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The Winery Business

Paul Tracy
Paul Tracy
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The average American consumed nearly 90 kilograms -- roughly 200 pounds -- of beer in 2002. By weight, beer accounts for nearly 90% of all alcoholic beverages consumed in the U.S.

But despite beer's dominance of the alcoholic beverages market, beer consumption isn't growing in developed markets like the U.S. and Western Europe. For example, the average American consumed about 99 kilograms of beer in 1980, about 96 kilograms in 1990, and about 90 kilograms in 2002. So as you can see, beer consumption by weight has actually been on the decline for several decades.

In dollar terms, of course, beer's dominance of the alcoholic drinks market is far less drastic -- according to Beer Marketer's Insights, a trade publication, beer sales accounted for roughly 57% of the total alcohol market in 2003. That compares to about 13% for wine and nearly 30% for alcoholic drinks. This survey too suggests that beer's dominance is actually on the wane -- dropping from 60% of the alcoholic beverage market just a decade ago.

This is not to say that U.S. consumers are spending less money on beer. Rather, beer sales are growing thanks to rising prices. However, the growth in this market tends to be extremely slow, and beer sales are not increasing as fast as the alcoholic drinks business at large.

The big growth in the drinks market is in wine. My chart depicts United Nation's estimates of annual wine imports into the U.S. over the last 40 years. Because the U.S. imports significant amounts of wine from countries like France, Australia and Italy, imports are a good basic measure of wine consumption in the nation. And by this measure, the growth in imports has been drastic -- imports rose more than 10 times in this 38-year period on an inflation-adjusted basis.

And, of course, this isn't just a U.S. phenomenon. In just about every developed country, wine is gaining market share in the drinks market. In the U.K., for example, wine consumption per capita in weight terms was up nearly 2.5 times between 1980 and 2002. And in Germany, a country known for its beer culture, wine consumption has actually risen over the past 25 years. Meanwhile, German beer consumption has fallen.

As is the case with most consumer goods, branding is key to the wine business. The best-known Chateaux, producers and wine labels command premium prices from consumers -- it's not unusual, in fact, for a single bottle of wine from a well-known vintner to cost $500. Wines from the best-known winemakers tend to be in high demand and consistently command such large premiums. These high prices are behind the industry's extraordinarily high profit margins.

Even better, the wine business has been the subject of a great deal of merger and acquisition (M&A) activity in recent years. The reason is simple -- the industry remains among the most fragmented in the world with literally thousands of small producers. In fact, the world's largest producer, U.S.-based Constellation Brands (STZ), holds only a 4% global market share and controls just 10% of the domestic market.

Many winemakers have trouble selling their wares internationally at favorable prices. After all, most of the industry's thousands of small players simply don't have the marketing muscle to advertise their brands. Even more importantly, these smaller vintners don't have the distribution power to make sure their wines end up in front of consumers in many different markets.

Smaller winemakers with solid brands represent attractive acquisition targets for major alcoholic drinks companies like Constellation Brands or Diageo (DEO). Such firms can leverage their existing economies of scale to garner even higher profitability.

With these points in mind, in the table below I list some of the world's best-known publicly traded winemakers. And in the text that follows, I highlight two of my favorites -- the first a global, established wine giant and the second a smaller player with excellent brands (and a potential takeover target).

Company (Symbol) Forward P/E Div. Yield Ent. Value ($M) L.T. Growth
Constellation Brands (STZ) 13 0.0% $8,570 13%
Diageo (DEO) 14 4.5% $50,380 12%
Brown Foreman (BF/B) 19 1.7% $7,450 11%
Cruzan Distillery (RUM) N/A 0.0% $215 N/A
Willamette Valley (WVVI) 35.4* 0.0% $25 25%
*Trailing P/E        


Business Overview
Constellation Brands is the world's largest winemaker with a roughly 4% global market share. The firm has built its market-leading position mainly via acquisitions over the years, including its recent $1.4 billion purchase of Robert Mondavi, one of the best-recognized brand names in the world. Apart from Mondavi, the company's other top-selling brand names include Blackstone in California and Hardy in Australia.

Constellation Brands (STZ)
Business: World's largest winemaker.
Competitive Advantages: Strong brand names plus marketing and distribution muscle.
Growth Drivers: Potential to push existing high-quality brands to a larger customer base.

Current Price: $23.43
Rating: Buy
Enterprise Value: $8.2 billion
FY 2004 Revenue: $4.1 billion

FY 2004 EPS: $1.19
FY 2005 EPS: $1.60 (est.)
FY 2006 EPS: $1.82 (est.)
Projected EPS Growth: +13%
P/E on 2006 EPS Est.: 13
52-Week Range: $18.11 to $31.60

In addition to the wine business, Constellation is involved in several other aspects of the alcoholic drinks business, including beer, alcohol distribution and spirits.

Competitive Advantages
Constellation's competitive advantages are two-fold: size and portfolio of brands. On the branding front, STZ owns some of the world's best-known and most respected wine labels.

