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The announcement that none of the potential pivate equity bids for TWE has come to fruition does not entirely surprise, although the purported attitude of some shareholders toward the price previously offered is curious. The nature of the due diligence and bidding process instituted by the TWE Board appears to have been designed to get just this result. The reports from TWE that both bidders supported the company’s strategy rather supports the hypothesis that this backing was a prerequisite for bid support, notwithstanding the fact that it likely reduced the value of the bids (unless both KKR/Rhone Capital and TPG really were clueless, which I doubt although without knowing who has advised them I can’t help but feel their wine industry nous is open to question). What remains to be seen is whether the agreement KKR and TPG will have signed up for in order to gain entry to due diligence now precludes them from returning with a new or revised unfriendly (i.e. unrecommended) bid. If so, this transaction appears to have been cynically managed to preserve the status quo, potentially contrary to the interests of TWE shareholders.

There have been many comments in recent weeks regarding the implications of private equity bidding for TWE. I do not believe that comparisons with Accolade are helpful. Accolade is a much simpler business and, as a consequence, its private equity owner CHAMP has been able to institute a much simpler strategy to add value.

By contrast, if I were a private equity buyer for TWE I would definitely be aiming to gear up as high as possible for the simple reason that I would be planning to sell assets quickly to reduce debt with a view to ending up with enhanced equity in the assets that remain after debt has been repaid from proceeds. The value adding process would not be a vainglorious attempt to grow earnings of the whole but rather an attempt to get the business back to a state of simplicity and focus. These are the hallmarks of the most profitable wine businesses worldwide, which TWE is not. Paradoxically, I also believe that the current wine conglomerate incarnation of TWE requires more capital and working capital investment than a smartly run smaller business cherry picked put of the balance of relatively unloved or undersupported brands.

Some media and industry commentators would have us believe that break up of TWE would be some sort of disaster for the Australian wine industry. I suggest this couldn’t be further from the truth, although part of that is a spectator’s desire to see how some of TWE’s famous brands could perform if actually set free and properly loved. Another paradox: it could be better for the Australian wine industry AND consumers AND investors. That would be a rare combination, but none are possible under the present configuration.

 

The ongoing takeover saga concerning what is now Treasury Wine Estates goes back to the misguided strategies of previous owners, made worse during the era of Fosters ownership.

Nevertheless, it appears that there may be some perspectives missing from the public discussion around the actions taken by Treasury, the manoeuvrings of the parties involved and the implications of change. In particular it always astounds how little the wine media understands the philosophies and the tactics of private equity (let alone the position of investors in public companies as Treasury presently is). By the same token, the financial industry and media often seem to display extraordinary naiveté concerning the business models and drivers of wine businesses. In this respect the fact that wine businesses are so markedly different to beer or spirits brands in terms of capital intensity, working capital seasonality, competitive pressures, brand and portfolio requirements and elasticity of demand are commonly misunderstood or ignored.

This was a problem for the now Treasury businesses during the Fosters era and long before that. Some would argue that the rot set in even before the Southcorp and Rosemount merger in 2001, when the two different business models collided in a catastrophic case study of what can happen when the new managers completely misunderstand both the drivers and the key relationships then underlying the business. The weakened Southcorp fell into the Fosters fold in 2005 and the process of value destruction continued for similar reasons.

Part of the problem is the nature of the key Treasury businesses. Penfolds virtually invented the icon-halo effect business model, centred on the image of desirability that spreads from Grange to the Bin series wines and then down to the mass market labels. This was a model that Rosemount had tried (with its Balmoral Syrah and Roxburgh Chardonnay) but never mastered. Its success had been driven by producing large volumes (especially of chardonnay) to a set formula using low price Riverlands fruit. Other brands within the portfolio had similar top labels, but these never achieved the same relationship perceived in the case of Penfolds (whether or not the so-called halo effect ever produced an economic benefit, which is open to argument).

This misunderstanding has been perpetuated through the Fosters and then Treasury corporate structure and hiring practices. For a long time Fosters wine divisional structure was based upon the end markets, which probably works well for beer but only created a gulf of separation from the production side of the business. Subsequently the structure has moved slowly back towards the production side as the imbalances between production and sales have become exaggerated. Even so, the company has still been caught doing what all of the other international drinks brand companies have done building up stock levels in China in anticipation of a boom, only to have found that the market was not as predictable as expected. For all the good ideas they may bring, both Fosters and Treasury hired consumer brand managers to run the business, not wine people with a deeper understanding of the industry (with consumer branding experts under rather than over them), and this has been a telling factor. It is a mistake that it is quite plausible private equity owners will also make if they have misunderstood the business.

Part of the problem is that Penfolds (and several but definitely not all of the other Treasury brands) is really an oversized boutique wine business. Its drivers aren’t entirely in common even with other mass market wine businesses. In its efforts to boost short-term profitability (partly based on the China blue sky myth) Treasury has been through a phase of aggressively lifting prices of Penfolds products and creating a range of new luxury Penfolds wines – possibly trying to emulate some of the value add strategies of spirits producers in recent years. The unsurprising consequence is that not all customers are happy with the perception that their loyalty is taken for granted. Even Penfolds Grange has lived in denial of certain realities: it is a multi-region blend at a time that the Australian wine industry is turning back to industry marketing based on provenance, while at the same time production levels are massively higher than they used to be so that Grange is far from being the rare luxury it once was. Once a mainstay of the independent wine trade it is now readily available (at a price) in supermarkets across Australia and New Zealand.

