Foster's Group's acquisition of Southcorp made the company one of the world's leading wine producers but some shareholders are unhappy about the direction the group has taken. David Robertson looks at the pros and cons of the deal, and how Foster's might be looking to take its wine business forward.

The Foster's Group's A$3.2bn acquisition of Southcorp, following its acquisition of Beringer Blass in 2001, has turned a company once known as the "Australian for lager" into a winemaker of global standing, accounting for 42% of Australian wine exports with annual production of 36m cases and turnover of US$2bn.

But the deal has not been popular with some shareholders and there is concern over Foster's ability to make the deal work. Just as Southcorp made a hash of merging with Rosemount following its A$1.5bn acquisition in 2001, investors are worried that history will repeat itself as Foster's tries to integrate Southcorp.

Foster's chief executive Trevor O'Hoy was understood to be resisting making an offer for Southcorp until he could get his US wine business, Beringer Estates, in order but changed his mind when the opportunity materialised. So, now that all but a handful of shares stand between Foster's and total ownership, what is O'Hoy going to do with Southcorp?

One of the big opportunities for Foster's is in the bulk-sales market. Foster's now has a sufficiently large areas of grapes under production to develop a profitable low-end business, allowing the group to dominate this market, certainly domestically and probably internationally.

Added to which, Foster's has a huge amount of experience in marketing beer. The combination of low-cost product and beer-like marketing might give Foster's an edge in looking to attract new consumers from beer to wine. Meanwhile, well established, such as Penfolds, are expected to continue to thrive in an organisation as geared towards brand power as Foster's.

The problem, however, comes in the middle ranks - as it did for Southcorp when it tried to integrate Rosemount. Middle-range wines cost almost as much as the premium wines to produce and market but lack a premium price. They are also just a bit too expensive, outside the key £5-7 or US$10 sector, to sell in large quantities.

Unfortunately, because Southcorp didn't prune any of these brands, the combined company will have 46 wine brands and 24 wineries - many of which fall into the middle-range category and are only marginally profitable at best. In order to thin out the middle range, some huge names may have to be axed and some fear that even classics like Lindemans and Rosemount are not safe.

Foster's has put a hold on all new projects while a 25-man integration team analyses the Southcorp business. Details of its plans should emerge in September.

One of the other problems facing Foster's is the possibility that supermarket retailers in Europe and Australia will drop some of Foster's brands because the company has become too powerful as a supplier making it more difficult to squeeze on price. John Murphy, the managing director of Foster's Australia who is leading the integration team, is understood to have identified the maintenance of supermarket shelf-space as a priority. How Foster's manages the supermarkets' response to the merger will be critical to the success of the Southcorp deal.

Foster's must also address shareholder concerns about a loss of value in the company. The Southcorp acquisition is unusual in that it has pushed a very profitable company into an unprofitable business. Wine now accounts for about 70% of Foster's assets but only 30% of profits; the rest comes from domestic beer.

Some investors fail to see the logic of this and the company's share price has suffered, down to A$5.38 from nearly $6 at the end of last year. The stock has also been damaged by the huge amount of debt that Foster's is now carrying (A$5bn), which led Standard & Poor to downgrade the company's debt rating to one above junk: BBB-. There are also rumours that Foster's might issue equity to cut its debt and this would further depress the share price.

Last week, Merrill Lynch analyst David Errington issued a research note heavily critical of the Foster's wine strategy, headed "doomed to disappoint". Errington said that forecast synergy savings of A$80-100m were likely to be wiped out by increased costs, questioning whether a giant company could succeed in an industry that has always been about boutique producers.

Errington also said that Foster's wine acquisitions have "effectively destroyed significant shareholder value". He highlighted the company's return on invested capital, which, in 2000, was 18.4%. After two big wine acquisitions, return on capital is now down to 10.1%.

This view is not a universal opinion among analysts, some of whom believe Foster's is a great "buy", but the company will have to work hard to demonstrate that its acquisitions have been good for shareholders.

Moreover, Foster's will have to keep reminding its staff of the same thing as sources suggest that some Foster's beer executives are unhappy about their role in supporting the wine business. And executive apathy and under-investment in the beer business could make Foster's even more unpopular with shareholders, leading to calls to split the beer and wine businesses before one destroys the other.

One result of the merger is that it has effectively taken Foster's off the takeover table. Most of the world's brewers will now avoid it as a potential consolidation target because of its wine activities. Whether this is a good thing for Foster's or says something fundamental about whether brewers should invest in wine remains to be seen.