Market Analysis: Wine Industry Analysis

Very recently, a debate over future grape/wine supply/demand has gained momentum in the industry. In recent years, several industry leaders have begun to question industry projections of future grape supplies, in large part due to inherent inadequacies in the grape acreage statistics. The irony of this debate is that the most recent market traumas have been focused on Robert Mondavi, Inc, due to: 1) perceived inability to control grape costs, and 2) shortages of wine product, specifically in the lower priced Woodbridge line. At the same time as Mondavi's stock has been buffeted by the unkind winds of Wall Street for these perceived inadequacies, many industry observers are, at the same time, crying of impending doom, as the impending sea of Merlot (and all grapes) threatens to drown us all…

A recent, 1998, study by the highly respected accounting/consulting firm of Motto, Kryla and Fisher (MKF) of future grape trends flatly stated "There is no grape glut." MKF demonstrated how the major premium varieties, Cabernet Sauvignon, Chardonnay, Merlot, and Sauvignon Blanc, may actually continue to be in short supply in the premium market segments. MKF's analyses, however, are based on some rather optimistic assumptions regarding future domestic wine consumption and economic conditions. The report addresses one issue, in which there appears to be general consensus, lower-priced Merlot, especially in the southern Central Valley, appears headed for significant oversupply.

The most recent (1999) MKF study reemphasizes the continuing demand for high quality Chardonnay and Cabernet, and even suggests the coming oversupply of Merlot could be a boon for creative wine marketers.

The debate accelerated significantly when Barron's magazine published a full-color cover warning of "The Coming Wine Glut" on August 3, 1998. While the cover story suffers from the usual journalistic inaccuracies, it does address the burgeoning grape supply, and the consequent wine supply, relatively accurately. The Barron's story hit the market in the same week as a drop in the general stock market. Buffeted by both the general malaise in the market, and the negative tenor of the Barron's article, public wine company stocks suffered significant losses. The irony of this particular situation is that the coming increase in grape supply may, indeed, be the greatest boon the wine industry has seen in many years, as the industry will, for the first time in this current market, have a sufficient supply of quality product, at reasonable prices, to move to a thirsty market.

Market analysts responded quickly, with NationsBank Montgomery Securities, Goldman Sachs & Co. and Hambrecht & Quist immediately issuing research reports challenging the story's conclusions.

A general industry response was published in the Santa Rosa Press Democrat on Tuesday, August 18, 1998, when Ted Appel challenged "Report of Wine Glut strongly disputed", which focused on the change in consumption patterns, and the rising demand, and short supplies, of true premium wines. While all acknowledge the impending wave of low-priced Central Valley grapes, the true point of this quandary is the supply/demand equation, and balance, in the upper tiers of the market, which is the focus of this analysis.

Another recent media article in the current series was published in the Wall Street Journal on August 24, 1998. The author of this article ignored the current predictions of falling skies and black Tuesdays, and focused on the primary characteristic of wine, fun. Titled "Wine Stocks may be Tanking, but Let's Party!" The reality of most private investments in public wine companies is that ownership in such stocks is perceived as an invitation to the party, or, as one Mondavi shareholder was quoted in the article, "The dinners and special events make me feel important, like I'm in the loop." There is clearly no doubt such emotions and rationale fuel the continued surge of investment in public wine companies, although such an attitude clearly reflects the prevalent attitudes of the current economic boom, with household incomes rising at unprecedented rates, especially here in California, the home of wine country business.

The WSJ article does, however, go on to recite the current trauma experienced by the party mongers, as even the vaunted Mondavi shares have plummeted 48% since January. Most noticeable in this illustration, however, is that the purest "party" stock, Chalone, which offers no monetary dividends, but does extend shareholders coveted invitations to attend the legendary shareholders soirée upon the rocky hillside of the namesake winery, and the opportunity to acquire special shareholders' selections at discounted prices, has weathered the current market storm most successfully, with only modest dips in share prices. It is, perhaps, possible that Chalone is most in tune with the current tenor of the market, which appears to value a memorable event more highly than mere financial returns.

