Crimson Wine Group: You can buy the wine for a 20% discount, but not the stock.

In the past few years, investors have come to understand the investment opportunities that corporate spin-offs can provide. The successful five-year track record of the Guggenheim Spin-Off ETF (CSD) has highlighted this opportunity. This article is going to examine the investment merits of Crimson Wine Group (CWGL), which was spun out of Leucadia National (LUK) earlier this year at around $7.30 per share. The company is not followed by Wall Street and keeps its conversations with investors to a minimum. Company does not issue earnings press releases, doesn’t hold conference call and doesn’t give guidance or much detail about the operations of its business. Most of the information about the company has to be gleaned from SEC filings and outside sources. Information voids such as this can lead to opportunity for diligent investors.

Before going any further we think it is important to repeat what Ian Cummings wrote about the wine industry in a past LUK annual report:

“We repeat our mantra on the wine industry: Even in good times, it is difficult to make estate wineries profitable, though as real estate investments they are good inflation hedges. The entire industry suffers from oversupply and intense competition from home and abroad. The sheer number of brands, combined with owners having to sell out last year’s vintage at (or below) cost, is a constant anchor on price. Estate wineries have high fixed costs and require large marketing dollars, making volume the key profit driver. We need more volume to make our goal of consistent, yearly cash flows a reality.”

There seem to be two basic investment angles that investors are considering when evaluating CWGL. The first is that the current book value of the assets on the balance sheet understates their current value and the second is the potential for the company to expand its current operations and to roll-up wineries to boost case sales, leverage costs and produce free cash flow. Even though there is much to like about CWGL, we find it hard to make a case that it offers a compelling valuation with a sufficient margin of safety at its current valuation.

Is CWGL’s book value understated?

In June, Barron’s published an article on the company. A respected blogger did some analysis here and there have been two recent articles on Seeking Alpha (here and here) discussing the merits of the company.  One SA article mentioned that the company had put the Pine Ridge and Archery Summit wineries up for sale back in 2001 for a reportedly $150 million and that the wineries could be worth more than this value due to rising land prices. The article also speculated that the value of all of the company’s properties could be “north of $250 million.” In the 2001 story, Pine Ridge cofounder Gary Andrus was quoted as saying, “There have been lots of guys trying to buy us, and the offers have been pretty ridiculous,” The offers have been so high that we got to the point of thinking about a possible deal.” We suggest taking the $250 million price tag as a starting point with a large grain of salt.

A comment on the SA article provided a link to an article published in Wine and Vines is 2011 shows the dangers of using “peak valuations” to try and determine the value of the land. In the article, an example was given of a Chardonnay winery in Sonoma that was originally listed for $4.7 million in 2001 (a year declared as the “peak” in land prices). It was re-listed in 2002 at $3.2 million and eventually sold in 2010 for $2.35 million. While Chardonnay wineries in Sonoma County are not directly comparable to Cabernet Sauvignon wineries in Napa Valley, the point is clear.

So what could the properties be worth? If a reader is hoping that we are going to answer that question definitively, unfortunately he is going to be disappointed. We believe it is better to be generally right when making assumptions about land values than to be precisely wrong. We also believe that due to the limited amount of time most investors have today, it is an unnecessary exercise to go and check tax and sales records and listing of wineries near CWGL’s properties to derive a precise valuation. We believe that there is enough information available to make a few reasonable guesses as to a range of values.

Guess #1

As of June 30th, the stated book value of the company was $193 Million. This compares to the current market capitalization of $230 million. A brief look at the balance sheet, reproduced below, shows why investors are so interested in trying to determine the “real book value” of the company.  The balance sheet is relatively simple and that about 50% of the book value is represented by property plant and equipment. Digging a bit further into the balance sheet, the un-depreciated value of the properties is $150 million, nearly $110 million of which is land, vineyards and other assets that would seem to hold their value or increase over time. An argument could be made that the un-depreciated value of those assets is closer to “replacement cost” and taking net working capital of $62 million and adding it to the $150 million gets you pretty close to the market cap ($212 million vs. $228 million). Of course, one could adjust this guess lower by giving the buildings and inventory ($82 million in value) a haircut and that would be ok with us too.  Precision is not the goal here, knowledge and understanding is.

