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Graham MacKay of South African Breweries: Rand illusion

In the past year more than just hops have been fermenting around South African Breweries.

In the past year more than just hops have been fermenting around South African Breweries.

In November the Financial Times published the news of an imminent bid for SAB by Belgian brewing company Interbrew, citing confidential documents prepared by Interbrew's financial advisers. Even stranger, the document , which used the code name "Zulu" for SAB , turned out to be genuine but partly fabricated. The FT later reported that Interbrew's advisers , Goldman, Sachs & Co. and Lazard , had prepared an analysis of SAB but that the pages that indicated the deal was about to happen appeared to have been faked. The takeover bid never surfaced, and Interbrew has sued the FT and other publications to get its hands on the documents in hopes of identifying the source.

Then in January The Wall Street Journal reported that the U.S.,s Miller Brewing Co. had held merger talks with a number of competitors, including SAB. That bid has also yet to be made, and an SAB spokesman declined to comment on "market speculation."

What may be attracting the attention of SAB's competitors is the 106-year-old brewer's success in smaller and emerging markets. SAB, whose best-known brands are Pilsner Urquell and Castle Lager, claims to be the most profitable foreign brewer in China. It's now trying to duplicate that success in Latin America. Last November the company acquired a Honduran beer maker, Cervecería Hondureña, and it formed a joint venture with El Salvador Beverages Business, an El Salvador brewery and soft drinks distributor.

SAB's affinity for these smaller markets has a lot to do with its origins in the isolated South African economy. Although the company's executives operate out of London, SAB was founded in Johannesburg to sell beer to South African diamond miners, and it still sells more beer than anyone else in Africa.

The company's South African heritage, however, has been costly in recent years because of the collapse of the rand. With the currency down dramatically since 1997, SAB's profits stated in dollars fell 1 percent for the four fiscal years ended March 31, 2001, while profits denominated in rands were up 61 percent. The shares, listed on the London Stock Exchange, traded at 488 pence last month, up from a six-month low of 407 in September. The company reported pretax profits of $302 million on revenues of $2.2 billion for the two quarters ended September 30, down from $310 million for the same period the previous year.

E.A. Graham Mackay, the company's CEO, plays down the possibility of imminent mergers and says there's plenty of opportunity for his company to go it alone.

The son of a farmer who ran a sugar estate in the former Rhodesia, Mackay studied engineering at the University of the Witwatersrand in Johannesburg and joined SAB in its computer systems department in 1978. He then held a series of executive positions, including chairman of SAB in South Africa and group managing director of SAB. In 1999, the same year the company moved its operations to London, Mackay was named CEO. He recently spoke about the future of the brewing industry and SAB with Institutional Investor Senior Editor Hal Lux.

Institutional Investor: There were published reports a little while back that Interbrew was interested in acquiring you. Can you add anything to that?

Mackay: It was a most extraordinary event. There was a leak. I think Interbrew found it extremely embarrassing. They,ve entered into court action over here to recover the documents and to protect themselves against the consequences. So yeah, clearly, they had been doing some work. I mean, I don,t know exactly how much of the work was initiated by them as opposed to being initiated by bankers, but I don,t think it was the first round of such an analysis. Of course, we do analyses like that all the time, and I think all of our international competitors do the same. And there are many more analyses done for us by outsiders on a kind of speculative or fishing-trip basis than we do ourselves. So there was nothing particularly surprising about the analysis.

Is consolidation the big trend in the brewing industry?

The realization has dawned that the underlying scale economies in beer that span national boundaries are not all that commanding at present, and therefore it's quite difficult to see value in acquisitions at high prices. The industry players are expecting further consolidation, and I think that in the very long term it will be justified, but it's quite difficult to see how to find value in the short and medium term through acquisitions.

You,ve focused on emerging markets and Eastern Europe. Why?

Initially, it was making a virtue out of necessity. We came out of South Africa, and emerging markets were the ones we were used to and that we could get to quite easily. The capital requirements initially were not all that high, and we didn,t have the operating experience on the world stage. But probably more important, there was a sort of seismic shift in the brewing industry when communism failed and some potentially large markets became available. One could go in there and acquire assets relatively cheaply. They were in bad shape, but they could be turned, and the competition was somewhat limited for the initial period after that. So you could establish a beachhead or a stronghold. That is unusual in the broad sweep of history in the brewing industry, because most national markets the world over are relatively stable and are pretty concentrated.

What have you found to be the keys to selling to the Chinese market?

Well, our business model is somewhat different from most of our competitors. We,ve tried to generate a more Chinese solution, if you like. We have some partners, and we think that's essential there, particularly as beer is a sort of a preexisting industry. You know, you,re not going in with new technology or new products or new offerings that are completely different from what has been there all the time. That means doing transactions with local interest groups and being networked into China. Then we,ve also kept our costs very low , both capital costs and operating costs. We concentrated on the top of the mainstream market, where there,s enough volume to be interesting but where prices are not rock bottom. And we,ve also concentrated on the second-tier regions, which can be turned into geographic strongholds for the short and medium term. Those are away from the very competitive and overtraded eastern seaboard cities where there's regular overcapacity and existing international players with products that are too expensive, effectively, to get decent volume. It's a much more local or localized strategy than many of our international competitors have adopted, and I think it has been mostly successful.

What are your plans for the U.S.?

We,re in the U.S. in a minor way. We have the Pilsner Urquell brand, which has been in the U.S. since the 1800s but went through a pretty fallow period while the business was owned by the Communist regime in Czechoslovakia. We took it over about two years ago, and we,ve been growing it rapidly on a pay-your-way basis. We,re not putting in massive marketing support ahead of what the brand can afford. But it's growing very solidly in the U.S. It,s about a 2 million-case brand now.

How much of your growth will come from Latin America?

We,re there in quite a small way at the moment. The businesses that we bought are relatively small in beer volumes. They are more soft drinks and water. We think that the beer markets there have been relatively underexploited. So we think there's growth to be had. I think that this will probably lead to other activity in the region, but I can,t be specific about that.

The performance of the rand has hurt your performance. Would you consider leaving South Africa?

The rand has hurt our overall operating performance dramatically. But it is quite perceptibly less influential on our share price now than it was at any time in the past, and we expect it to get progressively less and less influential as time goes on. What we,ve been doing is diluting our reliance on South Africa , not by disinvesting from South Africa, but simply by investing elsewhere and changing the balance. I don,t think that there's very much else that we can do, other than to grow the rest of our businesses as fast as we can. Through early 2002 the rand has lost 60 percent of its real value , its inflation-adjusted value , against the dollar since 1997. We don,t operate the business from South Africa. We have operating subsidiaries there, but the head office is here in London. We do use those subsidiaries to support our worldwide expansion from the point of view of human resources, people, management skills, training, operating procedures, brand management and everything else. It's effective to do that because it's a low-cost platform. Behind your question may be an implication that we should be disinvesting from South Africa. If so, the answer is that we are not contemplating doing that. There are many practical reasons why we would not want to do that; not the least of them is that it's a highly profitable business, even with a declining rand. It is extremely profitable, extremely cash generative.