Capital Asphyxia
Why access to capital is critical for the future of the wine industry
“Capital intensive” is a descriptor applied to industries that require substantial amounts of capital for the production of goods. Investors usually also apply descriptors such as “long-term” for the simple reason that such industries rarely provide reliable swift payback on amounts invested.
The wine industry is no exception. This will hardly be surprising given the lengthy process required from the moment of decision to plant a vineyard, through preparations and planting to full levels of cropping as much as (or sometimes more than) five years after planting. Even the resulting wine may have to wait (in the case of some red and sparkling wines as much as 3, 4, 5 or more years before it is ready to sell). When someone makes a quick buck out of wine, it is an anomaly.
This is not like any other “typical” food or beverage, and markedly differentiates wine from most “FMCG” products in a supermarket or food store.
The economics of wine production is heavily determined by the amount of capital required to establish and, just as importantly, to sustain a wine business.
The greatest capital requirement will always be for the vertically integrated business that owns its vineyards, processing capacity, warehousing, inventories and brands. Such businesses almost invariably require bank debt to establish as the capital resources required to form the capital assets and then to sustain the business for several years before profitability is even a possibility, will usually be beyond the scope of most individuals or families (even if the underlying property has been in the family for generations). The vertically integrated wine businesses without debt are, in the vast majority of cases, businesses that have been in operation for a considerable period of time or have access to additional capital sources.
Not all wine business models require as much capital. The so-called “virtual” wine business is able to operate a completely contracted model, using purchased grapes or wine, contract processing and storage, and taking all the risk at the brand and inventory levels. The nature of the risk of such businesses is different. Banks will be less willing to lend without the support of “hard” assets, so that there is typically much greater equity risk, especially the risk associated with the ability to move (i.e. sell) the bottled inventory. Another arguable facet of the virtual winery is that it is more likely to be a “volume play”. Lack of direct control of grape production means that the upside of being able to build prices to ultra premium or luxury levels is extremely limited. As a consequence, virtual wineries are forced to build sales and inventory levels in order to grow the level of income. This may look easier at the start up phase, but becomes a much greater burden if the brands prove to be successful and grow fast (although if sales are sufficiently profitable the possibility of obtaining bank funding for working capital starts to improve – which may or may not be the case in the present risk averse climate).
One of the features of the wine industry is the annual cycle of working capital. The high point of this cycle is the need to fund grape production or grape purchases before or shortly after harvest each autumn given that the resulting wine inventories will need to be funded for a minimum (with some small exceptions of early release wines) of 6-9 months for early drinking wines. This includes the funding of bottling, labelling and packaging costs on top of production costs, the components of inventory. So the typical cycle (ignoring sales) for most New Zealand wine operations is for a rapid rise in production costs over the late summer to shortly after harvest, then a progressive rise to a peak in early spring, followed by a progressive reduction into summer. This will change if there is a large volume of red wine (as is the case in some regions) requiring higher costs associated with barrel purchases, followed by longer storage although bottling and packaging costs are deferred. Another big factor can be exports, especially if the winery is exporting volumes to meet the Northern Hemisphere summer requirements – often shipping inventories held from the previous year’s vintage in the New Zealand autumn or winter of the following year, for example.
Funding the NZ Wine Equation
How much capital is tied up in the New Zealand wine industry? Before attempting an answer, I would preface by saying that this is a moving target. The value of invested capital is not based on how much has been spent, but on what it is worth at any given point at time (and the working capital is, as has been explained, constantly shifting).
So, for the point of differentiating, I have estimated that the historic capital cost of building the New Zealand wine industry to where it is today – i.e. the actual money spent on all parts of the industry – as somewhere between $3.4 billion after depreciation, or about $6 billion in today’s dollars before depreciation.
This is not what the industry is “worth” today, but thanks to falling land values is closer than it was perhaps 3-4 years ago.
The following table provides my estimates of the “peak” and current values of the key components of the industry’s capital equation:
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I should first emphasise that all numbers are estimates! Each figure has been established by a process of breaking down vineyard plantings and processing capacities on a regional basis and applying value factors (such as average prices per hectare, which are often hard to pin down in different regions). A number of factors have changed, namely more vineyards in production relative to the earlier time, so these are not simple like with like comparisons.