As a consequence many of the actions taken by Treasury in recent times have been misunderstood by both the financial and the wine press, albeit for different reasons. To many the changes in the Penfolds release calendar and the recent initiative to sell discounted wine fridges to boost wine sales have been perceived as attempts to boost short-term profitability in order to save the business from predators. This completely misunderstands the relationship between short-term profitability and economic value, especially since the most obvious consequence of both initiatives is largely to shift the timing of profits rather than the quantum. It was no surprise when a new bid emerged after all.

To state the obvious, the price at which KKR made its original approach to Treasury will not have been its best price. It was, nevertheless, rejected by the board. Few of the changes made by the company since, whether on costs, process improvements, marketing changes or sales initiatives, will have materially increased the value of the overall business. Nor are any of them things that a private equity buyer could not also do if it chose.

Moreover, it is clear that private equity buyers will have some options available to them that the present board either is unwilling to do or considers unpalatable. That means that private equity buyers may have the ability to enhance the value of the business in ways that the company cannot do.

The sum of the parts?

The simplest way of all is to recognise that the value of the parts of Treasury today is likely to still be greater than that of the whole (notwithstanding the fact that some of Treasury’s historically valuable brands have been neglected to the point they are already as good as worthless). This factor is most likely the reason why the takeover competition has developed the way it has. The fact there are two competing bids at the same price indicates that for TPG a matching price was really about having a seat at the table. This implies that the process may devolve into a behind the scenes auction of some of the parts to be followed by a formal offer being made (and recommended by the board) for the balance of the company. It is worth noting that while often competing, TPG and KKR have a long history of partnering on investments as well.

Treasury (and Fosters before it) has been a problem for Australian wine, but not always in the ways perceived in the media. It has simultaneous promoted the virtues of Australian wine but also unconsciously undermined the global market for Australian wine as well as for many of its own brands.

In a world of brands, brand hoarders often destroy value. The value of a brand is heavily dependent on both use and potential, but the lack of one of these can undermine the other. It can simply be impossible to maintain the level of marketing prioritisation required to maximise the potential of each of a portfolio of brands once a certain level of brand hoarding has occurred. Inevitably some good brands will be utterly devalued. By way of contrast LVMH is an example of a company owning a large collection of luxury brands that has developed clear strategies for what it adds to its portfolio and how it will seek to promote and add value to each brand.

Paradoxically, one of the most value additive strategies open to Treasury, or to a future owner, may be to sell Penfolds – the clear jewel in the crown. The problem with Penfolds is that its influence over the Treasury portfolio has continued to grow, and to assume increased internal prioritisation, so that it has become a dead weight on top of the rest of the business. The emphasis on marketing and selling Penfolds products has come at an enormous cost to sales of other brands. It is not inconceivable that the US stock glut, a consequence of poor market information, planning and inventory controls, was accentuated by the internal marketing priorities (whether of Penfolds or other US brands) suppressing demand for many competing products.

Treasury’s Australian wine portfolio alone includes more than 30 brands, a mix of famous old names and newish names somewhat obviously invented by marketers. Some of these brands, once household names in Australia, now either languish as homes for cheap supermarket bargains or are rarely seen. Even those brands receiving a little more love from the marketing department are still often competing against sibling brands or worse, have been formally de-prioritised in some markets. One of the difficulties with a demerger of the brands will be the extent to which previous management has closed down many smaller regional wineries, originally attached to individual brand companies, in the pursuit of a phantom holy grail of scale and lower costs.

The roll call of brands that once held significant (often quality-driven) positions in the domestic Australian and export markets, but which have now been relegated to bit rolls as multi-regional blends or price point gap fillers, is extensive. Some of these brands could recuperate and flourish with some love and investment. For others that could no longer be said, even for names with significant historic resonance.

Treasury Australian brand Roll Call (not comprehensive): Annie’s Lane, Bailey’s of Glenrowan, Coldstream Hills, Devil’s Lair, Great Western, Heemskerk, Ingoldby, Jamieson’s Run, Leo Buring, Lindemans, Maglieri, Metala, Mildara, Penfolds, Pepperjack, Robertson’s Well, Rosemount, Rothbury Estate, Rouge Homme, Saltram, Seaview, Seppelt, St Hubert’s, T’Gallant, Tollana, Wolf Blass, Wynns, Yarra Ridge, Yellowglen.

Even so, the parts are still worth more than the whole because the way the whole company works stifles the real potential of too many brands. New owners of parts might change that.

The recent decline in per capita domestic wine consumption in New Zealand (not to mention other countries where this has occurred) raises the obvious question: is the reduction across the board or variety specific? As one retail commentator recently mused, are we in New Zealand becoming slightly “sauvignoned out”? It is logical given our viticultural emphasis on the variety that the retail market share of sauvignon blanc might well be higher than in most of the countries we sell sauvignon blanc to (where there will be a larger overall selection of wines since the overall percentage of other imports will typically be much higher than it is here). I am not ignoring the fact that the percentage of sauvignon blanc we export from New Zealand is much higher than the proportion of any other varieties (or to express this in the reverse, we drink a much smaller proportion of the sauvignon blanc we produce than we do of any other variety). The issue is firstly whether the domestic market for sauvignon is close to saturation and, if so, whether future market trends will provide a useful lead indicator of the impact of changing preferences globally (whether or not sauvignon blanc’s local market share has actually diminished lately, given that I opened from the standpoint of a purely anecdotal remark and it is not necessarily proven to be the case).

The launching point for this discussion is the historic reality that wine sales globally have tended to be highly fashion or trend driven, for a wide variety of reasons. Styles and varietal preferences come and go over periods of time – often 1-2 decades. Even when a variety undergoes a recovery after a period of market neglect it is usually stylistically different to how it was previously. There may be an argument that generational change is a factor, for example. Climate change may also be an influence (as seasonal climate differences have long been proven to be an influence on many beverage markets).