Coincidentally, George Schofield has also released the first update of his Chardonnay and Cabernet Supply analyses, and his projections reflect what may be emerging as the mainstream consensus. While some, perhaps severe, oversupplies may loom in the lower quality Central Valley markets, market equilibrium appears to be approaching on the central coast, and a similar balance, or even grape shortages, may continue in the premium northern coastal regions.

Regardless how this debate rages, or whomever holds the current advantage in this ongoing saga, it is clear we are heading into a period of increased grape supply, and consequent wine supply. It is the opinion of the appraisers that this burgeoning supply will cause some significant trauma for some grape growers, most especially those in the central valley who have gambled and developed new vineyards without firm, long-term, grape contracts. Excess supply of specific varieties in specific locations, and price segments, would tend to depress prices, following the classic laws of supply and demand. Depressed prices would reduce growers' net operating income, impacting profitability, and in extreme cases, limiting the growers' ability to service debt, thus, causing immediate trauma to the grower/landowner.

The trauma would, most likely, work its way up the ladder of quality and price, beginning with the generic varieties in those areas of the Central Valley noted for lesser quality grapes. Conversely, however, many growers with desirable varieties, and firm contracts, can continue to prosper, as long as the contracting winery continues to honor its commitment to purchase grapes, at the contracted prices. History, however, teaches us that not all wineries will weather the storm, and some may be forced to reset prices, or to refuse some grapes at the scale.

The interesting aspect of this current quandary is that this scenario has been played out many times in the California wine industry, with times of perceived strong demand for wine prompting rapid expansion of productive capacity, with the growth of production typically accelerating, and eventually outstripping demand, leading to lowered wine and grape prices, and eventual reduction in production driven by failures of both vineyards and wineries. As the cycle continues, supply and demand eventually find balance, with successful vineyardists and wineries weathering the storm. The road through these cycles, however, is littered with those who have not.

While the industry generates a broad spectrum of opinions and forecast futures, we must assume some price adjustments loom ahead. The severity of such adjustments will be insulated in the higher quality production areas, most specifically the respected AVAs, but even these areas will feel some impact. Market adjustments in the southern Central Valley may prove deleterious to some growers in that area, most especially those growing grapes without the benefit of long-term contracts. Mr. Jon Fredrikson, a highly respected industry consultant, noted, very recently, in a presentation on the industry in Santa Barbara county;

"If there is a fundamental weakness facing the wine market, it is likely to be in economy wines sourced from grapes grown in the hotter, interior regions."

One major industry participant, a "luxury" segment winemaker, referred to the "decommoditization" of the market, with grape buyers viewing grape purchases with an increasingly critical eye, looking to the geography and climate of the specific property, and the reputation of the specific vineyard. This reflects the most recent industry trend, focusing on the "place" of wine, the "terroir" of grape production, and a consequent differentiation between grape growing areas, and even between specific vineyards within a defined area.

In the midst of this often-heated debate, Silverado Premium Properties acquired the Prudential portfolio of vineyard properties in the Sonoma and Lodi areas, at a reported price of $60 to $70 Million. This transaction came on the heels of the recently announced acquisition of the Geyser Peak winery by Fortune Brands, Inc., for a reported sale price of $101 million. The vineyard sale was reported in the Santa Rosa Press Democrat in an article which suggested the possibility of a future REIT. Silverado has continued on an aggressive acquisition program, targeting higher quality vineyards in recognized premium areas.

More recently, other contemporaneous market events include a recent purchase of the Alderbrook winery, just southwest of Healdsburg, and Beringer's acquisition of the St. Clements Winery, both at reported prices in excess of $12 million. The industry has also seen the recent acquisition of Sonoma-Cutrer, another Russian River Valley winery with a lucrative Chardonnay market, by Brown-Forman. Prior to this, the industry rumors had suggested Brown-Forman as a potential buyer of the Simi winery in Healdsburg. However, in April, Simi had announced an acquisition by Canandagua, at a reported price of $55 million. This was followed, quickly, by Canandaguaa's acquisition of the Franciscan complex, for a reported price of $240 million. Canandagua's rather dramatic moves into the premium arena reflects the obvious trend towards quality, with the major beverage companies seeking their place in the Napa sun.

