An Acquired Taste; a Winery Investment

I’m not much of a drinker. In fact, sometimes I force myself to drink red wine every month or so just to make sure I don’t completely disdain the taste if I go out on a meeting (or God forbid a date). Maybe its something I’ll appreciate “when I’m older”, as red wine drinkers tend to tell me. “It’s an acquired taste”, is what the wine drinkers usually spout whenever I tell them I’m not too much into the taste. However, my mom bought me a bottle of red wine for Christmas from the Zac Brown Vineyards, so I had to finish it, and it wasn’t terrible.

Investing in wineries is similar to drinking wine in that it’s something I don’t often do. Whether through chance or a subconscious avoidance of industries I don’t actively participate in as a consumer, I have managed to avoid the alcoholic distribution and manufacturing industry since my time as an investor. Yet value can be found in strange places. I’ve found value in Oregon, in a small winery called Williamette Valley Vineyards (WVVI). WVVI has increased revenues, operating income, and margins every year for the last four years. The company is run by a seasoned wine expert and with an extremely shareholder friendly business structure. The CEO and board of directors have significant skin in the game with Insider ownership reaching close to 30%, and tangible assets that give it a competitive advantage over its competitors.

Business Description & History

From GuruFocus.com: Willamette Valley Vineyards Inc is engaged in the production and selling of premium, super premium and ultra-premium varietals. The company’s wines are made from grapes grown in vineyards owned, leased or contracted by the company, and from grapes purchased from other nearby vineyards. The grapes are harvested, fermented and made into wine at the company’s Turner winery (the “Estate Winery” or “Winery”) and the wines are sold principally under the company’s Willamette Valley Vineyards label, but also under the Griffin Creek and Tualatin Estate labels. It has two operating segments, direct sales, and distributor sales, based upon their different distribution channels, margins, and selling strategies. The company is small, a market cap of $39MM and EV of $35MM, yet they bring home $20MM in revenues for the last reported filing.

The Jockey & Company History

Founder and CEO Jim Bernau is a wine grower at heart. His mission for the company is to, “create elegant, classic Oregon wines from the Williamette Valley Appellation. As native Oregonians, we treasure our environment and use sustainable practices in growing and vinifying our winegrapes.” His love for winemaking has led WVVI to earn the title of “One of America’s Great Pinot Noir Producers”, from Wine Enthusiast Magazine.

In 1983, Bernau bought the “Estate” site which at the time housed old pioneer plum orchards and blackberry vines. He planted Pinot Noir, Chardonnay, and Pinot Gris. Before the advent of advanced irrigation systems, Bernau hand watered the vines with seventeen lengths of 75′ garden hose. I love this. Bernau really knows this business. He’s been on every level of wine-making, to the point of hand washing his grapes out in the fields. That kind of connection between direct input and final output is a tremendous asset to him as a CEO.

The company has grown through partnerships and acquisitions. Through its merger with Oregon wine industry pioneer, Bill Fuller, the company added Tualatin Vineyards. Merging with the O’Briens established their presence with the Elton Vineyard. Finally, the company acquired the Loeza Vineyard in, which started planting in 2015. The company sources all of its barrel-aged Pinot Noir from its estate-grown vineyards and farms, over 790 acres in total.

With any company (especially smaller cap companies), its vital to double-check the compensation of management and its directors. In doing so, one can spot whether management’s interests will stay aligned with their shareholders, or will entice greed and pick-pocketing of said shareholders. Digging into the company’s annual shareholder letter, I found a great section on the company’s philosophy of compensation. It reads as follows (emphasis is my own):

The compensation of our named executive officers has been designed to implement compensation principles that align management’s interests with our shareholder’s interests to support long-term value creation. In establishing the compensation structure of our named executive officers, the Compensation Committee determined that the use of a performance-based incentive provided additional motivation for our named executive officers to achieve both short-term and long-term business and growth goals for the Company. Additionally, the use of a consumer price index inflation factor on base salary ensures our named executive officer’s will not lose buying power, on core compensation, while pursuing these goals.

This is true empirically as well given the fact that Bernau himself holds almost 11% of all shares outstanding.

Their Approach to Wine – Making

The company strives to grow, by hand, the highest quality fruit using careful canopy management that yields balance, and to achieve wines that are truly expressive of the varietal and the place where they are grown. The company practices environmentally sustainable farming and are part of the Low Input Viticulture and Enology Program. They ferment and barrel each vineyard lot separately and display the best of those in their single vineyard designate bottlings.