Nevertheless, it is probably safe ground to suggest that at some point in the foreseeable the continuing global market demand (and therefore market share) of sauvignon blanc will stop and then start to decline. Unless global demand for wine continues to grow, diminishing market share will mean diminishing actual demand for sauvignon blanc. The rate at which these trends will affect New Zealand will be affected by global competition from other sauvignon blanc producers (which, in the immediate future most likely means our main international export market competitors France, Chile and South Africa).

Will demand for sauvignon blanc subside dramatically? Probably not. The nature of the demand that drives sauvignon blanc sales globally is that it seems to be adopted as a favourite variety of a certain proportion of drinkers in each market. This means that even if global fashion changes there will probably be a solid core of demand that will remain fairly constant for a prolonged period of time. This will then deplete slowly through natural “taste attrition”. The rate at which these drinkers switch to other varieties will depend on the rate at which newly fashionable varieties or styles shift from the low but important market shares driven by early adopters to the point of mass adoption. Most fashionable varieties never make the shift to mass adoption and so it is trite to try forecasting what it will be, but the likelihood of this process happening is inevitable.

The process can also be producer/marketer-driven to a certain extent. It is quite plausible that the current wide popularity of sauvignon blanc has been accentuated by the marketing efforts of New Zealand and other producers of the variety that have helped to increase its exposure to large numbers of drinkers. This is itself poses a risk and an opportunity, because once any style or variety reaches saturation in the market of its time, the marketers of that variety or style typically have two choices: diversify choices within those styles as a means of maintaining market share (something that has already started to happen with sauvignon blanc, or to shift marketing effort to the active promotion of replacements in order to be at the “ground floor” for future opportunities. The latter happens only very rarely in practice (in most other markets as well as in wine) because most producers only realise that the market has changed too late.

When the market changes, New Zealand will likely continue to make and sell far more sauvignon blanc than anything else for a considerable period of time. The first damage will be to the marginal growers – to those who planted in anticipation of ongoing growth – or to those existing producers who will lose out to the latecomers, possibly because of disadvantageous locations. In either case there will be growing overproduction and falling prices at the grape, bulk and bottled wine levels (except, most likely, at the very top end).

One of the factors that will influence this cycle will be the fact that not every producer will experience it in the same way. Even when overall market share is flattening or falling there will always be some market participants, large and small, who are still experiencing growth. Some of these may be so focused on their own success and need for product security that they are ignorant of the degree of change in the rest of the market and are continuing to plant vineyards that will not be in full production for several more years.

The process will then become one of adjustment and there are a number of reasons why this process could be unnecessarily painful. Market adjustment is always an unequal process. Some are affected more than others. Some react much earlier than others who do not. In a wine world where growers have the choice of pulling out vines or taking short cut and grafting onto existing plants, the key to adjustment is to have the options determined and in place before the need arises.

Diversification is an obvious solution, but it is problematic and much riskier if it has not been an ongoing process. This is one of New Zealand’s great problems. New Zealand nurseries have imported a growing number of increasingly high quality varietal plant materials. There is room for more yet, but it is a start. The problem is that, with a handful of exceptions, most of the work with new varieties is being done by small wineries and growers. The significance of this has been accentuated by the changes in ownership and marketing priorities of most of the larger wine companies that dominate production today.

While 25-30 years ago the likes of Montana (now Pernod Ricard), Corbans (now Lion), Matua Valley (now Treasury) and Nobilo (now Constellation) were active importers and triallers of new varieties, this emphasis has almost completely gone. The large wine companies primarily want sauvignon blanc, pinot gris and pinot noir for export markets. The corporate philosophy of most large producers eschews significant experimentation. Paradoxically these companies, which have the most at risk should the tide turn, should be the ones most advanced in trialling both the growing and winemaking development of new varieties. They are the ones doing a disservice to their shareholders because the time taken to catch up to any new trend can be as long as a decade (once the time is allowed for access to adequate quantities of buds, replanting or grafting over, getting new vines into production, learning the viticultural requirements for new varieties in different regions, sub-climates and soils, learning the individual winemaking process requirements and developing styles, not to mention trialling styles with the market).

Doing all of this from scratch after the market has changed is simply dumb strategy. (So is the arrogance of thinking you can just buy the expertise).

I do not ignore the fact that if larger producers were actively pursuing diversification experiments it could have mixed consequences for existing smaller experimenters. The positives could include increased access to more diverse sources of quality plant materials, the benefit of accelerated viticultural learning and the market exposure advantages when several producers are marketing a new variety rather than one producer doing it on their own. The negatives include the greater risk of geographical or stylistic cul de sacs being taken by small producers; or losing the uniqueness or marketing point of distinction that can be essential for small producers.

The strategy of diversification is multi-faceted. In the first instance it is about risk management but, if managed intelligently, it is also about ensuring or creating future growth options. In this respect it is an essential component of a value enhancement process. For this reason it is curious that shareholders and financiers alike fail to demand diversification programmes of some form or other from medium to large sized wine producers for whom the programmes would be a small part of existing asset and budget allocations.

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:

Asset (all figures NZ$mil) Peak Current
Vineyards 5,417 3,149
Processing & other fixed assets (incl barrels) 1,870 1,558
Inventories 949 904
Other Working Capital 240 275
Total Asset Investment 8,476 5,886
     
Net Borrowings 2,500 2,347
Other Liabilities 300 300
Net Equity 5,676 3,086
   

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.

