Fat Prophets take a loss
An investment in McGuigan Simeon Wines (MGW) has been a frustrating experience for shareholders in recent times. After battling the loss of pricing power through the great Australian wine glut, the embattled wine maker now faces reduced grape supply, higher costs, and importantly, a major currency headwind.
Recognising the increased risks attached to the business, we recommended Members reduce their exposure by half in June. Since then we have monitored the situation closely and now feel the arguments for retaining exposure have deteriorated beyond our comfort level.
As we highlighted in FAT330, the potential of a weaker 2008 harvest poses a threat to McGuigan’s business. A large portion of the company’s sales are derived from the production of bulk wine, much of which is under fixed price contracts. As a result, McGuigan may be unable to pass on higher costs to many customers.
And given the drought situation in the all important growing region of the Murray-Darling basin, a weak 2008 harvest is now all but assured. Many growers in the region currently have less than 10 percent of their normal water allocation and there is unlikely to be sufficient rainfall to rectify the situation before vines die off.
A recently released industry report indicates that expectations are for a 2008 crop of between 800,000 and 1.3 million tonnes. This represents a dramatic shortfall on the 1.9 million tonnes that would ordinarily be produced.
The second major headwind faced by McGuigan is the double edged sword of continued Aussie dollar strength. On the domestic front, wine producers will find it difficult to pass on higher prices in the face of competition from cheaper imports.
Furthermore, a weaker dollar had assisted the company’s penetration of international markets, facilitating lower prices relative to local products. However, this price advantage is now disappearing, particularly in the US.
We believe CEO Dane Hudson’s strategy of focusing on brand strength to retain pricing power is the right course of action. However, we do not consider the company enjoys sufficient brand strength to offset the headwinds it faces in the year ahead.
Although McGuigan’s share price is near record lows, we believe considerable risks remain. When times are tough, companies’ financial health is all important. And on this front, we have some concerns. At June 30, McGuigan’s gearing ratio was 44 percent and net interest cover fell to 0.3 times, compared to over 3 times at the same time last year.
This extremely thin interest cover obviously causes concern given the profit headwinds outlined above.
From a charting perspective, the outlook for McGuigan’s has continued to deteriorate since our last review. In August, the stock broke below the August 2006 low of $1.905, extending the downward trend to a new low of $1.765 within the past week. This is the lowest level seen since 1998.
With unrelenting downward momentum and no sign of a near term rebound in prices, we believe there is a high risk that prices will continue lower. Accordingly, Fat Prophets recommend selling McGuigan Wines around $1.77.
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As at the date at the top of this page, Directors and/or associates of the Fat Prophets Group of Companies currently hold positions in ABB Grain (ABB), Aurora Minerals (ARM), Austal (ASB), Australian Wealth Management (AUW), Avoca Resources (AVO), Avexa (AVX), Argo Exploration (AXT), BHP Billiton (BHP), Babcock & Brown Japan Property Trust (BJT), Boart Longyear (BLY), Biota Holdings (BTA), Catalpa Resources (CAH), Catalpa Resource Options (CAHO), Coeur D'Alene Mines (CXC), Fat Prophets (FAT), Fat Prophets Options (FATO), Fosters Group (FGL), Global Mining Investments (GMI), Lihir Gold (LGL), Lion Selection (LST), Macarthur Coal (MCC), Maryborough Sugar Factory (MSF), Mundo Minerals (MUN), Mineral Securities (MXX), Mineral Securities Options (MXXO), Newmont Mining (NEM), Oil Search (OSH), Oz Minerals (OZL), Progen Options (PGLO), Platinum Australia (PLA), QBE Insurance (QBE), Rio Tinto (RIO), Roc Oil (ROC), St Barbara (SBM), Sirtex Medical (SRX), Territory Iron Ord (TFE), Telstra Corporation (TLS), Tox Free Solutions (TOX), View Resources (VRE), View Resources Options (VREO), Walter Diversified (WDS), Woodside Petroleum (WPL), Merrill Lynch Gold Fund, Platinum Japan Fund, Gold Bullion. These may change without notice and should not be taken as recommendations.
The above disclaimer does not apply to investments held by the Fat Prophets Australia Fund Limited ACN 111 772 359 (FPAFL).