The Strong and the Weak – a story of opportunity?

The Financial Strength of the NZ Wine Industry

 According to various commentators the New Zealand wine industry is presently either strongly placed, a basket case, or somewhere in between.

There are problems and this is acknowledged by all.  However, compared with some of our competitors a lot more seems to be going right, rather than wrong.  Yes, we have an oversupply situation – but again, for better or for worse we seem to have developed some mechanisms that we did not have in the past to be able to remove some of the excess from the system.

Generalisation opens the way for misunderstanding of the situation, and misunderstanding, or diagnosis based on erroneous assumptions, can give rise to incorrect prescriptions. 

So just as some wine companies have experienced falling sales or relied on discounting to move wine, other companies are thriving with sales growing strongly.  This is a healthy and normal situation experienced by most industries – the rise of new, innovative or fleet-footed businesses who out-compete older companies.

The same goes for the balance sheets of the industry.  For every company making losses and being nursed by its bank, there is another that has no debt or at least a significantly stronger financial position.

It is also essential to bear in mind that in an industry where family proprietors play such a significant role, the ostensible balance sheet of the wine business only tells part of the story.  What it misses is other “personal” indebtedness for some, as well as the capital resources (and cash flows) of those that have other businesses that are often used to provide additional support to the wine venture.

Aggregate or cross-section type survey analyses such as that undertaken by Deloitte, while extremely useful in the context of what they say about profitability, nevertheless do not discriminate between the weak and the strong.  What they present is a snap shot that looks neither as bad as some, but much less healthy than others.

Looking at this from the perspective of the problems faced by the industry, one clue as to a solution presents itself: utilising the strength of the strong for the benefit of all (including themselves).

Anatomy of Wine Business “Failures”

You know things are tough when industry chatter revolves around subjects such as who will be the next to fall into receivership or liquidation.

Often the unspoken element of the conversation is the thought “there but for the grace of god…”

Usually when someone writes an “anatomy” of business “failures” they are looking for a set or sequence of common features.  In the present NZ wine case I am unconvinced that there is much commonality at all.

Why do some businesses “fail”? Is it really “failure”? What are the characteristics of businesses that do not survive – to what extent is this the result of a failed business model, or do other factors have a bearing? 

In truth the answer is complex.  Why firms fail is complex indeed, but why some firms survive can be even more complex.  In some cases the difference between success and failure is a matter of management.  In other cases it is hard to discern beyond the role played by luck.  One very common factor is the notorious “domino” effect – where an otherwise healthy business is rendered insolvent by the actions or the failure of other counter-parties such as large customers. (A number of NZ wineries suffered significant losses, and often lingering effects, from the inability of overseas importers to settle on transactions back at the height of the international liquidity freeze and recession period from late 2007 to early 2009).

As much as the media loves to be able to point a finger of blame at “failures”, sometimes it is really highly unfair to do so.

Timing is another factor that has affected the health of several NZ wine companies – for example buying assets, and taking on debt, just before the credit crunch and recession struck.  Again it is easy to judge – why would anyone be so stupid to pay the prices that were being paid just 2-3 years ago?  Then again, if you were convinced that you need to secure sources of supply for growing orders and unsure whether land prices were going to continue to rise (as many thought they would, applying the logic of a looming shortage of suitable land for planting in Marlborough), the logic of buying was not necessarily ridiculous.  In other cases the debts were taken on because of partnerships (or marriages) ending, new generations buying out old, and other factors that happen all the time regardless of economic conditions.

The Issue of Capital

Wine growing and making is what is often referred to as a capital intensive industry.  It may require a significant value of investment, both in terms of equity and of debt or borrowed capital to fund any wine business.  In this it arguably shares more in common with other businesses such as electricity, roads and water – all extremely capital intensive, and all commonly referred to as “long-term” investments.  Owing to the level of capital investment, the time taken to earn an adequate return can be far longer than for a manufacturer, retailer or service business, for example.

This leads to the problem of the present day.  What the New Zealand wine industry most lacks today, both from the perspective of solving existing problems and also of continuing growth, is capital.  The industry lacks adequate capital resources.

So why would an investor invest (or a banker lend) to a wine business today.  The fact that prices and therefore earnings today are lower than a few years ago means that, even though asset values are also lower, returns are down.  Throw more capital at the problem and the returns will by definition be stretched over a bigger capital base and, possibly, unattractive for the undoubted risks out there right now.