New Zealand Winegrowers has made two public statements regarding excise in recent times.  In the first it advocated shifting the accounting for excise to the retail end of the chain.  In the second it advocated that the Government give the annual excise increase due on 1 July next year a miss owing to the significant impact it would have on the wine industry.

There is an unfortunate irony in that I suspect New Zealand Winegrowers is hamstrung by the technicalities (in particular that the true cost is not simply excise) in respect of its public pronouncements.

The fact is that excise on alcoholic beverages is a multi-layered beast.  Demonstrating this may go some way to show why shifting excise to the retail end of the chain is both economically and ethically more desirable, and yet unlikely to happen.

Moreover, in pulling its punches New Zealand Winegrowers has refrained from pointing out the double up in the excise increase attributable to this year’s increase in the rate of GST.  In short, the 5% forecast level of CPI inflation by next year includes the 2.2% annual effect of the increase in the rate of GST from 12.5% to 15%, which increase has already been factored into the excise impost (if not in theory, very much so in practice).

Allow me to illustrate this.  The following table shows the impact on either the winery or the consumer (or, as often than not, both) in the event of a 5% excise hike next year.

Case Bottle
Current Excise 23.42 1.95
GST on Excise 3.51 0.29
Total Excise Impost 26.93 2.24
Add retail margin (e.g. 35%)
Excise portion of markup 8.20 0.68
GST on markup 1.23 0.10
Total Excise Impost incl margin 36.36 3.03
Adding a 5% excise increase
Resulting Excise 24.59 2.05
GST on Excise 3.69 0.31
Total Excise Impost 28.28 2.36
Add retail margin (e.g. 35%)
Exise portion of markup 8.61 0.72
GST on markup 1.29 0.11
Total Excise Impost incl margin 38.18 3.18
Resulting Increases
Ex-winery excise 1.17 0.10
Consumer excise (ex winery) 1.35 0.11
Consumer excise (retail all inclusive) 1.82 0.15

While the 35% retail markup is an approximation (as some distribution and retail combined mark ups will be less, and others more, depending on the channels supplied), the true impact at the consumer level will be greater when restaurant margins and other costs are added in.

Note also that the Government collects income taxes on the proportion of the margin on excise that may be retained as profits by the retailer.

Of course this is not the whole story.  The 2010 GST increase had the following impact on the ex winery (GST inclusive) excise impost:

Current Excise (ex winery) 23.42 1.95
2010 GST increase on Excise (ex winery) 0.59 0.05
Pre increase Total Ex-Winery 26.35 2.20

What this means is that when you add the double slab of 2010 GST and 2011 increase, including GST on the increase, you get:

Total GST (ex winery) 4.27 0.36
Total Excise Impost (2010 & 2011) 28.86 2.41
Total Increase from 1 Jul 2010 1.93 0.16
% Increase on 1 Jul 2010 7.3 7.3

So how might excise have risen over 7.3% in 12 months? It is the proverbial anomaly when you have a tax on a tax.

Of course, it is one thing to have a double up – where the increase in a tax causes the increase in excise and, therefore, in the tax on that excise.  The other question is the extent to which that reaches the consumer.  If the retailer refuses to pay a higher price or compromise on its margins, the economic cost to the winery for continuing to supply that retailer is not the level of excise it must absorb, but the level of excise including the GST on the cost that is not able to be passed on.

Based on the assumption that at present a little under 40% of New Zealand wine is drunk domestically (and therefore subject to excise), and that about two thirds of this is tied to “immoveable” price point structures, accordingly about 66% of the total increase in excise, plus GST, is worn by the industry, and a mere 1/3 (representing about 13% of total NZ wine production) will be passed on to consumers or borne in some proportion by retailers.

It is curious then that the Law Commission and other advocates for higher levels of excise as a consumer behaviour influencer have not wholeheartedly supported NZ Winegrowers on its stance regarding shifting excise payment to the retail end of the chain.  The fact that excise may be paid, by the winery, months or years before a bottle is sold is conveniently overlooked.  More importantly, the whole situation goes to show how impotent and irrelevant the present system is from the perspective of using excise as a tool to fight alcohol abuse.

Two reasons, both morally questionable and conveniently overlooked from a revenue perspective, why an excise shift won’t happen:

  • The tax on tax factor – Government would lose both the GST and income tax on the profit margin earned by downstream distributors and retailers on the excise charged as part of the price to them.
  • The breakages and losses factor – a certain amount of wine will always be damaged or stolen after it has left the winery.  The Government still collects excise on these losses.  There is no provision for reversal, since the people who handle wine after it has left bonded warehouses (usually the winery or storage facility) are not accountable to NZ Customs.

On closer inspection, however, are either of these actually material or true?

The breakages and losses factor is difficult to quantify without adequate data.  Assuming 2% as a breakages and losses factor (and I do not know if that is low or high) would mean a revenue loss of approximately $13 million on current excise estimates (including beer, spirits and other beverages also).

As regards the “tax on a tax” factor, if retail prices do not change from present levels, this need not be the case at all.  There will be a range of costs and savings shifted between the upstream and downstream sectors.  Retailers would be able to justify higher margins on the basis of taking on administrative costs (although in the age of GST compliance these should be not be onerous).

