Have BRL Hardy’s investors been sold short?

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With no rival bidder surfacing, Constellation Brands seems set to acquire one of the most successful wine businesses in the history of the industry. And as BRL Hardy's share price continues to climb, analysts appear to be revelling in the news. But as David Robertson reports, BRL Hardy and its investors should be wary of some long-term concerns.

BRL Hardy's takeover by Constellation Brands will create the biggest wine company in the world but as the corporate advisers pop the champagne investors should consider whether this is a deal too far.

BRL has been a star performer on the Australian stock exchange since it listed with a market capitalisation of A$67m just a decade ago. The $10.50 a share offer from Constellation values BRL at a staggering $1.85 billion; a growth rate that rather puts to shame all the stars of the internet revolution.

Unless other suitors step in to spoil the party (Diageo and Fosters are the only likely contenders) the Constellation bid looks like a foregone conclusion. The International Wine Investment Fund, which owns 11% of BRL Hardy, described the offer as a "fair deal" and is not expected to rock the boat. ING Investment Management, which owns 5.4%, also said the deal was "fair" and other institutional investors have indicated that they are likely to accept the offer.

But why? The price of $10.50 a share is not unreasonable and was even beyond some analysts' expectations. BRL's share price has fallen from a peak of $11.61 last February to $6.40 in November because of investor concerns related to UK earnings. The $10.50 price was also well ahead of last week's closing price of $9.44 (before trading in the stock was halted on Friday) and values BRL at 13 times expected 2003 earnings. This is only slightly less than the 13.6 times earnings Fosters paid for Beringer and the 14 times earnings Southcorp paid for Rosemount. Given the weakness in BRL's share price the valuation seems more than fair but this is a very short-sighted view.

BRL's share price dropped towards the end of last year making $10.50 look attractive but looking at the 10 year track record, and with a growth rate of 21.2 per cent a year, there is every reason to suspect that the share price could go well beyond $10.50 in future. The management has delivered brilliantly up until now - why should they not continue to do so?

Of course, the reason companies like BRL look for a big brother is that they need the experience and capital to utilise their under-exploited assets. That is the economic theory but reality is different. In many cases management are looking to cash out, to boost their pay packages or they are seeking safety from bad news that might be coming around the corner. As a result less than a quarter of Australian M&A deals match expectations, according to research by consultants AT Kearney. The global average is about 28%, but even that is hardly cause for celebration. In more than half of mergers and takeovers absolutely no economic value is created so it is very appropriate to consider who benefits and who loses from this deal.

A number of reasons have been put forward to justify the deal. The trigger appears, according to JP Morgan and Merrill Lynch, to have been approach, or an indication that an approach was imminent, from another party. This prompted BRL to hot foot to Constellation, with whom it already has a partnership, to seek protection. But it is hard to see how this benefits anybody other than the incumbent management who can protect their jobs by staying with Constellation. Surely the management should have courted interested parties; they should have engineered an auction to get the best price for the company. After all, this is what Montana Wines in New Zealand did. By playing Lion Nathan against Allied Domecq the deal went through with a valuation of 16.6 times earnings.

The Constellation deal does allow BRL to protect its joint venture with the American company, which is called Pacific Wine Partners. Set up in August 2001 PWP has been an outstanding success with sales up 300% to US$82.4m for the nine months to the end of last November. The venture has two Californian wineries and has produced stunning results for BRL, pushing brands like Hardys and Banrock Station into North America thanks to Constellation's marketing power. PWP is becoming so successful it is forecast to contribute half of BRL's profit growth in the next three years.

But all this sounds remarkably like one of the other reasons that a smaller company might merge with a larger one: to give it access to new markets and financial and technical know-how to expand market share. If a joint venture can achieve this why does Constellation have to buy BRL? If it was merely a matter of deterring predators Constellation could take a large stake in BRL in the way that Kirin has with Lion Nathan (45%). This would allow the BRL management to continue with its proven ability to run the company without taking the edge off their performance by having to report to a company based more than 10,000 km away in New York.

The last major argument is the old "big is beautiful" idea. Consolidation is necessary to survive in the global market place - expand or die is a mantra that has seen other major Australian wineries doing deals: Southcorp with Rosemount, Foster's with Beringer, Orlando Wyndham with Pernod Ricard, Petaluma with Lion Nathan.

Constellation chairman and chief executive Richard Sands described it as "staying ahead of the curve" but is this really the case? BRL has already proven that small and agile can create a A$1.85bn company and there are a number of potential problems that could make "staying ahead of the curve" a very damaging experience for BRL investors.

One of these potential problems is Constellation's debt, which at US$1.3bn plus an expected US$500m for BRL could prevent the sort of investment that is one of the major factors in a deal like this. Moodys already has a less than impressive BA2 rating for Constellation's senior debt and might downgrade further after this deal, which will make it even harder for BRL to leverage its parent's size to its own advantage. Many investors are still reeling from the damage caused by massive debt burdens at companies like VivendiUniversal and Marconi and should consider whether this is justified.

The necessity of learning historical lessons from last year's corporate failures is intensified by the underwhelming performance of the core Constellation business.

Deutsche Bank has warned that 62% of Constellation's businesses are failing to meet targeted revenue growth of 4%. Other analysts have also pointed out that the company is overly dependent on its licence to sell Corona beer in the US and with a commitment to double sales in the next five years this deal looks very favourable to Constellation. But again, why would BRL need a debt-laden parent that lacks the broad business clout of an Allied Domecq or Diageo?

Despite these legitimate concerns the deal will be completed. There are too many people who benefit for it not to succeed. And perhaps BRL-Constellation will go from strength to strength. Or perhaps BRL will become part of the 50% of businesses that fail to generate value from a takeover, tarnishing what has been an amazing decade of growth for the company.

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