For the purpose of estimating financial numbers, including inventories and debt levels, I have adopted a sampling approach based on published 2010 financial information (including 4 of the 8 current Tier 3 producers), extrapolating for estimated levels across the board.
I do not pretend that this estimate will be exact and acknowledge that it may, in fact, be well wide of the mark. I use it here, therefore, as much for its explanatory and indicative value as for any other purposes.
The point? Well for one thing I have estimated that the total capital investment supporting the New Zealand wine industry is current approximately $5.9 billion, down from a peak of about $8.5 billion thanks largely to falling land values.
It is this factor, combined with falling profitability owing to weaker overall prices (exacerbated by currency movement), that means banks are somewhere between shy and downright scared to lend to wine businesses.
However, looked at on a bigger picture basis, the industry’s level of borrowings has risen from 30% of total capital assets to 40%, thanks largely to falling land values. In other words there is still more than 50% more equity invested in the industry than debt, even before allowing for the value if investment in brands and other intangible assets are brought into the picture. Overall one might deduce that the industry is (or at least was) therefore carrying about $500 million more debt than it could comfortably bear (based on asset values and assumed aggregate cash flows).
Selling down inventories is one way to reduce this. However, the numbers suggest that the scope to repay significant amounts of debt through inventory reduction is limited. Maybe $100 million (including an estimated $40 million in product discounting already made over the last 12 months (but not yet accounted for in my numbers) is as much as could be expected from this source. (The fact that Pernod Ricard might sell its Lindauer and other brands, including inventories, as well as vineyards and plant, for just $88 million probably says about as much about how much inventory it has sold down in the last 15 months as it does about the values of other assets involved in the deal).
The best way to ameliorate the impact of high debt ratios is to improve profits and cash flows. In essence high debt levels are never as bad if you are paying them down more rapidly from healthy cash flows. Selling down inventories boosts cash flows in the short-term, but is never sustainable as a longer-term strategy. It usually results in short-term high market share, but long-term lower market share (which will have contributed to the materially lower value placed on the Lindauer brand relative to what it may have fetched a few years ago).
What does the lack of capital mean?
Bank credit and lending policies have two components. If banks are lending without major constraints, not only may credit be available to fund vineyards and other industry assets, but funding will also be more likely to be available to investors seeking to purchase investments in wine businesses. However, if bank credit is severely constrained, as it is at present, not only will there not be funds available for expansion projects, replacement projects or working capital requirements, but there will also be limited funds available for potential investors that might otherwise provide equity investment resources for companies (including business owners now finding it more difficult to even borrow against their homes or other assets in order to put money into their wine businesses).
Moreover, most banks appear to be pressuring wine industry customers to find ways of reducing exposures, rather than simply maintaining them. The result is that businesses are forced into practices that compromise their long-term value. Businesses are obliged to take cash flow short cuts, such as selling wine inventories at loss-making discounts in order to either repay debt or to find the cash resources for other essential projects.
Typically the short-term cash needs being funded will be working capital. In a growing business working capital will usually be rising in tandem with volume and sales growth. Taking an overall view of the industry, this is indeed what has been happening since sales volumes and values have both been increasing.
However, since inventory values of the largest companies have been static (and certainly have lagged sales growth), and since industry production has matched or exceeded sales over the last three years, the implication is that inventory levels have grown for the rest of the industry. This in turn has other implications: working capital has needed to be funded, but there are few avenues to obtain the capital to do so. This has further contributed to the level of short-term sales of bulk and cleanskin wines, and the financial pressure on small to medium wineries just increases.
In the mean time wine is not being aged before sale – instead even 2010 red wines are rushed to market. This is far from the environment conducive to the growth of fine wine value propositions. The lack of growth and reduced ability to build higher value pricing of all but the very top wines means that the values of wine businesses, what they are saleable for, is diminished. Take away growth, and business values fall.
