Culled Wines

Chronic oversupply led the Australian wine industry to commit promotional hara-kiri. But now supply is moving back into line and the strongest brands should benefit, reports Joanne Hart

AUSTRALIAN wine has been one of the great success stories of both the marketing industry and the alcoholic beverages business. 

Twenty years ago, virtually no one outside Australia drank Australian wine and those who did considered themselves to be rather avant-garde.  Their friends thought them either frightfully sophisticated or slightly odd.

Today, Australian wine is Britain’s favourite in value terms; in the US it ranks only behind Italy as far as the import market is concerned.  Last year, more than 200m litres of Australian wine were sold in the UK and almost 120m litres were exported to the States.

Growth has been exponential, particularly in the late 1990s.  Between 1995 and 2002, the British market for Australian wine grew by 22% annually, meaning that every single year, tens of millions more bottles were being bought by the UK consumer than in the year before.

Dinner parties are far more likely to see an Australian Chardonnay sitting in the centre of the table than a white Burgundy and brand recognition is extremely high.

Data such as this would suggest that Australian wine producers should be riding high. Profits should be soaring ahead, management should be in clover and shareholders should be delighted with their lot. The cold hard truth tells a different story, however.

Southcorp, the country’s biggest producer, recently reported an appalling set of profit figures with underlying halfyear earnings down 81.4% to just A$59m.  The company forced the departure of its chief executive; the finance director resigned and a new CEO, John Ballard, was brought in to provide strategic direction and focus.

Southcorp’s tale of woe is the most widely known outside of Australia but producers from all over the country have been suffering with their profits, many of them are struggling just to stay afloat. The reason for this is simple: chronic oversupply.

Between 1994 and 2002, Australia increased its area under vine by 12% annually, even though overall intake was growing by just 10%. Growth in the sheer amount of wine produced was particularly intense between 2000 and 2002. During that period, the amount of grapes crushed surged from 1.1m tons to more than 1.6m tons.

The industry hoped and expected that demand would match supply but producers were being greedy.  Theirexpectations were unrealistic and their customers took advantage. Prices were driven down ruthlessly and promotional activity took off to the point where many insiders described it as suicidal.

"Oversupply was an issue," admits Paul Henry, regional manager, UK and Ireland, of the Australian Wine Bureau.

The omens for this year and beyond, however, are somewhat better than they have been so far this century.  A prolonged drought and rain at just the wrong moment have produced a reduction in the harvest for the first time in six years. The weight of picked grapes has fallen by about 12% to 1.4m tons and yield has declined by around 20%.

In addition, the industry has finally come to terms with the fact that it cannot continue to plant new vines with little or no thought given to market forces. "Plantings are in line and replantings are dramatically down," reports Henry. What this means is that, whereas the number of hectares of new vines surged by 23% in one year a few years ago, growth this year will be closer to 5%. "If you were to ask if there is an oversupply issue in Australia, the answer would be a resounding ‘No’," Henry insists.

Outsiders, however, are slightly less bullish. "Oversupply remains a key issue for the industry to manage and we believe it will expose the vulnerability of players with poor distribution and poor brands," says Tim Buckley, Australian drinks analyst at leading US bank, Citigroup.

The problem of oversupply has been exacerbated thanks to continued consolidation in the UK grocer y industr y, the single most important destination for Australian wine exports. Last year, supermarket sales rose by 32% in volume terms, a fantastically impressive figure. In value terms, though, the increase was 29%, implying that average prices fell slightly during the year from an already low base.

Over the past three years, Tesco, the market leader, has continued relentlessly to gain share from rivals and Asda has maintained a persistent downward pressure on prices under the influence of its owner, the world’s largest and most ruthless retailer, Wal-Mart.

Now Safeway is expected to disappear into the arms of one of its peers or the retail entrepreneur Philip Green, who already owns BhS and the Arcadia chain of fashion outlets. Whoever wins the Safeway battle is unlikely to simply wave through existing supply contracts.

Each will be scrutinised for the chance to gain just a few more pence from beleaguered suppliers.  Wine producers will not be immune from this process and each and every sign of weakness will be seized upon and put to the retailer’s advantage.

