Lion Nathan Limited We’re in the business of sat.

Lion Nathan Limited

We’re in the business of satisfying thirst. We do it very well. We’re also thirsty our- selves. Thirsty for continued profitable growth. Every gain delivers more for our shareholders. We’re thirsty for knowledge. People and their preferences change all the time. We’re open to ideas from everywhere that will make us better at beverages and brands. We’re thirsty for a bigger share of the market. It’s a competitive place, but we’re determined to prevail through the sheer quality of our brands. We’re doing all this with passion, integrity and a “can do” attitude that enables us to face reality and turn it to our advantage.1

Background

Lion Nathan Limited (hereafter, Lion) was formed in 1988 by the merger of two New Zealand companies: Lion Corporation, a brewer, wine and spirit manufac- turer, and hotel operator, and LD Nathan & Company, a food and general merchan- dise retailer with consumer goods and soft drink interests. The company’s strategic direction had been heavily influenced by its longtime leader, Douglas Myers, who retired from the chairmanship of the company, which he held since 1997 (Exhibit C1). Lion was the leading brewer in the duopolistic New Zealand market.

Lion quickly realized the need to transform itself from a small New Zealand– focused company into a strong Australasian business with an increasingly inter- national outlook. In 1990 it bought 50 percent of Natbrew Holdings in Australia. The company also entered into a franchise arrangement with PepsiCo Inc. to man- ufacture, market, and distribute Pepsi products in Australia. In 1992 Lion Nathan acquired the remaining 50 percent of Natbrew and expanded the Pepsi franchise arrangement to NewZealand. In 1993 the company added Hahn Brewery and South Australian Breweries to the operation. The company’s Australian breweries now had a 41 percent share of the Australian beer market and accounted for about 75 percent of Lion’s assets (see Exhibit C2). Lion was the second largest brewer in Australasia.

Lion entered the China beer market in April 1995, when it spent NZ$21.6 mil- lion to purchase a 60 percent interest in the Taihushui brewery in Wuxi ( approxi- mately 120 kilometers west of Shanghai), with the Mashan District Government as the joint venture partner. Unlike most foreign joint-venture breweries in China, the Wuxi brewery had been turned from a loss maker to a profit center before Lion became involved. According to the 50-year agreement with Taihushui, Lion would have management control of the joint venture, and it was envisaged the local management would be retained, supplemented by Lion personnel in special- ist areas such as production and marketing. In January 1996, ownership of the Taihushui brewery was increased to 80 percent

The Taihushui purchase was funded out of Lion’s operating cash flow from its existing brewing businesses in Australia and New Zealand. Lion’s CEO, Myers, said the Wuxi joint venture gave Lion a significant foothold from which to build a greater presence in a high-growth area of China—the Yangtse River

Delta. Although beer consumption in China was growing rapidly, with per capita consumption increasing by 15–20 percent annually since 1990, it was still low by Western standards. Current annual per capita consumption in the Yangtse River Delta area averaged 14 liters, less than a fifth of New Zealand’s or Australia’s con- sumption. Myers said, “The time is right for the Chinese move.”

Annual GDP growth in the region at the time exceeded 17 percent, and there were already more than 3,000 joint ventures in Wuxi alone. Around 70 million people lived in the delta (an area about the size of Tasmania, half the size of New Zealand’s North Island). Along with its Yangtse River Delta neighbors Shanghai and Suzhou, Wuxi ranked among the five wealthiest cities in China.

Lion expanded its interests in China with the opening of a new $180 million state-of-the-art wholly owned brewery at Suzhou in March 1998. The 200-million- liter capacity at the Suzhou brewery gave the company capacity equivalent to the total New Zealand beer market, and the group had more employees in China than in New Zealand.

Introducing another twist to Lion’s internationalization strategy, the Kirin Brewery Company of Japan purchased a 45 percent interest of Lion in April 1998. Although Kirin, as the dominant shareholder of Lion, affirmed that, like Lion, it saw the relationship as a long-term and enduring one, there were some concerns about their Kirin’s intentions (see Exhibit C3).

In April 1999, Lion announced that it was entering into an agreement with Brauerei Beck & Company of Germany for a long-term partnership in China for the Beck’s brand. The agreement would provide for Lion to brew and sell Beck’s beer throughout China. Lion’s managing director for China, Jim O’Mahony, said that the agreement was a clear indication of both brewer s’ long-term commitment to China.