Perhaps the most perceptive view of the current situation was published in Impact, September 1, 1998, in Kevin Barry's lead article; "US Wine Market Continues Growth, Amid Worries Over Future Oversupply". A subheading "Despite worries about pricing and oversupply, the US table wine market looks set to continue growing at its current record-setting pace." The article perhaps captures the mood of the industry best as it goes on;

"Another good harvest and a wine glut means good news for the marketing departments of wineries prepared to make the necessary investments in sales and marketing… If wine quality improves with volume, consumers and the entire wine category also have much to gain… With new varietal plantings coming on line each year and existing vines producing better grapes, the long-term future of the US wine market looks bright. The winners will be those companies with the vision and marketing ingenuity to fulfill consumers' diverse and demanding palates… However the supply situation plays out, this should be an exciting time for an industry that stands to make significant gains in quality, volume and visibility over the next several years, even if economic growth subsides."

At an October 2, 1998 conference in Shell Beach, Heidi Scheid, CFO of Sheid Vineyards, offered her perspective on the current debate. Among other factors, Ms. Scheid stated her company's target rate of return on investment is at 15%, after taxes. As a "C" corporation, then, at a 40% tax rate, an investment must return 25%, before taxes, to yield a 15% return, after taxes. Ms. Scheid commented further that, although Scheid is aggressively seeking new vineyard acquisitions, even advertising heavily in trade and area publications, they have not identified any properties, which meet their criteria, within the past year. Older vineyards must be assessed in terms of the production anticipated in coming years.

Clearly, the delta and central coast will enjoy dramatic increases in production within the next five to ten years, as will the entire state, and successful vineyardists must anticipate the market's response, and plan accordingly. Scheid is exploring the use of contracts on a per-acre basis, rather than the traditional per-ton basis, thus, side-stepping the usual grower vs winery debate over yield. Historically, growers have always striven to maximize yields, while winemakers seek the highest quality grapes, and push for reduced yields, and attendant higher grape quality and intensity. In this market, then, older vineyards must be viewed in light of their productive capacity in those coming years, and priced accordingly.

A comprehensive survey presented at an industry event, the Wine Industry Financial Symposium in Napa on October 21, 1998, revealed current thinking of industry participants. When questioned as to how long the current upswing in the market will continue, 39% of survey respondents replied 1 to 2 years, with 34% saying 3 to 4 years, and the overall average indicating 3.1 years. This is down from the same data as reported a year ago, at 3.3 years, and two years ago, at 3.8 years. In 1996, 48% of respondents pointed to 3-4 years, so clearly we are recognizing the cyclical nature of this market.

To the question; "Are we entering a period of major change?", 80% of respondents agreed. A majority of respondents agreed that Appellation or region-based advertising was significant. An overwhelming majority (84%) felt that an economic downturn would be a possible constraint to growth. It is interesting to note that 44% of vineyardists felt that an insufficient grape supply could also be a constraint, while only 35% of wineries shared this view. Respondents all strongly agreed the industry has potential for increasing profitability, with 70% of winery, and 73% of vineyardists responding positively in this area. When asked if US per capita consumption could be doubled over the coming 25 years, 55% of wineries responded positively, while 71% of vineyardists agreed.

To summarize, grapegrowers appear to be more optimistic about the future than wineries, which may have a more realistic view of the current market.

In terms of grape supplies in the immediate future, all agreed Cabernet Sauvignon would be in short supply in the North Coast, balanced on the Central Coast, but in significant surplus in the Central Valley. Merlot is expected to be in surplus in all areas by 2000, except Napa/Sonoma, while Pinot Noir is perceived as in short supply in all coastal areas. Chardonnay is seen as surplus in all areas, with significant surplus in the Central Valley, and 40% of survey respondents seeing a surplus on the Central Coast. Here again, a localized view is more extreme, as 15%± of North Coast wineries see a surplus on the North Coast, while 30%± of North Coast growers see a deficit. It is also noteworthy that in 1997, wineries, overall, perceived Central Coastal Chardonnay as in balance in 2000.

The debate continues to rage, with recent articles offering differing views of the situation. David Goldman offered his response, itemizing the reasons "Why Barrons Is Wrong" in an article on the "Investment Merits of Wine Stocks" in the November, 1998 issue of Wine Business Monthly (WBM).

