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Penfolds for Sale

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

The Treasury Wine Estates business has been battling for over a decade to work out how to make money from wine. There is a simple answer: it can't because there is a limit to how much people will pay for mythology. Its flawed business model prevents it succeeding which is why the quicker it can be sold the better.

Speculation has been mounting that more than one potential buyer for Treasury Wine Estates (TWE) is in the wings. A $3.05 billion bid from private equity group KKR in May was spurned for being not enough but the Chinese Bright Food Group has said it has an interest in Australian wine assets prompting thoughts the business might go the way of several other Australian food and beverage brands.

Almost every report about Treasury Wine Estates has a reference to Penfolds and, most likely, Grange. With perfect scores from the likes of The Wine Advocate, TWE has managed to push the price of Grange past $750 a bottle. Saying its total production could be sold in Shanghai alone kicks along the scarcity value. Surprisingly, though, auction prices for any vintage since the late 1960s are now below the asking price for the latest release suggesting a flaw in the market somewhere.

Despite Penfolds being eyed continually because of its astronomically priced flagship brand, the average selling price per case for TWE as a whole was just $53 over the six months to December 2013. Herein lies much of the predicament faced by TWE and its predecessors going back before Southcorp. Tempting people with Grange but forever selling them lesser quality is an unsound business model.

Once a consumer is reconciled to never drinking quality, price overwhelms the decision and discourages brand loyalty. Coca Cola succeeds partly because there is no better version than the one consumers are told is the best they can buy.

TWE is coy about how many bottles of Grange are produced each year but even at the 2014 recommended retail price of $785, 10,000 dozen, the upper limit of estimated production, goes nowhere near validating a $3-4 billion market value.

Wine, more than any other consumer product, requires highly adept capital management skills. Foster's initiated its foray into wine in the 1990s in the belief that it knew about brands and the logistics of delivering containers of intoxicating beverages to every licensed premise in the country.

Apparently outstanding operating margins excited investment analysts and bankers who encouraged the move by the brewer to consolidate mass brands under what is now the TWE umbrella.

The wine business proved the antithesis of the beer business. Beer barely took a week to make. It was at its best when fresh. It was paid for within 21 days, sometimes before cash for the materials going into its production had been outlaid .

A snapshot of the problem is evident in the financial reports of TWE at the end of December 2013. An $88.4 million EBITDA was chewed up by a $66.4 million increase in working capital. It was worse a year before. A $103.2 million working capital increase accounted for the overwhelming majority of the $109.9 million profit. In both cases, needed capital expenditures took more than what was remaining. Even the company with the strongest brands in the land had to borrow to keep producing.

Wine production is an insatiably capital hungry business because vintages are stored before release. The higher the quality of wine the longer the cellaring and the more capital required to fund the business. The stronger the growth, the larger the inventory accumulation.

At the end of December, the company held $1.2 billion in inventories in support of annualised sales in the half of $1.6 billion. In contrast, Wesfarmers with annualised sales of $62 billion in the December half year carried inventories of $5 billion at the end of December.

TWE is also at risk of forcing its premier brand to do too much. The Penfolds name has to sustain a $700 price tag as well as an entry level $12 tag. Think of Moet and Chandon having a $5 bottle of champagne.

Unfortunately, Penfolds cannot afford to produce a lower quality product to match the lower price points. The brand must stand for quality no matter how much is paid. A high quality entry level product immediately removes some of the incentive for consumers to pay more when they cannot discern a material difference between what they are drinking and the more expensive alternatives.

In the event that TWE tries to raise entry level price points, there is an abundance of semi anonymous competitors to fill the gap. Creating a wine brand is almost as easy as designing a label. Karratha Estates grown from vines left on the Abrolhos Islands by Dirk Hartog in 1616 can somehow be made to sound plausible.

The ready acceptance of new brands reflects another flaw in the business model. The uniqueness of a vintage is part of the wine making mystique. If the same brand is not going to taste the same from year to year, there is less for consumers to fear from moving to different brands. It would be the same if no two bottles of Pepsi were going to taste the same. Consumers would gravitate to another cola drink on the shelf if the price of Pepsi went up.

For investors, cyclicality is also a problem. A wine company has a risk profile akin to that of a miner while it tries to portray itself as a beverage version of Louis Vuitton or Tiffany & Co.. Here was another part of the business built on a false mythology. Outcomes fell far short of the expectations that were created about what the company had to offer investors.

Every so often, even while held within Foster's, the company has brought in a new chief executive to transform the business as if there was an alternative way to get better results. The fact that so many have tried and all have failed so miserably might suggest otherwise.

Knowing all about these vulnerabilities, large retailers in Australia and Europe and distributors in the USA can play one wine maker off against another knowing that their sales were unlikely to suffer whichever product made it onto their shelves. If they forced a build up in inventories, so much the better. That would permit a better price next time.

All of this leaves TWE in an invidious position as it once again attempts to ginger up its business model to highlight the distinction between Penfolds and the rest. Again, it is counting on the mythology of an unrepresentative brand to paper over underlying faults in the business model.

Perhaps the best alternative is to sell out as soon as someone is sufficiently distracted by the apparent prestige of the brands and their nominal prices to look more deeply into the business.

Once again, there is likely to be an outcry over an iconic Australian brand falling into the hands of foreigners but, if they are foolish enough to pay the premium, it would be just as foolish to ignore the offer.


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