In June 2000 the company shifted its domicile and primary stock exchange list- ing to Australia. Lion’s chairman, Doug Myers, said, “The decision to relocate

the company head office is a sensible business decision which recognizes that our Australian business, which makes up 70 percent of our assets, is the main growth engine of the company.” The company would remain listed on the New Zealand Stock Exchange. As a result, Lion became a New Zealand–based company that earned most of its income overseas and had an overseas-based con- trolling shareholder.

In August 2000, following the resignation of O’Mahony, Lion appointed James Brindley and David Carter as joint China managing directors.

Contrary to initial predictions, Lion’s China operations were never profitable, for example, the reported losses for 1999, 2000, and 2001 were A$27.2 million, A$24.4 million and A$19.3 million, respectively.

In 2001, Lion’s Chinese brewing operations in the Yangzte River Delta showed some improvement. While volume grew 5 percent to 83.7 million liters, revenue increased 8.6 percent with improved pricing and mix shift. In local currency, the loss of RMB 83.8 million was a 32 percent improvement on the comparable 12-month period in the prior year. In Australian dollars, the loss improved by 21 percent. Despite these improvements, the company’s Chinese breweries con- tinued to run below capacity.

In a media release on July 5, 2001, Lion announced that it had terminated all discussions with two of China’s largest brewers. Commenting on this decision, Lion CEO, Gordon Cains said

As well as successfully progressing a range of initiatives to improve the financial and operating performance of our Chinese business, we have, over the last twelve months been looking at the options available to us to participate in the consolidation of the Chinese beer market. Having patiently negotiated in good faith with a num- ber of major brewers, we have now reached a point where we do not believe that a sensible outcome can be achieved in the foreseeable future. As a result, we have advised these two parties that we do not believe their proposals are realistic options for Lion Nathan and its shareholders. While this is disappointing, we are keen to bring an end to the uncertainty that is not helpful from an operating perspective.2

Opportunities were currently being investigated to address this issue. In August 2001, following the retirement of Douglas Myers from the board and chairmanship, the board appointed GT Ricketts as the new chairman

The Market in China

The Chinese beer market was highly fragmented, with a large number of brew- eries comprising regional and subregional markets. Although it has experienced some consolidation in recent years, the competitive environment was expected to remain difficult, with most brewers having real difficulty achieving adequate returns. In early 1998, there were around 860 breweries of any significant size in China. They included 40 with foreign joint-venture participation by a roll call of brewing giants: Heineken, Carlsberg, Guinness, Anheuser-Busch, Suntory, Fosters, San Miguel, Asahi.

Lion was wrestling with a number of problems in the China side of its business. Transport in the region was expensive and unreliable, with a series of canals of varying depth, width, and height clearance. To negotiate the waterways barges could be no larger than 60 tons. However, to get beer to the distribution hub in Shanghai in sufficient volume to make the trip worthwhile required much larger vessels. Lion was spending a lot of money to recruit and train local executives with little knowledge of Western marketing and management techniques. The task was not an easy one and, at least in the initial stages, meant a heavy commit- ment of expatriate resources to create a corporate culture. Getting well-educated, well-trained staff was difficult, and keeping them was worse in a market full of foreign companies desperate for well-qualified locals. Many Chinese employees didn’t have great loyalty to their company and would move firms for as little as an extra $20 a month.3

The key challenge was to adapt the Chinese guanxi (relationship) way of doing business to Western minds, particularly those that emphasized selling. Lion’s human resources director in China, Shane Slipais, said, “Relationship building is vital to all success in China, either personal or in business. Chinese spend more time on and off the job with each other than in Australia or New Zealand. The secret of doing business in China is to be rigid in what you want to achieve but be flexible in the way you get there.”4 Guanxi worked in both formal and infor- mal ways. Outright confrontation in the workplace was generally a no-no, and employer/employee disputes were dealt with through intermediaries.

Compliance with regulations, such as paying taxes and not polluting the envi- ronment, was far less obvious. The pecking order put multinational companies at the top of the compliance list, Chinese state-owned enterprises at the bottom and overseas-Chinese-run businesses in the middle. Corruption was endemic in any system where a form of authority, in this case the Communist Party, was above the law. It was a day-to-day reality.5 From a Western perspective, the main problem was the need to understand different business philosophies and practices. Failure to do so could be expensive. As one commentator stated, “There is a rule of thumb about China—do your homework before you get here. Take your worst-case sce- nario for cost and time, multiply it by two and you have the full cost estimate.”