Let me illustrate. Under the present system, using a 35% indicative mark up rate, the general pricing economics look as follows:

Case Bottle Industry ($mil)
Case ex-winery 100.00 8.33 708.61
Excise 23.42 1.95 165.95
Total ex-winery price 123.42 10.28 874.56
Add retail margin (35%) 166.62 13.88 1180.66
Retail Price incl GST 191.61 15.97 1357.75
Effective total excise (incl GST) 26.93 2.24 190.84
Total value of GST 24.99 2.08 177.10

However, if the excise collection is shifted downstream, the same formulae would produce a different result:

Case Bottle Industry ($mil)
Case 100.00 8.33 708.61
Add retail margin (35%) 135.00 11.25 956.63
Excise 23.42 1.95 165.95
Retail Value (excl GST) 158.42 13.20 1122.57
Retail Price incl GST 182.18 15.18 1290.96
Effective total excise (incl GST) 26.93 2.24 190.84
Total value of GST 23.76 1.98 168.39

The level of total GST revenue lost is just $8.7 million under this scenario.

If, instead, prices are maintained at the same levels as originally, and we then work back to obtain the retailer margin:

Case Bottle Industry ($mil)
If price unchanged: 191.61 15.97 1357.75
Less GST 24.99 2.08 177.10
Price excl GST 166.62 13.88 1180.66
Less ex-Winery price 100.00 8.33 708.61
Less Excise 23.42 1.95 165.95
Retail Margin 43.20 3.60 306.10
Retail Margin (%) 43.20 43.20 43.20

While the percentage margin is expanded, the actual value remains the same so that, aside from shifts in compliance and funding costs, the net taxpayer position remains the same.

The biggest single added cost would be the transitional cost of establishing bonded storage areas and the downstream compliance regime – although this is no different to what a winery with a cellar door or restaurant operation already has to manage, and would continue to have to do so.

Overall, however, from a wine industry perspective the small reduction in compliance costs (since all would need to continue as bonded areas) is less important than the balance sheet impact.  Based on the (occasionally substantial but usually a matter of months) gap between incurring excise liabilities and receiving payment for most wine sales, the estimated working capital requirement incurred by the industry averages approximately $40 million and may well peak at closer to $50 million, not only incurring debt costs but also tying up valuable working capital that is not able to be utilised elsewhere.

At the present time, that release of overdraft working capital could mean the difference between survival and failure of many businesses under pressure from their banks.

At the beginning of any year there is a surfeit of reviews of the year past (2009) and forecasts for the year ahead (2010).  As I personally tend to perceive 2010 and 2011 as still highly transitional years for the global wine market, with discounting and stock reductions likely to continue for a time, uncertainties in terms of pricing, values and consequently financial support, I have instead shifted my focus ahead to 2012. This is the closest thing to a shift to a “new normal” (give or take six months or so).  As global economic conditions are likely to be more stable (rather than the present mix of positive and negative factors), consumer behaviour and market structure are more likely to settle, at least to the extent that this ever really happens for the wine industry!

What has happened?

2007-2010            Global recession and its impact on wine demand (with some something of a lag?)

2007-2011            The “credit crunch” and its impact on capital financing

2008-2010            High levels of discounted exports of bulk wine

2009-2010            Heavy domestic discounting/de-stocking

2010-2011            The bumpy, uneven process of finding the new “normal”

In recent years the failure of some existing offshore distribution networks, including the fact that for most (but clearly not all) brands this has not created defensible brand loyalties in the face of discount pressures, has been a significant driver of the level of volumes directed to bulk exports.

The Impacts

Consumers

Consumers have gone cheaper.  In part this has been because of the sheer weight of discounting in much of the retail world (itself often reflecting the power of the retailers to dictate to over-stocked producers); but also, and quite related, is the tendency of consumers to tighten belts and trade down in price points.  The extent of the discounting has simply allowed consumers to maintain (and sometimes upgrade) quality of purchases at the lower prices.

The big question on everyone’s lips is: if the major economies are healthier, job worries have eased, incomes are stabilised where they were for many consumers and the array of labels available is closer to what it was before the crunch (i.e. most of the short-term discounting brands have disappeared), will consumers revert to earlier purchasing behaviour or will they adopt a new normal of lower prices and reduced demand for wines representing conspicuous consumption?  Will the shape of the pyramid have changed, with a smaller tip and fatter low-end footprint?

Of course, one of the related issues is whether consumer tastes have changed in the interim and, if so, will it affect decisions regarding price or other factors?  By 2012, the period of the crunch, of the global transition that I have referred to here will have been five years.  Five years is a long time in a fashion sense, especially for certain wine styles. 

The New Age Global Consumer

The next generation of wine drinkers is on its way.  The same as has always been the case.  This next generation will have cut its teeth on cocktails, spirits, RTDs or beer, just as previous generations have done.  Wine as a beverage has never appealed to everyone.  It has long appealed to a small number of early drinkers (late teens and early 20s), to a growing number of drinkers in the mid to late 20s, and found its way to become beverage of choice to a steady core of drinkers from the late 30s on when other demographic factors become more significant.

… and the New Temperance

Given the unavoidable effects of the New Temperance movement, wine more than any other beverage has both an opportunity and an imperative to both differentiate and distance itself from other alcoholic beverages.  In particular it must fight to avoid being associated with beverages that are themselves associated with binge drinking.  To date wine, across the world, has singularly failed to send an unequivocal message that it stands for moderation, for consumption with food, for traditions that are not a threat to health and safety of consumers or society.  If it fails to do so by 2012 it will experience the economic consequences of the tool of choice for legislators around the world that are determined to place all alcoholic beverages as a category of ethical problem on a par with tobacco: materially higher excise or taxation.

Red or white or rosé?

Will the wine market become more like the beer market?

Anyone who follows the beer market in different parts of the world will be aware of the impact that the weather has on beer consumption.

