Strategies to Improve Profitability in
the Winery
This article was originally published in the March-April 2014 issue of the Wine & Viticulture Journal
Drawing on experience advising winery owners and financiers, the authors explore strategies to
assist wineries improve financial performance and solvency and to address the current grape
surplus. Effective inventory management and maintaining throughput in an environment of price
deflation are key to alleviating cash flow constraints and improving the availability of working capital.
Wineries are, in the current environment, required to consider a raft of
innovative solutions to improve performance. This article considers
the challenges facing wineries and broadly identifies potential
solutions and options available to winery operators.
Challenges facing wineries include lower prices for bottled wine,
adverse movements in foreign exchange rates (although there has
been an improvement in recent months), eroding margins, a build-up
of inventory, downward revaluation of grapevine assets, onerous
grape supply contracts and the impairment of intangible assets.
The impact of some of these challenges depends on the level of
sophistication in financial reporting and size of the winery
concerned, while the impact of others is common to all wineries.
A recent example of the challenges facing wineries was highlighted
by the US operations of Treasury Wine Estates (ASX:TWE) whose
share price was slashed (down 14 per cent) after it disclosed $160
million in asset write-downs. This predominantly related to the US
market, where TWE has destroyed stock and provided rebates to
distributors as an incentive to clear old stock. TWE also provisioned
a further $85 million to exit onerous grape supply contracts.
Wineries struggling with too much inventory may consider redirecting
excess wine towards the bulk market. When implementing such a
strategy, wineries need to consider the flow on impacts which include:
• a negative impact on brand – both regionally and nationally
• converting inventory to cost of goods sold (‘COGS’)
• a deterioration of gross margins
The graph below shows the movement in inventory over the last
decade. The overall level of stock is still concerning and is having a
detrimental impact on the profitability and solvency of wineries and
grape growers. The Winemakers Federation of Australia has identified
that at current levels, inventory sits at 1.5 times the annual volume of
sales, placing downward pressure on grape prices.
Table – Inventories of Australian wine held by wineries over the
period 1999 to 2012
Source: ABS 2013
Adverse weather conditions which include a dry winter, black frost in
October 2013 and heavy rainfalls in South Australia during February
2014 have reduced production forecasts of what had initially been
expected to be another large vintage of approximately 1.8 million
tonnes. Current expectations suggest that the national crop may
only reach a level of between 1.5 million and 1.6 million tonnes.
Large wineries should feel a sense of relief noting the adjustment
in seasonal supply.
The cash cycle (time taken from purchasing grapes to selling wine)
is being closely monitored by financiers in the current environment.
However, converting excess wine into bottled product and eventually
accounts receivable is not a straightforward decision and needs to
be considered along with the broader strategic market positioning
of the winery.
Branding considerations and consumer perceptions are critical to the
direction and strategy of a winery. Many wineries are taking advantage of
the bulk trade as this method of sale is an anonymous way to realise
product. For example in January 2012, bulk wine exports were for
the first time greater than bottled; a trend which has continued and
increased through 2013. However, the indirect implications of this
strategy can have a dramatic impact on national and regional branding
and the ability to generate price premiums in future seasons. This is
a particular concern as the bulk market could potentially recondition
consumer psychologies downgrading perceptions of product quality.
The impact of this on the profitability of any individual winery will be
influenced by both the longevity and severity of the bulk market
strategy employed at a national and regional level.
Profitability
Price deflation across the industry has placed pressure on the
gross margins of wineries. A gross margin of 50 per cent is generally
considered sustainable. However, diminishing top-line growth has
inhibited gross margins of wineries. Selling product into the bulk
market has an adverse effect on the gross margin and profitability
of a winery. In this regard, there is a counterbalancing impact of
alleviating working capital on their gross margins. For wineries under
financial pressure, there is an obvious benefit in unlocking inventory
and selling stock on hand, even at a discount, to free up cash.
However, wineries positioned at the premium end of the market or
who have a positive EBITDA, may prefer to maximise profitability
rather than cash by holding onto stock and selling wine through
traditional channels.