The list includes Mondavi's lineup of wines; particularly valuable is the range of super-premium, expensive wines. Mondavi wines such as Opus One command very high prices -- usually upwards of $200 per bottle. Not only do such wines command premium prices, but they also have a loyal following and tend to remain in high demand even during sluggish economic times.

Secondly, in the wine business, bigger can certainly mean better. STZ is one of the largest drinks companies in the world and, as a result, sports an impressive global marketing and distribution network. This gives the firm a real leg-up when introducing new products or expanding existing brands into new markets.

Growth Drivers
The most obvious source of growth for Constellation will come from leveraging recent acquisitions. Right now, for example, Mondavi is a very well known brand in the U.S. However, it does not enjoy the same notoriety overseas -- less than one-tenth of Mondavi's sales came from outside the U.S. prior to the firm's merger with STZ.

This offers a tremendous growth opportunity for STZ. The company can push Mondavi through its existing international sales and marketing network -- a move that will give Mondavi wines instant access to millions of additional potential customers. STZ can take Mondavi's most successful existing products and push them out to a much larger customer base.

Furthermore, large companies like STZ are in an excellent position to start advertising wine more aggressively. To date, beer is far more heavily advertised worldwide than wine; beer advertising has been credited with allowing major producers such as Anheuser-Busch to grab market share. It's likely that STZ will try a similar tactic in the wine market to promote its market-leading brands.

Valuation and Outlook
Constellation Brands is surprisingly cheap given its outstanding track record. The company trades at just 14X next year's earnings (fiscal year ended February 2007); meanwhile long-term growth is pegged at approximately +13%.

In addition, STZ wins points for its extraordinary free cash flow generation. On a trailing 12-month basis, STZ generated more than $560 million in free cash flow -- equivalent to a free cash flow yield of 10%.


Business Overview
Willamette Valley Vineyards is a small Oregon-based winemaker. The company has a particularly strong lineup of Pinot Noir wines -- a variety of wine (and grape) that's seen rapidly growing popularity in recent years. Oregon, in particular, is known for its high-quality Pinots. The company's Pinots range in price from less than $20 a bottle to as high as $50.

Willamette Valley (WVVI)
Business: Leading producer of Pinot Noir wines in Oregon.
Competitive Advantages: High-quality brands in a very attractive market niche.
Growth Drivers: Wider distribution of existing products in the U.S. should power increased sales.

Current Price: $4.95
Rating: Buy
Enterprise Value: $24.7 million
2004 Revenue: $9.3 million

2004 EPS: $0.11
2005 EPS: N/A
2006 EPS: N/A
Projected EPS Growth: +25% to +30%
P/E on trailing 12-month basis: 35
52-Week Range: $2.06 to $6.13

Competitive Advantages
Willamette's main competitive advantage stems from its high-quality, well-known wines. Several of the company's vintages have received ratings of more than 90 points out of a total of 100 from influential wine publications such as Wine Spectator and Wine Enthusiast. Many consumers use these ratings when selecting and buying wines.

In short, the company has carved out a very solid brand reputation in a fast-growing and popular niche -- Pinot Noir wines from one of the most up-and-coming Pinot-producing regions of the U.S. As one of the largest winemakers in the Willamette Valley, the company is well positioned to capitalize on the growing popularity of Oregon Pinot Noir.

Growth Drivers
The company first focused on very localized sales channels -- distributing its wines mainly throughout the State of Oregon. But that's changing.

WVVI has started selling wines directly to consumers around the country via its website. The cost of selling wines directly is lower because there's no distributor or middleman to pay -- the company can offer a slight discount and still earn fat profit margins. In addition, the firm is expanding its network of distributors to put its wines in front of more customers around the nation.

By expanding its distribution channels and partners, Willamette has gained access to a much larger market. That spells more wine sold and likely higher sales of more expensive wines. With those goals in mind, it should come as little surprise that the company has been steadily increasing the percentage of its revenues that come from out-of-state customers.

Valuation and Outlook
Willamette is a very small company and is not followed by analysts yet. As a result, consensus earnings estimates aren't even available for the firm. Over the past three years, however, the company has managed to post revenue growth of roughly +25%. Meanwhile, earnings have grown at an even faster clip thanks to cost savings associated with direct distribution and greater economies of scale. With this in mind, my staff and I believe the firm could easily post earnings growth of between +25% and +30% in the coming years.

On a trailing 12-month basis, the stock trades at about 35 times earnings. Although at first glance that might appear expensive, when you factor in the firm's incredible growth potential, WVVI's valuation looks much more reasonable.

Furthermore, the stock's $25 million enterprise value, strong growth and relatively low debt burden would make it an easy acquisition target for the likes of Constellation Brands or Diageo. In fact, the stock would make an attractive takeover candidate for just about any company looking to grab a foothold in the burgeoning Oregon wine-producing region. A bigger company could accelerate WVVI's growth by leveraging its existing distribution networks to sell the company's wines.

Paul Tracy will be available to take your questions until Monday, October 17. Please use the form below to submit your questions.

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