The more that wine displaces beer as a beverage of choice in certain markets, does it mean that wine may also slowly assume some of beer’s characteristics?

Similarly, if climate change ultimately means warmer weather, will the wider wine market (as distinct from the fine wine sub-set) tend to shift towards styles that may be regarded as more “refreshing”, featuring the cut of acidity over “fatter” or more overtly wooded styles, for example. 

It is far from a secret that climate and temperature influence the styles of wine grown and consumed in many parts of the “Old World”.  Is it therefore a coincidence that as the world has experienced what the WMO has cited as being the warmest decade since temperature records have been kept globally, the post-“French Paradox” swing to red wines appears to have stalled or even reversed in many markets, and sales of rosé wines have surged?

Will this have reversed in the face of a string of long and bitterly cold northern hemisphere winters?

Weather and climate does influence consumer behaviour.  What will the weather be like in 2012?

The stalled hunt for a Plan B white

In Australia the Alternative Varieties Show has served as a showcase for the ongoing moves to diversify the varietal scope of the Australian industry, highlighting and promoting new grapes and winestyles.  Whether those varieties are even truly at home in some of the very warm, dry climates they are being planted in is not the point.  The Australian industry has identified the need to develop alternatives and actively supports this, resulting in quite disproportionate media coverage, for example.

The same cannot be said for New Zealand.  There have been voices for several years promoting the need to find varieties that can serve as foils in case sauvignon blanc slips out of wider market favour. However, unlike Australia, the tendency is to look at varieties already growing in New Zealand as candidates for “promotion” (e.g. pinot gris), rather than to find and experiment with new varieties.  There are exceptions, of course, with companies such as Coopers Creek and Trinity Hill actively marketing new alternative varieties. 

It is arguable that far more attention in the last 10 years has gone to finding alternative red varieties, rather than whites, for experimental purposes.  This may, also arguably, be something of a lingering consequence of New Zealand’s subconscious tendency in the past to perceive itself as an inferior or marginal producer of red wines (in contrast with its growing tendency to regard itself as a world-beater with almost all white grapes).

Of course most of the world’s wine consumers are more likely to want to drink either a white or a red as a separate preference, so the chance of consumers fleeing sauvignon blanc for pinot noir or for syrah is very low – these are completely different markets. If sauvignon blanc were for any reason to go out of favour with consumers, the majority of those consumers would be expected to migrate to other white wine flavours and styles.  This has the potential to expose not just New Zealand sauvignon blanc, the vast majority of which is made in a very specific style, but also all of the producers of copy-cat sauvignon blanc styles elsewhere around the globe.  Of course if a drinker buys a Marlborough sauvignon blanc today, the chances are that they will get a wine in a style they are quite familiar with, just as a buyer of an Italian pinot grigio would generally expect, for example.  On the other hand, as it is often commented, buy a New Zealand riesling or pinot gris and there is considerable doubt that the same can be said given the relatively wide variety of sweetness levels and styles in which these wines are made.

During 2009, the year Australia found out its albariño grapes were in fact savagnin blanc, the first commercial plantings of albariño occurred in New Zealand. Given that the fruits of these first plantings will be on tasters lips in 2012, are they likely to inspire dramatic expansion in the future if people like what they taste – a maritime grape being grown in a very maritime country that, arguably, has its own unique characteristics (and winemaking technology) to bring to the originals?

Increasingly the answer looks like no.  Growers are paring back yields all over the country.  There is now something akin to a stigma attached to new plantings or to replanting when the industry mantra is balancing supply and demand – never mind the fact that the new can create its own demand if it is good and distinctive enough.  New Zealand’s attitude to trialling the new and different is much more tentative than Australia, which may even manage to have more real albariño planted by 2012 than New Zealand, despite its 2009 setback and despite the avoided question mark over why such a grape is even grown in Australian conditions.

The Role of the Multinationals

Inevitably the role of the large multinational wine and liquor companies within the New Zealand wine industry has become the subject for increased scrutiny given both the degree of importance these companies have in terms of the industry as both buyers of grapes and sellers of wine to both the domestic and export markets; combined with the wider implications of sales statistics suggesting increased discounting during 2009.

By and large the large companies, most of whom are multinationals, have been good corporate citizens in New Zealand.  There is, of course, the risk of over-generalisation since many overseas investors in New Zealand have much more limited scope and scale than some of the larger global wine companies.  Overall, however, they have mostly tended to reinvest profits back into their New Zealand investments.  They have generally been good employers and trainers, as well as active sponsors and benefactors of the community and the arts.  They have brought both structure and management disciplines, often lacking in smaller companies, to the industry.

Of course they have also made significant investments in the industry, both in vineyards and also in processing and marketing infrastructure.  In support of this investment they have actively promoted New Zealand wines offshore.

As a further generalisation, they have tended to emphasise larger volume production and volume-oriented strategies with a relatively token investment at the boutique or ultra premium end of the market, where New Zealand has only rarely succeeded in replicating the sort of icon-centred marketing strategies employed by several companies in Australia.

Accordingly, the multinationals have for the most part been good for the industry and the economy, that is while the global economy and global demand has been strong, but the market changes of the last couple of years have exposed certain weaknesses of the multinational model. 

A lot of the industry export growth expectations have been predicated on the strength of the networks built up over the last 10 years, including those of the multinationals. These have been found wanting.

In particular, the New Zealand arms have become subject to global weaknesses.  Should an overseas parent have financial imperatives (and this is not to speculate or to state that New Zealand winery parent companies have been in financial distress) that dictate global requirements for cost controls or for balance sheet restructuring, by way of examples, the investment heavy New Zealand operations may become subject to pressures not necessarily created by domestic performance.