The company owns 534 total acres, leases 293 acres, and contracts out 304 acres for a total acreage reach of 1,131. Through its owned acres, the company harvests 364 tons of grapes, 557 tons through its leased vineyards, and 1,052 tons through its contracted vineyards. These contracted vineyards represent grapes that company purchases in bulk

Valuations

The company is trading 20x earnings, 1.92x sales, par book value, and 11x EV/EBIT. The company sports a current ratio of 17.9x and a debt/equity ratio of 34.6%. These numbers only have substance when compared to the averages of their competition, however. Average P/B of competitors is 2.5x, P/S is 1.3x, EV/EBIT average is 17.7x, current ratio average for its sector comes in at 1.6x. Finally, debt/equity sector average is 59%. On paper the company is one of the cheapest options out of its competitors and sector.

Wine Industry Drivers

Tailwinds in the Winery Business

Drinking wine is like a sport in America, with the United States leading in total volume consumption of the spirit to the tune of 357.5MM cases (data collected in 2014). That’s a ton of wine. The United States also leads the world in number of people drinking wine, approximately 44% of all US adults. As a whole, the wine industry has grown roughly 2 – 3% per annum over the last 21 years. These aren’t stellar numbers, but slow and steady growth returns capital to shareholders and leads to profitable investments.

When it comes to specific wines, Pinot Noir leads the way, tripling in growth since 2004. Red blends saw a 10% increase in sales in 2016, and lower cost wine saw a reduction in sales volume. What does this mean? This means that when people buy wine, they’re happily paying a premium for quality. Pinot Noir is one of the highest priced varietal wines on the market yet it’s tripled in sales since 2004. People are paying extra, and this is good for WVVI.

According to analyst consensus, the alcoholic beverage industry is expected to grow at around 17% over the next year, beating the S&P average of around 10% growth.

Getting Oregon Specific

Oregon is relatively new to the wine making scene. In 1966 there were only two winery licenses in the state. Fast forward to 2015 and there are 702 licenses. Obviously there’s money to be made. Although Oregon is new to the space, the location makes it ideal for the higher priced wines like Pinot Noir, which accounts for 62% of all harvested grapes. Direct to consumer sales are growing roughly 15%, case sales grow close to 10%.

Region – Specific Disadvantages

As a location, Oregon brings specific disadvantages compared to other regions. First, Oregon wines are little known to consumers worldwide, and total wine production within Oregon is small relative to competing regions like California or France. Because of this, competing regions tend to have increased label recognition, larger production levels, as well as financial, marketing, distribution, and unit cost advantages. Secondly, Oregon has unpredictable rainfall patterns in early autumn. This means if vineyards receive above – average rainfall prior to autumn harvest, the quality of harvested grapes could be materially diminished, which would significantly affect the quality of wine produced.

Finally, with any plant commodity, the risk of infection has to be noted. When it comes to wine grapes, phylloxera poses a definite threat. Phylloxera is an aphid-like insect that feeds on the roots of grapevines (a wine-growers literal worst nightmare). Phylloxera has been found in a few commercial wineries in Oregon, but appears to be not as detrimental as the phylloxera in California. The damage of the phylloxera is slower growing in Oregon than in its competing regions.

Region – Specific Advantages

Oregon’s advantages far outweigh the disadvantages. Due to the climate, soil, and other conditions for growth, the WVVI vineyards are situated ideally to grow the more expensive types of wines (the Pinot Noir’s, Pinot Gris, and Chardonnay’s). This isn’t mere anecdotal phenomenon, its empirically true as well. In 2015, Oregon wines contributed  a mere 1% of domestic wine production, yet accounted for 21% of the wine scores of 90 and above.

The company believes that because of these factors (soil conditions, climate conditions, etc.), long-term growth prospects for the company and the region specific industry are excellent. The company believes that, “over the next several years the Oregon wine industry will grow at a faster rate than the overall domestic wine industry, and that much of the growth will favor producers of premium, super premium, and ultra-premium wines.”

Business Deep – Dive

Foundation

The business has some short – term problems mainly with its capital expenditures and its cash from operations. As of the last reporting period, the company had $4.2MM in CAPEX and $3.1MM in cash from operations. Like I mentioned, this appears to be short – term. The company took on additional expenditures to purchase various acres of lands in Walla Walla and Dundee Hills. From its most recent quarterly report, the company expresses confidence in its business operations, saying, “The company believes that cash flow from operations and funds available under the Company’s existing credit facilities will be sufficient to meet the Company’s foreseeable short and long – term needs.”

When it comes to leverage, the company is extremely healthy. It has roughly enough cash on hand to pay off all of its total liabilities. That helps me sleep at night. The company doesn’t need to issue shares, but it recently sent out a preferred shares offer to the tune of a 5% dividend yield trading around $5.00 / share. This preferred Besides the preferred share offering, the company recently bought back some of its common shares. What’s even more interesting about the preferred shares is that owners of preferred shares are entitled to a 25% discount on wine purchases through WVVI.

