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- The significant growth investments and transition to higher margin products and distribution channels are being ignored at Willamette Valley Vineyards (NASDAQ:WVVI).
- The temporary modest decline in sales should be viewed as a positive as it is the result of a focus on profit rather than pure volume growth.
- An attractive valuation limits the downside while unique company specific growth factors and a secular trend towards greater wine consumption provide strong tailwinds.
WVVI owns and operates vineyards and a winery in Oregon. It produces and distributes premium, super premium and ultra-premium wines including Pinot Noir, Pinot Gris, Chardonnay, and Riesling through three primary channels (direct-to-consumer or retail, in-state and out-of-state distributors).
Being one of the biggest and best has its advantages
First, the winery is in a prime location next to Interstate 5 (the major north-south freeway), only ~2 miles from Salem (the second-largest metropolitan area) and 45 minutes from Portland, which results in increased tourist traffic, especially from the many bed & breakfasts.
Moreover, the winery is < 1 mile from The Enchanted Forest (~130,000 paying visitors annually) and next to the Hope Valley RV park (~110 overnight RV sites), which draws even more visitors. This high visibility results in greater name recognition at retail outlets and restaurants.
Second, the winery enjoys favorable growing conditions including sufficient rainfall (typically results in no need for expensive permanent irrigation), a soil type that produces high quality grapes as well as favorable elevation, slope and climate (e.g. evening marine breezes).
Third, WVVI is in the "sweet spot" in terms of production. For example, since annual production is below 250,000 gallons (e.g. 217,000 gallons in 2012), it qualifies for a graduated tax credit of up to $0.90 per gallon on the first 100,000 gallons. This reduces the amount of federal alcohol taxes paid (e.g. $1.07 per gallon). However its production makes it one of the largest wineries in Oregon by volume, which provides multiple competitive advantages over other local wineries (e.g. better marketing and distribution arrangements, grape purchasing, access to financing, ability to satisfy retailer and restaurant demand).
Moreover, WVVI can grow production at a relatively lower cost as it does not need to acquire additional land given that it owns or leases 592 acres, which enables it to grow ~75% of the grapes needed to meet production capacity of 297,000 gallons.
Furthermore, the 300 owned acres are probably carried on the balance sheet at a significant discount to market value. For example, in December 1999 it executed a sale-leaseback agreement and sold ~79 acres of its Tualatin Vineyards property with a net book value of ~$1 million for ~$1.5 million or a 50% premium. In December 2004, another sale-leaseback agreement resulted in the sale of ~75 acres at the same property with a net book value of ~$551,000 for ~$727,000 or a ~32% premium. These sales were both almost ten years ago, which means the value of the land has probably risen since then due to the significant growth of in-state wineries.
Fourth, as one of the largest in-state wineries, WVVI is uniquely positioned to benefit from the stronger expected relative growth (compared to the overall domestic wine industry) over the next several years, which should favor producers of premium wines. Moreover, given that Oregon is not nearly as well-known as wineries in California, there is greater growth potential as the state plays "catch up", although it will not come close to reaching a similar level of production or visitors in the foreseeable future (if ever).
Focus on long term gain - not short term growing pains
Investors should view the past several years as a transition period that should result in WVVI eventually being more profitable, generating higher free cash flow and having an overall better business model. The following two catalysts should ultimately translate into an improved bottom line and higher multiple.
First, as shown in the chart below, retail sales (e.g. wine sold at tasting rooms and through the wine club) are steadily increasing, rising from 15% of total revenue in 2008 to 27% in 2012.
This factor alone is a significant margin driver as retail sales are more profitable due to the wine being sold at retail prices rather than free on board (FOB) prices for distributors. The transition towards retail will not happen overnight nor will it be without challenges. For example, in mrq sales declined 3.6% due to lower sales through distributors. However this decline was partially offset by an increase in retail sales including ~390 more wine club memberships. Moreover, the 4.8% decline in cases sold in 2012 was the result of a decision to discontinue certain low-margin products that were inconsistent with the overall brand.
WVVI now distributes its wine through an independent distribution company after discontinuing its in-state distribution division Bacchus Fine Wines in June 2012. This eliminated increasing regulatory and overhead costs, eliminated purchased wine inventory and drove a significant increase in gross margin. For example, the gross margin rose from 44% in 2010 (the year before the start of winding down Bacchus) to 58% in the ttm period.
Second, and related to the above retail sales growth, the temporary negative free cash flow, lower operating margins and higher debt is less of a concern given that the recent investments responsible for this should provide stronger and more profitable long term growth.
Construction began in February 2013 on the remodeling and expansion of the hospitality center with features to include additional barrel storage capacity, a club-member tasting room, a larger general public tasting area, enhanced kitchen services, new spaces for hosting smaller parties, expanded deck seating and a new lawn terrace for large, outdoor events.
There are three key takeaways. First, given that construction was expected to be completed last year, there should be a significant decline in investment spending at the same time incremental revenue is generated, resulting in an expected swing back to positive free cash flow.
Second, this should result in growing retail sales (especially as room rental income rebounds after declining during the remodel), which carries the previously mentioned higher gross margins. This should result in greater word of mouth advertising and allow for continued reductions in distributor incentives, resulting in further margin expansion.
Third, this investment highlights the long term view of management, a positive asset given the long term nature of the industry (e.g. grapes are typically available for sale 5-24 months after harvesting). For example, its Estate Vineyard uses a trellis design that doubles the number of canes for grapes to grow while spreading the canes, providing additional solar exposure and air circulation. This design costs more but pays off over the long term due to the higher grape quality, which results in higher prices for its bottles.
WVVI trades at a discount to its pure play, domestic competitors as shown in the chart below.
Moreover, the industry consolidation over the past 15 years* highlights the lower relative valuation. For example, the median wine/liquor EBITDA multiple since 2004 is 13.8x. Constellation Brands paid 12.6x EBITDA for Ravenswood Winery in 2001 and 14x for Robert Mondavi in 2004. Fosters paid 14.9x for Southcorp in 2005 and 12x for Beringer (PDF alert) in 2000. The most relevant deal comp is when Diageo paid 17.1x for California-based, premium winemaker Chalone Wine Group in 2004.
WVVI is even more undervalued considering EBITDA is temporarily depressed due to the previously mentioned investments. As EBITDA rises, the multiple should decline to the mid to high single digits, which should make WVVI even more attractive to a larger peer.
*Multiples over a longer time period are still relevant given the slow pace of change compared to other industries such as smartphones or computer hardware.
- There is intense competition from other wineries (e.g. in-state, California, Washington) as well as other premium domestic and foreign wines.
- There are agricultural risks involved in winemaking and grape growing including diseases (e.g. pests, fungi, viruses), drought and frost that affect supply and quality. The risk of phylloxera (a pest that attacks the rootstocks of wine grape plants) is reduced as the vineyard properties have been planted with rootstocks believed to be resistant to phylloxera since 1992.
- Lower discretionary income would most likely result in a shift by consumers away from premium wines towards lower priced alternatives.
The target price is based on a 13x multiple, a discount to its closest peer CWGL as well as industry deal comps.
A stop loss should be placed below the $6 support area. The time frame is 12-24 months as it will take longer for the recent investments to bear fruit (pun intended).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.