Sent: 16-03-2010 10:00:12
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Knowing your Shareholders
Foster's, BHP and Wesfarmers are examples of companies that have radically altered their risk profiles through acquisitions. Such changes usually need new shareholder bases to match.
There were contrasting reactions to Foster's and Wesfarmers in the recently concluded earnings season. Foster's was a disappointment, having promised much. Wesfarmers, having been sold by a sceptical market, received some accolades for its rehabilitation of the Coles retail businesses.
Even now, neither market commentators nor Foster's shareholders seem to have fully realized that its risk profile was changed permanently by its move into wine.
In 1997, Foster's embarked on a multi-beverage strategy when it bought Australian winemaker Mildara Blass. It subsequently purchased US headquartered Beringer Estates and, then, Australia's leading wine brand owner, Southcorp.
For many of the key Foster's corporate strategists, these moves made good sense insofar as they were simply an extension of the company's existing exposures in the market for alcoholic beverages.
Also, for some, the well entrenched distribution infrastructure for beer offered synergistic opportunities that would give Foster's a competitive advantage over other wine makers.
The Foster's strategy changed the company's risk profile in two important respects.
Wine was a far more capital intensive business than the beer business in which Foster's had long engaged through Carlton and United Breweries and, more recently, through Resch's, Cascade and Matilda in Australia, Courage in the UK and Molson in Canada.
The value of wine held in inventories could be at least as much as the producing company's annual revenue. In contrast, the time taken from purchase of raw materials to sale of the final product, in the case of beer, could be less than a month. Sales proceeds were due in seven days. Payment for inputs was due in 14-21 days. Compared to wine, little working capital was needed.
- Wine was a highly cyclical business. While beer might be seasonal (insofar as more is consumed in summer than in winter), the wine industry can go through multi-year cycles as inventories adjust in much the same way as in any other global agricultural commodity market.
These changes implied that the investment risk profile of Foster's had changed significantly. Such changes also implied a need to cultivate a new shareholder base whose investment needs matched more closely the new risk profile.
There is nothing inherently wrong with being a commodity producer with a cyclical earnings pattern as long as investors know what they are buying. Otherwise, they will be prone to disappointment. Equally, corporate executives need to understand the risk characteristics of their company when they set about cultivating a shareholder base. Otherwise, they will suffer a backlash by inadvertently misleading investors about what they are buying.
Arguably, Foster's fell into both traps.
BHP is another high profile company that went through a similar adjustment. In 1995, BHP purchased the Magma copper company, adding to its share of the global copper market that it already held through its recently purchased interest in Escondida, the world's largest copper mine.
Its metamorphosis from an iron and steel maker whose fortunes were tied to the state of the Australian economy to a commodity producer caught up in day to day global market fluctuations gave it a distinctly different risk profile.
After this, BHP no longer played its historical role as a proxy for the Australian market. As with Foster's, the BHP earnings profile became more volatile and the management battled for many years to rebuild a new shareholder base that wanted the different profile (and the occasionally very attractive returns accompanying commodity price cycles).
Wesfarmers is transforming its risk profile just as radically as Foster's and BHP.
The 2007 Coles acquisition moved Wesfarmers in the opposite direction to BHP and Foster's. Wesfarmers reduced its reliance on commodity markets and, in doing so, reduced the prospective volatility of its earnings stream.
Wesfarmers had long had an enviable reputation for the quality of its strategic decision making. Nonetheless, among investors, there was lingering uncertainty about its risk profile: it was neither a resources stock nor a typical industrial company.
The Coles acquisition put it firmly into the industrial company category. One benefit was that industrial sector analysts would feel more comfortable in making recommendations about it.
Existing Coles shareholders would acquire a more cyclical exposure. To that extent, they suffered some of the BHP-Foster's problem.
Existing holders of Wesfarmers stock, on the other hand, would have their earnings volatility diluted. The more risk friendly of them might have preferred the higher risk profile as an acceptable cost for the occasionally above normal returns that come with resources cycles.
There was scope for Wesfarmers to lose shareholders. However, Wesfarmers had set out to change the risk profile of their earnings. The company's strategists seemed to know what they were doing.
BHP and Foster's, on the other hand, appeared largely oblivious to this consequence of their transactions. They were thinking more abut the ultimate size of their new industry footprint and had not prepared the ground adequately to capture the new, more risk friendly, shareholder base they would require for the longer term.
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