The company currently has an ROIC of 7.85% and a WACC of 6.02%, meaning its returning more than its high water mark of its cost of capital. Although the spread is a bit tight between the two, I’m confident in the ability of the company to positively widen that spread given the relatively fixed costs associated with the winery business.

Since 2010, the company has grown ROA from 1.90% to 5.10%, ROE from 2.7% to 6.70%, and ROIC from 2.88% to 7.19%. This has led to the company increasing its book value per share from $3.18 to $6.95, an average growth rate in book value of 19.75%. Net income has grown from $410,000 to $2.63MM, an average yearly increase of 90%, while operating income has grown from $850,000 to $4.17MM, a CAGR of 65%.

Sales Strategy

The company sells its wines through two major channels: Direct sales and Distributors and wine brokers. The company receives the majority of its sales through its Distributors and wine brokers, yet credits the Direct sales approach with higher margins and increased brand recognition / building. The company doesn’t rely on one or two customers to drive majority of sales, which is a good thing. As of 2016, the highest percentage one customer accounted for was 19% of total revenues.

Whatever they’re doing is working. Gross Margin has grown from 44% in 2010 to 63% in 2016, a 7% average increase per year. During that same time EBIT margins increased from 5% to 22%, an average growth rate of 17.2%. Finally, net margins increased from 2.40% to 11.20%, 61.11% average annual growth.

Finding Fair Business Value

WVVI currently has a deficit in Free Cash flow due to higher capital expenditures than its operating cash flow, so in order to find a value, I’m going to use an Earnings Power Value. If we normalize EBIT margin in a range between 23% and 32%, and couple that with an average sustainable revenues of $21MM to $26MM ($26MM being a rough estimate if business operations continue to improve), we get a normalized EBIT range of $5M to $8M. After subtracting our tax expense we’re left with a Net Operating Profit After Tax of $4M to $7M. From that number, we deduct our maintenance capex and add our D&A (which we assume 95% of capex) to reach Adjusted Earnings of $3M to $6M.

With our adjusted earnings estimates in place, we can divide those by the WACC which will be 8.75% to 6.50% (low to high). This gives us an Enterprise Value range of $39M to $98M. Subtract Non-Shareholder claims of ($10M) and we have an Equity Value range of $29M to $88M. Finally, if we divide the equity value by the amount of shares currently outstanding, we arrive at a Fair Value range of $5.78 to $17.72. This represents a 27% current downside risk and a 121.3% upside reward.

Variant Perception

The market is overlooking this smaller wine player in favor of the larger, more established names in the sector. Share price has moved in a range  between $7.80 and $8.70, with a One Year return of close to 0%. The market seems to be focused too much on the recent capital expenditures to fund growth, which has in the short-term reduced FCF to negative margins.

This is too short – term of a look, and the future growth prospects are in place to fuel earnings power increases over time, which will lead to positive cash flow generation. The company has natural moats that are hard to beat. They outright own 534 acres in some what is called the “perfectly suitable” climate for the superior quality wines (Pinot Noir, Chardonnay, and Pinot Gris). This isn’t easily replicated, there is only so much land available in Oregon to grow wine grapes. This means whatever land WVVI continues to own or lease in Oregon, it deepens and widens its moat. Another addition to its location and land moats come from its business leader James Bernau. The knows how to make wine and has been on both the front lines of production, as well as the front office of business expansion. He’s extremely passionate about the company, and even has a cool YouTube video documenting what he calls, his “30 Year Quest”.

This is not a rapidly growing company, and one shouldn’t expect the company to grow in multiples of 20+% annually. This isn’t a company for those that are looking for quick returns on capital. This is a longer term bet on the competitive advantages of both the conditions of the soil, the reputation / quality of the wine, and the belief in a management team whose interests are solely aligned with those of its shareholders.

Getting Technical

As I mentioned earlier, the company is trading in a price range from about $8 to $9, which has formed a nice rectangle on the weekly charts. If price is able to cross above the 50 MA inside the rectangle I will seek to take a starting position of around 25bps and add once again if price breaks above the upper resistance price level of $9.

Where is My Fallibility?

Here are some reasons why I could be wrong on WVVI:

  1. The company could continue to finance its operations through debt instead of generating free cash flow.
  2. Instead of buying back shares, the company seeks to issue shares in the future, further diluting the earnings power of each share.
  3. Phylloxera infiltrates most of the company’s acreage, wiping out hundreds of acres worth of harvestable grapes.
  4. The company fails to increase brand recognition and accolades and is squeezed out of competition through larger, more financially capable companies.

 

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