Now it is the multinationals that have ended up most obviously exposed to excessive stock levels and difficulty moving them since they have been more reliant overall on exports than most of the smaller players.  Yet they have also been more limited in terms of bulk export options (owing to the risk of cannibalising the offshore networks) and so have had to discount domestically to aggressively drop stock volumes.  Cutting contract exposures means that they will end up with a smaller overall share of the pie by 2012 (maybe as much as a 5-10% smaller share of production/sales in 2012 than 2007).

Moreover, New Zealand is often perceived as a product slot in a global portfolio, serving a very particular purpose.  This is often not conducive to product evolution – a particularly important issue with respect to Marlborough sauvignon blanc; and can also become a serious handicap when competing with products from other countries in the same stylistic slots within the portfolio.  When competing within one’s own portfolio in any given country within a company’s sales system, the decision of which product to back locally can become a complex issue, often decided by the local profit margin.

With respect to sauvignon blanc, provided sales continue to flow this is rarely a problem as the product tends to have a priority position.  If sales fall below projections, resulting in a disproportionate increase in current or forecast inventory levels, the financial pressure to discount in order to reduce stock levels increases.  Despite the 66% production increase in 2008 from 2007, and the similar level of production in the clearly superior 2009 vintage, the domestic and export statistical evidence is of a greater increase in overall sales volumes driven by discounting as well as market growth.  Consequently, the experience of the last two years suggests that the level of de-stocking may have been even greater, suggesting cash flow pressures have been an equal or greater driver behind discounting behaviour if bulk sales might otherwise have been sufficient to shift the volume increment.  In this context New Zealand’s small overall size is such that its total bulk wine sales are relatively insignificant against those of other large producers.

As a consequence, there are grounds to believe that should New Zealand producers move beyond the current cash flow driven discounting imperative, the country could be closer to finding the supply/demand balance than many think to be the case.  The question then is whether by 2012 the key brands will have survived intact, or whether they will have been compromised by discounting behaviours.

Mergers and acquisitions occurring offshore have sometimes proven detrimental, even if the consequences have rarely been understood within the country.  Such acquisitions frequently result in the realignment of offshore distribution networks, sometime causing dislocation in the transition process and disruption to existing end customer relationships over and above the issues that new brand managers may have fitting acquisitions into their portfolios.

The current wine glut in other product areas has more severely exposed the impact of intra portfolio competition as a serious constraint.  In styles such as sparkling wine and varieties such as chardonnay there has been a clear lack of willingness to necessarily promote some NZ wine styles against those of other countries in the same portfolio, notwithstanding the efforts of New Zealand management to make headway within the international systems that they work in.

Perhaps ironically, the outcome is a reinforced, excessive and arguably unhealthy default focus on sauvignon blanc.

Similarly, New Zealand has traded heavily on the quality of its pinot noir credentials. While justifiable in many respects, the risk that has been exposed is that of limiting the global exposure of other New Zealand reds, and of reducing their market access, despite simultaneous growing international acclaim.  The generally smaller independents are left to try and push this opportunity.

The other key issue with regard to the multinationals is the degree of influence they hold over grape growers.  The multinationals have been by far the largest buyers on a contract or spot basis from the grape grower section of the market.

In recent times, when either offshore indebtedness or other cash flow pressures have forced rapid heavy discounting to reduce stock levels, it has been the multinationals that have led the way – especially in domestic supermarket sales.  Other domestic producers have been forced to match discounts or else experience diminished sales and stocks languishing on shelves.

In a 2012 future where global price points have shifted downwards for the long haul, the large companies have limited scope to gain sufficient additional economies of scale or other opportunities to reduce production costs – so logically the long-awaited squeeze on grape prices, showing signs of appearing in 2010, will be in full “new normal” mode over the next 2-3 years.

M& A and Industry Structure

In a world where debt is severely constrained, even merger or acquisition (aka M&A) options that make excellent commercial sense may not be feasible. By 2012 the new normal will still be a far more conservative lending environment than that of 2007.  However, the extreme risk aversion phase of the bank economic cycle will have started to pass so that the issue for most banks will still be that of capital rationing.

In this environment the past perceptions of the wine industry as being riven by glut and discounting will not be helpful to the lending process essential for much M&A activity.

Even for those with the necessary resources, there are concerns around the three key rationales for operational expansion of wine businesses through acquisition:

  1. operational improvements,
  2. security of supply, and
  3. brand expansion.

The concerns surrounding these three factors are:

  1. Without adequate controls the operational improvements may exceed the costs;
  2. Cancellation of existing contracts plus the sharp drop in the price of grapes means this will no longer be a key issue; and
  3. brand expansion may not be a universal or fashionably desirable strategic goal, especially for larger multinationals (as compared with brand profitability).

So, those second tier firms with a shareholder value strategy based on being taken out by a global player have: (a) lost value; and (b) a serious need for a plan B.

M&A in the smaller end of the market will continue, with a mix of new entrants and mergers among peers. Transaction rationales will vary considerably, as they have always done.

In 2012 the historic normal will continue: some firms will get bigger and others will get smaller.  In terms of industry structure, the main growth will be in the middle.

It is already apparent from NZ Winegrowers data that for the first time in several years the number of wineries has declined slightly.  NZ Winegrowers classifies its members within three tiers: Category 1 small wineries with sales up to 200,000 litres; Category 2 with sales up to 4 million litres; and Category 3 with sales above that level.  At the time of writing there are 6 Category 3 members (three locally owned/controlled and 3 offshore owned),  61 Category 2 members and 608 Category 1 members.  Numerically it has been category 2 that has grown most quickly, doubling in numbers over the last 5-6 years as a number of smaller companies have taken the opportunity to expand export sales.