Another article in the January, 1999, issue of WBM, subtitled: "No Glut at High End of Market" quoted the exponential price growth for the high-end wines, most especially the luxury Napa Valley Cabernets. In this article, Abigail Sawyer cites the Diamond Creek price rise to $300 a bottle as evidence of the supply/demand imbalance. Similarly, Warren Winairski's Stag's Leap Wine Cellars' Cask 23 has gone from $75 to $120.

The decline in high-end French wines continues, as reported by Tim Fish, in WineToday.com, on April 12, 1999, Bordeaux prices continue to drop. Even the prized First Growths of Chateaux Margaux and Latour announced prices for the 1998s that were 10 to 14% cheaper than 1997, even though the 1998 is considered superior to 1997. Fish noted, however, that the surges in First Growth prices since 1995 have proven beneficial for upper-tier California Cabernet. As First Growth Bordeaux have jumped 200%, or more, since 1995, California Cabernet remains a bargain by comparison.

Bulk wine sales have also begun to soften somewhat, after feverish activity earlier in 1999, although demand remains strong for higher-quality premium bulk wines, as reported in the April 17, 1999 issue of the Wine Business Insider.

Another Wall St. Journal article, on April 26, 1999, focused on the newest entrant into the game, Premier Pacific Vineyards LP, a new partnership focusing on the acquisition and development of premium vineyards and wineries. This article repeated the bullish anticipation of increasing prices and profitability in the upper tier of the market, and suggested the best is yet to come.

The gadfly of the industry, Lewis Perdue, continues to press his case for a coming glut in his episodic columns in TheStreet.com. Also, Lew has just published a book on the California Wine Industry, "The Wrath of Grapes", which articulates his view of the industry, and the coming supply/demand imbalance.

The most recent opinions offered in the various industry media suggest the Central Valley will experience some diminished demand for grapes, already seen in the 1999 crop, and this appraiser's experience tends to confirm this. The drop in demand appears to be the result of many of the large producers' shift to "other than standard" wine products, such as Canandaigua's Arbor Mist "Peachy Chardonnay", Gallo's "Wild Vines" products, and Franzia's "Chardonnay with Natural Flavors". These products do contain some wine, but only a portion of the total volume is actually wine, with the remainder merely water, sugar, and flavoring. Consumer response to these products has been very strong, so we must assume this trend will continue. The net result to the grower, however, is less demand for bulk wine, and consequently, the grapes to make that wine. These products remain the focus of a sometimes-heated controversy within the industry.

As reported by Rich Cartiere, in his Wine Market Report, on September 11, 1999, Central Valley prices declined dramatically, with Gallo's price for Lodi Cabernet dropping 25%, after Canandaugua had dropped their prices for Cabernet and Chardonnay by 30%. Conversely, however, we have seen prices for coastal Chardonnay rising as wineries searched for additional grapes to fill their tanks, as the true size of the short crop became apparent.

To summarize this issue, the industry is gearing up for increased production of grapes in all areas, and anticipating surpluses of all major varieties in all areas, with the obvious exception of the true high-end luxury wines. The trend has been distorted, however, by the short 1998 "El Niño" and 1999 "La Niña" crops, with the available grape supplies significantly below the levels seen in 1997. It is noteworthy that the average grape price declined by 3.5% in 1998, while production declined 13%.

The net effect of the anticipated future surpluses is the unknown factor. Consumption of domestic premium wines will be the key. If the wineries can market higher volumes of premium wine, and increase consumption apace with the anticipated grape supplies, the grape market should remain fairly stable. If, however, consumption and finished wine sales do not grow in step with the increased production, history would suggest grape demand would suffer, with a consequent resetting of grape pricing.

Will history repeat itself? An article from the Wall Street Journal, January 5, 2000, states, (with tongue firmly in cheek; the article is datelined Dec. 31, 1879) :

"…Investors are thirsty for a return to the good times….With thousands of acres of cheap land available, many new players jumped into viticulture, while existing ones expanded….But all that production created a glut, which became evident three years ago when much of California's wine fetched barely 15 cents a gallon…."