The desire for short-term profits and/or high rates of return did not bring much success for foreign investors in China. Chinese partners emphasized long- term relationships with reasonable returns and mutual benefits. Only half of Chi- na’s breweries made money, and the foreigners’ track record so far had not been conspicuously better than the locals’. Both Lion’s Australian archrival, Foster’s, whose three loss-making breweries together notched up a deficit of $29 million in 1997, and British brewer Bass decided to quit. However, Lion appeared deter- mined to stay back (see Exh 4

EXHIBIT C4

Lion Determination

Brewers Hit Big Trouble in China but Lion Decides to Tough It Ou

rewer Lion Nathan is not going to follow competitors choosing to flee the red-ink generating Chinese market.

Despite year-upon year of huge losses since it first set up in China, Lion Nathan is ploughing on with its Asian venture as other big name brewers suddenly quit the market. British brewer Bass has decided to pull the plug on its $80 million joint venture in China, the world’s second-largest market.

“There is an overcapacity in China,” Lion Nathan’s managing director of the Chinese operation, Jim O’Mahony said. “The industry needs consolidation and we’re not overly concerned whether that process is by people exiting or folding.”

Bass said talks had begun to sell its 55% share in a joint venture after it fell out with its local partner in China. Foster’s last year grew tired of the much hyped potential of the 1.3 billion strong Chinese market. It sold its breweries in Tianjin and Guangzhou.

The losses for Lion’s Chinese venture have risen sharply in the past three years. In 1997 it was $8.8 million, in 1998 it tripled to nearly $30 million and for the financial year ended August 31, 1999, the loss before interest and tax was $32.6 million.

Bass has pulled out over problems with its local partner. “The gaps between our cultures have led to different views and even clashes, as the foreign party felt it didn’t get what it wanted,” a Bass spokeswoman sai

Lion’s Brands

In New Zealand, Lion was one major listed company that used Interbrand to value its beer brands. David Wethey stated, “Often a company would look only at brand equity when it was thinking of buying or selling the brand. But establishing the value of a brand was important right throughout it s life in a company.”6

Lion’s brands, not the beer, were worth $2.2 billion according to Lion’s balance sheet (see Exhibit C5). Unlike the beer, the brand was an intangible asset and, as such, hard to pin a price tag on. However, Lion’s 2001 annual report stated that its brands were revalued annually and the valuations were supported by inde- pendent valuations. Furthermore, it was claimed that the company’s policy in this matter was in compliance with the applicable Australian accounting standards (see Exhibit C6).

Warwick Bryan, Lion’s manager of investor relations, commented that if New Zealand’s proposed accounting standard (ED 87, a photocopy of IAS 38) were to be adopted, that would mean two-thirds of the brands would have to be imme- diately removed from Lion’s balance sheet and the remainder would have to be removed over 20 years through amortization.7

The Advertising Agencies Association stated that, in 1998, tangible assets rep- resented only approximately 29 percent of the market value of Britain’s FTSE 100 companies. They also stated the idea that only brands valued through a buy-and- sell process should make it to the balance sheet was “oxymoronic,” because the whole point of buying a brand was to purchase something with potentially endur- ing, or increasing, value.8

Commenting on IAS 38, powerful factions felt accounting standards were heading in a different direction to commercial and economic reality. The issue was further complicated by the fact that not all companies with established brands, even within the same industry, treated the value of their brands as an asset on the balance sheet. Underlying the fuss was a fundamental debate about how well the accounting profession was serving the business and financial communities.

As one commentator stated, “In the information economy the fastest growing industries are those in which intellectual property is companies’ greatest, if not only, asset. What’s the value of Microsoft without Windows?”9

LION NATHAN LIMITED AND ITS CONTROLLED ENTITIES Statement of Financial Position As at 30 September 2001

XHIBIT C6

BRANDS

Brands are stated at fair value. Revaluations are made annually and are support by independent pendent valuations. This policy is consistent with prior years, and complies with the revised AASB 1041 Revaluation of Non-Current assets

The fair value for beer brands owned by the Lion Nathan Group has been recognized where earnings of a brand can be separately identified, where title in them is clear, their ownership could change independently from the rest of the business, and where the brands achieve earnings in excess of those achieved by unbranded products.

Brands are considered to have no predeterminate finite economic life and are not amortized. The carrying value of each brand is subject to annual review and any permanent diminution in the aggregate value of the brands will first be charged against the Lion Nathan Group revaluation reserves.

REQUIRED

Assume Lion’s new chairman decided to conduct a thorough investigation into the entire China operation, and he invited you, a U.S. consultant with accounting qualifications, to do this. Write a report identifying the main strategic issues and recommending the courses of action available to Lion in facing the current realitives of this global initiative.

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