In the latest article on the continuing trend of consolidation in the wine industry, Chris Brook-Carter looks at Southcorp's attempts to sell its packaging division, which, according to a new report by Salomon Smith Barney, may fuel acquisitions in the US.

The name of Southcorp is inextricably linked to consolidation at the moment. Only last week the company was mentioned in the same breath as Diageo and Allied Domecq, with the two spirit giants looking to expand their drinks portfolios. However, with the appointment of Merrill Lynch to oversee the sale of the Australian company's packaging division, Southcorp's position as acquirer rather than acquired has taken on new meaning.

Graham Kraehe, Southcorp's CEO, has told that Southcorp is committed to becoming a major player in the international wine industry, backed by its brands, the scale of its operations and global potential. He said that the sale of the packaging business was the preferred option that would permit further expansion.

The appointment of Merrill Lynch last week confirms the company's commitment to go down this route. Kraehe said: "Merrill Lynch is currently investigating and assessing options including divestment via a trade sale, a spin-off to existing and new shareholders and any other option to maximise value to Southcorp shareholders."

In a recent report on the possible sale of the packaging arm, investment bank Salomon Smith Barney (SSB) estimates that the sale of the packaging division could realise the company $A1 billion. If this is used merely to cancel debt, it would dilute earnings per share (EPS) by 15%.

However "were Southcorp to hypothetically divest its entire packaging asset in one or more moves it would be left with near zero net debt and shareholders funds of $A1.6 billion. Given net gearing is quite sustainable at current levels, Southcorp could easily fund an international wine acquisition of up to $A1.1 billion," the report said.

In this case although the net resulting EPS would still be a negative 9%-13%, the rate of EPS growth should accelerate from the current 8%-10% to a sustainable 10% or higher as revenue synergies came through.

"While cost savings are unlikely to be material, revenue synergies should be a key upside resulting from any international wine acquisition. As such, in time, 2+2 should equal 6 in terms of profitability."

A US wine company will be particularly attractive to Southcorp because it would leverage the Australian company's profile in the US, particularly with the powerful liquor wholesalers. "The US now represents 22% of all Australian exports (second only to the UK at 45%) and is the highest price/litre and EBIT margin destination for Australian wine. As such any leverage into the US is of prime importance," SSB said.

There is a reverse side to this coin as well. In the UK, Australia has huge penetration of the market. This is not true of its New World rivals in the US, perhaps E&J Gallo apart. Any US wine company would gain quickly from the potential of its Australian parent company's sales and distribution networks to cross sell its products.

SSB also goes on to explain another compelling argument for wine consolidation, though of a much more defensive nature. "Globally supermarkets and retailers are consolidating at a rapid rate," it said. "This process is well developed of wine supplier consolidation. As such any global wine company able to provide a stable of international brands from each of the major wine regions (France, Australia, the US, Chile etc.) should boost its position as a key supplier. So far many wine majors (E&J Gallo, Mondavi, Beringer, Kendall Jackson, BRL, Southcorp and Foster's Mildara) are working on this strategy but so far mostly from the much slower organic growth basis."

The options available to Southcorp are many. One analyst with a leading investment bank told "Southcorp, post sale of packaging, would most likely look at an alliance or joint venture with or acquisition of (or being acquired by) a US premium wine maker of size. This could involve Sebastiani Wines, Kendall Jackson, Mondavi, Beringer, or anyone of the global liquor giants, for example Allied Domecq, Diageo or Seagram. Who knows how it will pan out, but obviously Southcorp is very actively looking at all options, right now."

But it will not be plain sailing for the Australian wine giant. Firstly selling its packaging division will be tough. "All up, unless Southcorp considers an IPO of the group as a whole, we consider it unlikely that a buyer for the group as a whole would pay up sufficiently," explained SSB.

"As such, a break up and sale by division could maximise proceeds. However, this also runs the risk of certain units being sold quickly, but several being left behind, leaving Southcorp with morale and/or fire-sale pricing problems. Given the very depressed pricing of packaging companies globally, we would be surprised if control premiums could be extracted on sale," it concludes.

The analyst said: "The likelihood of a sale of packaging will depend upon what level of haircut Southcorp management are willing to take. If they were to sell it for $800m, they could probably IPO it successfully in two months time. If they want $A1 billion or more, it will be a big ask."

On top of its sale problems, Southcorp faces a US market where consolidation of the market is not a foregone conclusion. Many of the big wineries in the US have large family interests behind them. Traditionally family run businesses are reluctant sellers. Add on top of this the small number of premium wine companies actually suitable for a company like Southcorp and you begin to get a picture of the difficulties facing the Australian firm if it wants to move into the US market.

Chris Brook-Carter

For more information on SSB products and reports call 00 61 2 9321 4000 for Sydney, Australia; 44 0207 398 6100 for London, UK; or 00 1 212 723 4177 for New York, US.