For investors in McGuigan Simeon Wines (MGW), the last two years has been a testing time to say the least. Just when we thought conditions couldn't get much worse... they have. Originally suffering from an excess of supply during the wine glut, the Australian wine industry and McGuigan in particular, must now battle a problem that is the polar opposite.

Since our last review in May, there has been a further deterioration in the near term technical outlook. As shown on the daily chart, a decline during the past week has seen prices break below the April low of $2.44 to extend the four-month downward move.

Due to the ravages of drought, frost and bushfires, the 2007 Australian grape harvest has fallen by over 30 percent. McGuigan's own crop fell 33 percent to around 158,000 tonnes. While management anticipated a reduced harvest, the extent of the fall took them by surprise.

And although the smaller crop has addressed excess supply, it now seems the pendulum has swung too far. The lesser 2007 vintage has significantly pushed up the cost of production. As such, McGuigan expects to record a loss of $4 to $6 million for the full year to 30 June 2007.

A major problem McGuigan faces is that a large part of its business (around 30 percent of revenue) is in bulk wine sales. Essentially, the company produces bulk wine for clients under fixed price contracts. So with a lower grape supply leading to higher grape prices, McGuigan can't pass the cost increases on to their bulk wine customers.

Furthermore, McGuigan's processing facilities are now under-utilised. Given the fixed cost nature of this business, volume is all-important. Hence, a lower grape harvest means lower processing volumes.

CEO Dane Hudson is seeking to address the capacity issue by improving efficiency at the company's wineries, such as the primary Buronga Hill winery. In addition, it is likely that other facilities will be sold off. In fact, McGuigan's Griffith winery is already on the market and the company is considering selling South Australia's 90,000 tonne Loxton operation.

However, compounding the problem is the threat of a weaker 2008 harvest. Buronga Hill is in Victoria's irrigation dependent Sunraysia region, where a question mark hangs over water allocations. There is currently zero water allocated for next month and if it continues like that, there will be major implications for the 2008 vintage.

In a huge turnaround for the industry, management is beginning to stockpile inventory in the event that drought continues. The irony is that McGuigan was forced to write down inventory last year, in order to clear the excess and return levels to balance. At the time, we supported the move as necessary to accelerate the recovery. Hindsight has proved us wrong.

Outside of bulk wine, in recent years the company has managed to grow market share in the UK. In large part, sales growth was driven by the low cost of Australian wine during the industry's glut. However, the deal with Waverly TSB has greatly enhanced the company's distribution channels for branded products, which should support export growth.

In fact, the company's product mix is shifting to higher priced and higher margin brands, which currently account for around 35 percent of sales. Also supporting higher prices is the quality of the 2007 harvest, which although low in volume, has borne very high grade fruit.

Greater brand strength is an essential component of Mr Hudson's long-term strategy, which has the potential to bolster profit margins and market share. And while the tough conditions may continue for longer than we anticipated, we still expect McGuigan to eventually emerge as a more efficient (and therefore profitable) winemaker.

On the charts, the latest development is clearly disappointing and signals an increase in near term downward momentum. While prices remain below the $3 region, we believe that there is considerable risk of further weakness in the stock and thus cannot rule out a move toward the $1.90 low of August 2006.

In summary, adverse weather conditions have resulted in a complete reversal of industry dynamics. Having devised long-term strategies to battle over-supply of grapes and wine, the company must now grapple with supply shortages.

Consensus Valuation Estimates

On the surface, a shortage of wine supply indicates pricing power should return. But as a major processor, McGuigan has a large fixed-cost base and ideally requires a balanced industry to generate strong profitability. But nature isn't playing along.

While the stock looks cheap now, we believe the share price will continue to underperform for some time. We therefore recommend Members reduce exposure and sell half of their holding. However, we plan to maintain some exposure to the eventual turnaround.

With the uncertainty surrounding harvest conditions, we are increasing the stock's risk profile to high. To reiterate, we recommend Members sell half of McGuigan Simeon Wines at around $2.26.

Interests associated with Fat Prophets declare a holding in MGW