So what happens when the bank won’t lend, and when the overdraft is near its limit? In essence, there is a spiral effect that halts growth and, eventually, reduces business values. In so doing, the value of a bank’s security is in turn further compromised in ways that are less obvious than short-term property values, but far more insidious and damaging from an economic perspective. This is the wealth effect in sharp reverse. This is years, or sometimes even decades, of hard work lost.
On the other hand, succession and estate planning become much easier when the numbers are much smaller!
Solutions?
How do we shift the industry’s capital structure back onto a level or even growth footing?
Removing the excess inventories and some excess assets would clearly be beneficial. Those excess inventories of lowest quality wine (some of which would be better distilled or as the basis for vinegar production, so as not to interfere with markets) are a bigger system blockage than the volumes of mid level wines that might seem harder to sell but are often suffering more from the structural issues of the retail end of the industry than from their own merits. Those structural issues are the concentration of retail control (off and on premise) in a small number of producers and the impact of larger producer discounting on wider consumer behaviour.
Changes to either would allow a process of blockage clearing from the other sectors of the industry to gather pace.
Accordingly, steps such as further inventory reduction and, on the industry’s wish list, moves such as shifting the liability for excise on wine sales could reduce current industry indebtedness by as much as $140 million, or about 6%.
A further balance sheet improvement could simply come from the freeing of debt availability for acquisition purposes. The values used to drive the industry balance sheet above are based on capital-starved depressed prices, prices being set sometimes by mortgagee sales in some areas, not necessarily economic values justified by future income levels in each area. By my estimate, if prices were to rebound closer to a level reflective of a grape price increase of $200 (adjusted according to levels prevalent in different regions), the consequence for land prices would be a boost of close to $700 million nationwide, hauling the industry debt to assets ratio down by 6% to between 33-34%.
Improving the flow of product through the industry is the key, ultimately, to allow grape pricing to adjust to more sustainable levels, removing many vineyards from the critical list and allowing property prices to stabilise. In so doing, pressures on the banking sector would ease and the relationship between a grape grower or winery and its banker to return to something closer to normalcy.
The other key step involves a shift back to spending on marketing. With market stagnation, many wine companies have substantially reduced expenditure on higher risk (but potentially higher reward) marketing expenditure. Why spend money on market research when you feel you know the markets that already work for you – even if price discounting strategies are presently the only way to survive in those markets. What has happened is a default reliance on the Givernment to fund the market research and market opening initiatives in regions such as Asia, North America and newer corners of Europe. In a proportionate sense, the rewards of a sensible market development strategy can far exceed to costs. The potential cash flow benefits to the industry are not to be underestimated in terms of the flow through effect on debt levels.
Finally, removing blockages is the key to getting equity investment to flow back into the industry. Getting that investment back in will restart a virtuous cycle allowing asset values to rise, sensibly rather than speculatively.
In an ideal world there are such investors lined up already. That may, however, be optimistic in a climate where offshore investment capital has become politically compromising. Overseas investors rightly get mixed reports. The best, however, care about the land no less than existing growers who live on it and are able to help open markets. We should welcome them, or not, according to their merits. The worst mistake we can make, because it will come back to haunt us, is to judge all foreign investors alike as rapacious asset strippers to be shunned.
The equation? Firstly, I estimate that there are untapped capital resources of as much as $400 million in specific ungeared balance sheets. This is not to say everyone who is presentable in a relatively comfortable position should go out and raise all the debt they can, so as to become as troubled as everyone else! However, I believe it means there is between $100 and $150 million of capacity that could be utilised in a sensible and controlled way to acquire assets and implement growth strategies that would ultimately pay of both in greater wealth for the investors and also “win win” benefits for the industry and community.
Separately, in my opinion the industry today is short of equity capital to the tune of approximately $230-270 million, depending on other steps coming to pass. The point is that, unless someone like the NZ Super Fund was willing to commit to a material sum for investment (say, on a co-investment basis) this amount will simply not come from local capital sources within the next 3 years. Being more realistic about what local investors might be in a position to put in, the present equation suggests an overseas investment requirement of about $200 million (spread over a number.
What is simple and clear, is that the suffering will linger without it.
Doubtless WineThink 