Even Somerfield, the poor relation of the supermarket industry, was recently faced with a bid approach from a pair of seasoned businessmen, John Lovering and Bob Mackenzie.  The bid may come to nothing, but if the two men succeed, it is unlikely to result in more favourable terms being offered to Somerfield’s suppliers.

Nonetheless, there does appear to be room for optimism. Citigroup’s Buckley says, "For the majors and small producers with strong brands, we view the current environment as an opportunity." In essence that means the importance of brand strength and efficient and effective distribution channels remains paramount.

"In the wine trade, as in every other part of the beverage industry, the significance of brands is increasing every year. Consumers are becoming more and more name-conscious and correspondingly reluctant to buy a wine that they have never heard of before," says one equity analyst from a leading UK stockbroker.

Sainsbury’s wine buyer Alan Webb suggests, "The prospects, particularly for well-known names, are pretty good.  BRL Hardy, Yalumba and others of this calibre should be fine." In fact, Sainsbury’s is forecasting double-digit growth in sales of Australian wine this year. The supermarket group believes that prices of Australian wine might even begin to rise.

In 2002, for instance, 70 out of every 100 bottles of Australian wine were sold on promotion. This year, however, that percentage may fall. "Most people have it in their strategy to reduce promotional activity. Naturally, we want to make sure we have strong sales on and off- romotion," says Webb.

There is little doubt that many of the Australian wine producers are beginning to help themselves to overcome problems in the industry.  Between 2006 and 2009, the number of hectares devoted to vine production is expected to grow by a modest 3% annually, a substantial drop from the overproductive years at the turn of the century.

Some producers, such as BRL Hardy, have already learnt how to turn the market to their advantage. In 2002, the company reported a 16.4% increase in underlying earnings to A$144.6m.  The result was particularly admirable compared to Southcorp’s performance but it still represented a decline from previous years.

BRL Hardy’s response has been to merge with the US drinks giant Constellation, a movethat should help its penetration of the American market.  For many years, the Australian wine trade focused its efforts on the UK. 

Recently, however, there has been a realisation that this market cannot continue to grow at the same rates for an indefinite period. Research analysts estimate that volume growth will slow to around 12% over the next few years, almost half the rate at which it expanded last year.

By contrast, the US is forecast to buy 31% more bottles of Australian wine this year than it did in 2002, a figure that follows seven years over which growth has averaged 33% annually.

The US market has three advantages over the UK market. First, it is much larger than the British market; second, penetration has been relatively low, despite recent growth rates; and, third, there is little sign of the retail consolidation fever that has been such a feature of the UK.

Pricing pressure has begun to manifest itself in the States but to a far milder degree.  There is also evidence that the Australians are trying harder to control their profits destiny. "There has been a corrective influence in 2003. Lessons have been learnt and supply will be more carefully managed in the future," says the AWB’s Henry.

These lessons do not just include a more thoughtful approach to vine planting but also a more pragmatic approach to shareholder value.  Many of the larger wineries are pairing up, and analysts believe this trend to consolidation will continue.

"Australia will definitely see more consolidation among its wine producers to match what is going on in the UK retail trade," said one beverages analyst at a leading investment bank in the City. "Consolidation might also be perceived as a benefit in the drive to penetrate the US market. Big players can achieve better buying terms and can afford to get the best distribution deals," he added.

While this is the case, it is likely that the market will see an increasing divide between the large global players and the smaller niche operators.  The former will play to their brand strengths and make the most of their distribution muscle. The latter will aim to produce particularly interesting wines.

Researchers believe, as well, that changing demographics are likely to favour premium-end production, particularly in the UK.  The population is ageing and, as more people enter the relatively affluent 45 to 65 age group, they will be seeking out more sophisticated and also more expensive wines.

Oversupply may continue to weigh on the Australian industr y, however, and the dynamics of the market are such that pricing pressure will remain intense.  Vineyard growth is slowing dramatically, nonetheless, and important lessons appear to have been learnt.  It seems unlikely that the trade will repeat the mistakes of the past – at least not in the short term.