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Market Review
Expected Consolidations and IPOs Raise Investor Awareness
By Traci L. Mangini
First Security Van Kasper, Inc.
Since early 1999, pure wine stocks have significantly underperformed the major market indices in spite of solid earnings performances by many wine producers and the overall strength of the premium wine market. This performance came on the heels of a lackluster 1998 when pure wine stocks, with the exception of Beringer Wine Estates, also underperformed. So why are investors apathetic toward wine stocks while First Security Van Kasper remains bullish?

First Security Van Kasper believes that investors are mainly concerned with the size and lack of liquidity of these stocks. In a market where small-cap stocks as a whole have gone out of favor, Beringer and Robert Mondavi are the only mid-cap companies in the publicly traded wine group and the remaining companies have market caps under $100 million. Also, until recently, investors have had limited exposure to the wine stocks. There are only seven publicly traded California wine companies and they are relatively new to the public markets.

Additionally, some investors may be avoiding wine stocks due to the agricultural component of the business, perhaps not realizing that supply can be controlled to a significant degree. The market also punishes these stocks when there is speculation of an economic downturn, despite the fact that wine really is not a major purchase decision. Furthermore, these companies operate in a complex legal environment, for which the wine industry has organized dozens of committees and groups to defend their interests.

Despite these concerns, for a number of reasons, First Security Van Kasper believes that trends are positive for the industry and that wine stocks are extremely viable investment options. The shares of pure wine companies typically trade at P/E multiples at significant discounts to the other beverage companies, which can trade at multiples hovering around two times their projected growth rates.

First Security Van Kasper believes that the lower P/E multiples afforded to wine companies are representative of investors' concerns over their comparatively low Return-on-Investment ratios versus other types of beverage companies. For example, California wine producers have an average Return on Invested Capital (ROIC) of approximately 8 percent while distilled spirits and beer producers have average ROICs in the mid-teens and soft drink companies have an average of about 20 percent. We attribute the differences in ROIC among the other beverage industries to their very different capital structures.

Capital Expense
Capital expenditures are considerable for most wine companies and we don't expect that to change in the near future. Unlike other beverage companies, wineries tie up much of their working capital in inventory, holding some wines for as long as 3–4 years before the vintage is released.

Many wineries, especially those producing high-end premium wines, in pursuit of a more vertically integrated business structure, are investing substantial amount of capital in land acquisitions and vineyard development particularly in the prime growing regions of California. This investment strategy affords the company greater control over input costs, supply, and quality levels. However, these investments, particularly in raw land, can take up to 3–4 years before they begin to contribute revenues, and payback periods can extend far longer. Furthermore, supporting higher production levels requires additional investment in processing capacity, which is becoming more limited.

America's per capita wine consumption has increased over the last five years, appearing to cannibalize some distilled spirits and generic wines sales, but clearly it still has a long way to go before reaching the consumption levels of Western Europe.

To build demand, the wine industry has been focusing greater attention on marketing, increasing annual marketing dollars by 30 percent in 1998 to $131 million—on top of a 22 percent increase in 1997—according to Adams Business Media. While still modest compared to the $764 million spent by the beer industry and the $291 million spent by the distilled spirits industry, representing increases of 5 percent and 14 percent, respectively, this increased spending is a step in the right direction. First Security Van Kasper believes that the continued increase in marketing expenditures—along with positive shifts in consumer demographic and lifestyle trends to healthier and more social lifestyles, and the potential for wine sales on the Internet—should fuel premium wine demand in the mid-to-high single digits over the next several years.

Glut, Consolidation Pressure
Because of their lower valuations, First Security Van Kasper believes that premium wine stocks have unrealized value and represent attractive investment opportunities offering strong potential earnings growth. Apparently, several public distilled spirits companies agree, as they paid substantial entrance premiums in the highly publicized acquisitions of high-end premium wineries that took place over the last 12 to 18 months. Not many industries have been able to command such significant price increases while exhibiting such strong volume growth as that of the premium wine industry.

While the overall supply appears to be in balance, the demand for high-end premium wines seems to be exceeding supply. It is true that the expected future glut from the recent increase in new plantings could put some pricing pressure on the $7-and-under categories, however it should not significantly impact the supply of high-end premium grapes due to the scarcity of prime vineyard land.

First Security Van Kasper expects investor awareness of wine stocks to increase as the future pace of consolidation and public offerings accelerates. Currently, the investment community awaits the possible IPO of Kendall-Jackson Wine Estates Ltd., adding another mid-cap market share leader to the group of publicly traded wine stocks. Also, with consolidation at the wholesale level and the possible rising costs of wine production, smaller wineries that lack strongly branded products, wide distribution networks and production efficiencies will likely be at a disadvantage and could be attractive acquisitions candidates.

We believe that the Street incorrectly values wine stocks and believe that at their current price levels they represent good buying opportunities. We expect to see rapid consolidation in this industry over the next several years, attracting even more attention from the public markets, and enhancing these stocks multiples. This combined with the strong fundamentals of the California premium wine business, favorable shifts in consumer demographic and lifestyle trends, and increased focus on marketing should fuel continued growth in the demand for wine. Therefore, if one can accept the agricultural issues and the lack of liquidity of many of these stocks, we believe investors will find them to be excellent long-term investments.

Traci Mangini is a Vice President in the Research Department of First Security Van Kasper. Mangini joined the company in September of 1997, where she served as the Supervisory Analyst prior to researching coverage of the Beverage Alcohol Industry. Mangini was previously employed by NationsBanc Montgomery Securities and completed her Master of Science in Management from Boston University's campus in Rome, Italy.
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