Of course there are exceptions – businesses that are really flying and that ought to make excellent investments.  Ironically, the success of these highlights how much worse things might be for the rest.

The crux of the matter is that shortage of capital means a reduction of opportunity costs: a lack of options resulting in only a limited array of actions that managers are able to take.  This is the handicap factor of not being able to do something now, and of having to wait – lack of capital limits the scope of options to improve the position of a business. 

One way of improving a business might simply be to retire indebtedness.  However, to do so will usually mean either injecting new equity capital or selling assets.  In the present environment, neither of these may be either attractive or even possible. (Some businesses that have raised additional capital now find a need for more, and at the same time are learning that they only had the one chance but wasted it).

One Way Forward – Utilising the Strength of the Strong

One way of defining business strength is the abundance of options.  Strong businesses have the most choices available to them, and those choices have implicit value.  Businesses without choices, without options, lack value.

The options that are available may be highly varied.

Businesses that are growing strongly may have a range of market opportunities available to them and need instead to choose how to ration their product between such opportunities. (Arguably this was how the wider New Zealand wine industry looked just 5 years ago).  They may also have more choices about where or how to procure more product.

Businesses with strong balance sheets, with plenty of assets but low levels of debt are most likely also the most profitable businesses in the industry today.  Some have inherited their strength through the ownership of properties bought for much lower prices a long time ago.  Others have simply been conservative financial managers and have never allowed themselves to become exposed to much risk – firms that might have been thought to have lagged behind the market a few years ago but are now sitting pretty!  It matters not how they acquired their strength, only that they are strongly placed.

Other businesses have strength in other forms – access to cash or to capital from other sources, captive local markets, access to particular expertise, exceptional reputations, or exceptional market contacts are all examples.  Each example has the potential to create those options, those choices, that add value.

The future of the whole industry is in the hands of those with options.

It could be that one source for future industry enhancement is by recognising the brands or products that are wanted by the rest of the world at sufficiently profitable prices, and galvanising industry support behind those with these brands or products to meet demand.  To express this in an extremely general sort of way, the present owners of the brands or products benefit from the profits from growth; other parts of the industry become suppliers at an economically justifiable price that ensures the industry-wide margin is enhanced.

It could also be that many owners of businesses with balance sheet strength or with capital resources available to them that are otherwise in short supply, are sufficiently motivated to use their strength to acquire or to merge with other businesses.  

There are a number of consequences of combining a strong and a weak business, hypothesising for the time being that both are similar in size (whether on account of land, crush size, winery capacity, volumes sold or sales revenues) and hypothesising also that no new equity or debt is raised. The odds are that the debt level of the combined business will be at levels that will not worry the banker and are likely to be more comfortably covered by the combined business profitability. There may well be cost savings to enhance this position.  There may well be more choices with regard to products and as to how grapes are processed then channelled to market.

In short the business may simply be more attractive from an external point of view than the sum of the two to begin with.

Then there is the other big issue: both sets of shareholders will have stakes, only the strong will definitely have the bigger stake (and the big question will be by how much).  Typically this is where two main problems arise.  The first is the fact that no one person (or family or shareholder, etc) has complete control any longer – this is probably a good thing as there are very few people in the industry who are equally strong at all elements of the winegrowing process from growing grapes, to winemaking, to marketing, to financial management; the input of more expertise may well be an unforeseen positive. The second is the difficulty the weaker business has in accepting that they do not have comparable value to the business that otherwise appears to be the same size, plus the equal difficulty in communicating the fact that by merging with someone stronger they may actually end up with greater “wealth” than they had before.

Equally, many owners of very strong businesses are averse to the idea of changing from the tightly controlled, comfortable world and comfortable business model that has served them well through a tough economic period.  This is a readily understandable response.  If, however, the owners of such businesses are thinking to a future with retirement or generational succession, they may well be missing out on opportunities that are very available to them with suitable care and thought.

The strong are not going to buy out the rest of the industry.  The types of merger or alliance discussed here will not apply everywhere or to everyone.  But if people care about the future of the industry and are aware of the limitations imposed when everyone sits and does nothing, when the strong and the weak are merely possums on different sides of the same road at night, then the message here is that industry people should stop and think rather than simply rejecting solutions.

The NZ wine industry is short of capital.  Without better employing the capital that we already have, as an industry, the recovery will be longer and riskier for everyone.

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