Wineries attempting to adhere to bank covenants based on EBITDA
(Earnings before interest tax depreciation and amortisation) need to
monitor the detrimental impact of shifting sales to the bulk market.
By realising wine on the bulk market, inventories are converted to
sales, hence reducing net assets and increasing the COGS. So while
realising inventories will allow wineries temporary cash relief, there
will be associated reductions in the interest coverage (these sales are
typically made at a loss, reducing EBITDA further).
Inventory
Adequate inventory turnover is a key consideration for a winery as this
metric has a direct influence on the availability of working capital.
Inventory turnover is calculated as COGS divided by average inventory
and it measures the number of times that a winery can turn over
inventory on hand. In this respect, a ratio of less than 1 indicates
increasing inventory and pressure on working capital.
This metric is particularly important for the SME (small or medium
enterprise) winery as larger wineries are more easily able to shift
sales between brands to alleviate working capital constraints. SME
wineries which have a select brand offering are forced to consider
innovative solutions by pursuing alternative channels or selling
methods to maintain inventory turnover.
COGS
COGS may be calculated in one of two ways, variable costing (‘VC’)
or absorption costing (‘AC’). In an environment of increasing inventory
levels AC will have a less detrimental impact to a winery’s financial
performance in the short term. Using AC, costs associated with
producing wine (e.g. management overheads, electricity, marketing
costs etc.) are only expensed to the profit and loss statement when
the end product is sold. If wine is not sold, these costs are not
expensed in the current period and are carried forward in the balance
sheet as inventory, improving the entity’s net asset position and
perceived solvency. Conversely, with VC all costs are expensed as
costs during the period which they are incurred.
When inventory is increasing, COGS will be lower under AC and hence
the gross margin of a winery will improve. Implementing this system
of costing will improve performance. However, it will also have a
consequential effect on the working capital position of a winery
due to rising inventory.
Grape supply contracts
In the current environment of surplus wine and price deflation,
renegotiating grape supply contracts is critical to the viability of
a winery. Wineries must recognise in their financial statements a
provision for the costs associated with meeting onerous grape supply
agreements. This was the case with TWE previously mentioned.
The unavoidable costs forecast to be incurred in meeting a winery’s
future obligations directly impact the balance sheet and solvency.
Larger wineries with higher levels of market power have the ability to
shift non-core grape suppliers out of contracts and onto the spot
market. Some wineries are also renewing grape supply agreements
for non-core growers on shorter terms or imposing yield restrictions
to improve flexibility (for the winery).
Biological Assets – Grapes and grapevines
Vertically integrated wineries which have strategic interests in vineyards
should also consider the valuation of grapes and grapevines
(biological assets measured under AASB 141). Initially and at each
reporting date grapevines and grapes are required to be measured at
their fair value less costs to realise. Prior to the introduction of AASB
141, grapes and grapevines were often measured at their book values
(cost less accumulated depreciation). An important consideration in
the current environment of negatively trending grape prices is the
variance between cost and market values. Any revaluation to the
correct reporting standard by a winery will have a direct (generally
downward) impact to balance sheet.
Conclusion
Reporting requirements and the effectiveness of a winery’s
information systems can have a significant impact on the profit or
loss of a winery as well as its sustainability. Effective management of
profitability drivers is critical to improving performance as well as
maintaining lender support. With pressure from lenders to maintain
covenants tied to financial performance, non-financial factors and
asset valuations, the linkages and flow through implications of
decision-making are critical. In an environment of difficult decision
making for wineries, the balance between short term solvency and
long term viability must be carefully managed.
Contacts
Sydney
Greg Quinn
t: +61 2 8116 3278
e: [email protected]
Melbourne
Rod Slattery
t: +61 3 9269 4204
e: [email protected]
Brisbane
David Leigh
t: +61 7 3222 6822
e: [email protected]
Perth
Simon Theobald
t: +61 8 9216 7601
e: [email protected]
Auckland
David Webb
t: +64 9 304 1301
e: [email protected]
www.ppbadvisory.com
Important: This information is not advice. Readers should not act solely on the basis of information contained in this document. We recommend that formal or independent advice
be sought before acting in the areas covered herein. 00716INS. May 2014.