club operations.
Longer term, if the mix of wine-related business continues to evolve towards the clubs, Foster's could face an interesting dilemma in managing the growth and optimising the returns from its two very different exposures to a future in wine.
e-mail: bartho@theage.fairfax.com.au
© 1999 The Age