It is in terms of share of volume that most changes will take place between 2009 and 2012.  During that time it is likely that total Category 3 and Category 1 litreage volumes will decrease, in relative share terms if not also in actual amounts, meaning that the present Category 2 members will expand volume and share of production and sales. (Note that the list of 61 Category 2 wineries includes 34 Marlborough-based, 9 Hawke’s Bay-based, plus 6 Auckland-based companies, all of whom draw more grapes from Marlborough and/or Hawke’s Bay than from Auckland).

Between 2012 and 2020, at least 3 to 5 of the current Category 2 companies will expand into Category 3.  The question is therefore whether this happens through brand and sales growth, or through acquisition.  It should not be ignored that there are companies within the higher tiers that have expanded aggressively in recent years through asset or business purchases, have higher than advisable levels of debt, and that have constrained cash flows and limited asset sale options with which to materially reduce debt gearing.

Land values

The overhang of properties for sale tells its own story.  In the period to 2012 the trend in land values will be downward.  To the extent that high sauvignon blanc yields and grape prices together justified the value of Marlborough land, together with the shortage of grapes when demand was rising, the logical effect in a world of yield limits and lower prices is a fall in both economic and actual values.  This has already happened but the real fallout will be when cash flow pressures force more sales at lower prices, since these factors rarely hit “overnight”.

Overall the impact may well be greatest in those vicinities where viticulture has become a monoculture, i.e. where grape growing has in recent years become a significantly higher value land use than alternative crops or land uses.

The silver lining?  The pressure will increase for greater production efficiencies, and the viticultural contracting sector, able to dictate pricing in recent years, will be under greater pressure although grape buyers will ensure that this does not mean short cuts and diminished quality.  The days of taking the comfortable easy options are over.

The Rising Regional Imperative

The other story that will gain strength by 2012 will be the increasing importance of the regions as the heart of the new New Zealand industry.

The history and development of the wine industry in Marlborough, Central Otago and Hawke’s Bay over the last 5 years is the key indicator of this trend.

Each of these regions has developed a regional story and identity to take to export markets.  Once New Zealand’s geographic indications system is bedded in place, regional identity, which has been the essence of “brands” such as Marlborough Sauvignon Blanc and Central Otago Pinot Noir, will become pivotal to the attempts of other regions to establish, define and protect their identities.  The regional story will become more important to export producers than the New Zealand story, although this process will take a lot longer than 2012 to fully mature.  Some regions will lack the identity to develop further in this environment, accepting that their place is more about a largely local niche market.

The impending demerger of Fosters Group’s global beer and wine businesses has been long expected.  The general consensus of the financial community has long been that the wine strategy was flawed, especially in terms of the mismatch of assets with beer and the resulting overexposure to wine assets at the top of the market.  Most seriously of all, whether deliberately or not, it bought its wine assets just prior to the big beer merger binge of the last few years, effectively denying its shareholders the ability to materially benefit from a period of high beer business valuations.

Above all, timing has run against Fosters on at least three counts: the wine acquisitions were made in the lead up to the global financial crisis and recession; regardless of whether its acquisitive behaviour contributed to the “asset bubble”, Fosters acquired its Australian assets at the top of the market shortly before the market fell out of love with mass market Australian wine styles; and the Australian dollar has moved immensely against it during the same time period.

On a different level, there are grounds to argue that the execution of the wine strategy has also been flawed, and that this is at least as significant in terms of its implication for values.  In particular there is a sense that the acquisition of Southcorp was heavily predicated on cost savings, rather than market opportunity factors (and to a certain extent Fosters only ended up repeating some of the costly mistakes made by Southcorp after the Rosemount merger), while the response to currency pressures and the pressures from large offshore supermarket purchasers was also to try and drive down costs. 

This cost focused approach ultimately sacrificed quality, and in particular the unique aspects of many of the brands collected through the various mergers, increasing the market sense of a collection of largely indistinguishable fruit driven carbon copy wines and a loss of the sense of substance that had been associated with several of the key brands over their respective histories.  Names such as Wolf Blass have been devalued and simply no longer have the cache associated with them 10 or 20 years ago.

An arguable exception is Penfolds, the one brand that has not lost the ability to leverage off the reputational power of its icon labels such as Grange, St Henri and Bin 707.  What has happened, however, is that through the series of mergers of the last decade Penfolds has ended up as an ever smaller portion of the overall company portfolio, such that the quality of icon-leverage branding has been progressively diluted even when the quality of its wines has remained strong.

The market imperatives of the Australian wine industry have changed, thanks to changes in global consumer tastes.  The cost-driven approach, which implies that Australia’s goal is to compete with South American producers or, worse, California Central Valley producers, is doomed even before taking into account its reliance on hot climate irrigated grapes when the water that produces them is not reliable at all.

This leads to the key question.  Analyst reports have pinned an enterprise value of A$2.1 billion on the wine business.  Is this based on the assumption that the wine business can, or even should, be maintained as a single business?  Would this value be different if the brands and assets were instead further separated?  The rationale for doing so would be that for all that might be lost in terms of synergies, including global marketing channels, the freedom for individual brands and their winemakers/marketers to properly focus on quality and to sell their own stories without the compromises implicit in big brand portfolios, might actually create more value and reverse the value destruction of the policies of the past.

As an aside, from a New Zealand perspective there will be intrigue as to the future position of Matua Valley, which has grown under Fosters to become one of the six largest producers in the country.