30-Jun
Cash  $15.00
Investments  $7.00
Total  $22.00
A/R  $5.00
Inventory  $41.00
Other  $1.00
Total  $47.00
Property, Plant & Equipment  $108.00
Goodwill + Intangibles  $21.00
Total Assets  $198.00
Total Liabilities  $5.00
Shareholder Equity  $  193.00

Source: SEC Filings

30-Jun
Land  $42.00
Buildings  $41.00
Vineyards  $35.00
Winery  $22.00
Caves  $6.00
Other  $4.00
Total  $150.00
Depreciation  $42.00
Net PP&E  $108.00

Guess #2

While there can certainly be a vanity aspect to buying a vineyard and that some part of the purchase price is not reflected in economic reality, the truth is, over time, similar to farmland values in the Midwest, the main driver of land values for vineyards is the cost of the grapes and the economic profit that can be realized from them. Below are a few slides from a wine industry financial conference presentation put on by Silicon Valley Bank in 2011. They show how land values generally track grape prices over time. Readers should take away several important points from these charts.

First, while $300K an acre for land in Napa County is generally thrown out at the “mark to market” price of CWGL’s acreage, it should be noted that there is a wide disparity in acre values in Napa County. It is true however, that acres that produce cabernet sauvignon grapes (the grapes that are produced at Pine Ridge) are valued higher than those that produce other grapes. Secondly, the charts show that, in the last decade, not all grape prices have increased and in fact several have declined (which would impact the value of the land they are produced on). Finally, it should be noted that land values, while not showing many periods of decline, show long periods of time of stagnation. Acre valuations appear to have periods of step ups in value and not a linear progression.

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pic1

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Leucadia National’s disclosure about their wine business has been good enough for us to track a few relevant metrics (an overused word for sure) over time. For example the company disclosed that their investment in Pine Ridge and Archery Summit was $49 million in 1998. If we compound the value of that investment at 5% and adjust for recent land sales we get a value today of about $76 million. Below is a table that tracks the acreage owned by the company from 2004 through 2012.

PR PR-leased AS AS-leased CV DC SEG
2004 204 20 95 20
2005 204 20 95 20
2006 209 20 96 20
2007 209 20 96 20 611
2008 203 20 100 20 82 611
2009 184 20 99 20 97 611
2010 168 20 99 20 97 611
2011 168 20 100 20 97 611 299
2012 156 20 100 20 97 611 299
Value PR+AS Value CV PR+AS+CV Value DC Value SEG Total AS@$80K PR-AS PR per
2004  $ 58.00  $58.00  $58.00  $7.60  $50.40  $0.25
2005  $71.00  $71.00  $71.00  $7.60  $63.40  $0.31
2006  $70.00  $70.00  $70.00  $7.68  $62.32  $0.30
2007  $70.00  $70.00  $6.00  $76.00  $7.68  $62.32  $0.30
2008  $70.00  $19.00  $89.00  $8.00  $97.00  $8.00  $62.00  $0.31
2009  $68.00  $19.00  $87.00  $8.00  $95.00  $7.92  $60.08  $0.33
2010  $65.00  $19.00  $84.00  $8.00  $92.00  $7.92  $57.08  $0.34
2011  $64.00  $19.00  $83.00  $8.00  $86.00  $177.00  $8.00  $56.00  $0.33
2012  $62.00  $19.00  $81.00  $8.00  $86.00  $175.00  $8.00  $54.00  $0.35

Source: SEC Filings

Code: PR= Pine Ridge, AS=Archery Summit, CV=Chamisal Vineyards, DC= Double Canyon, SEG=Seghesio

Note: Only 87 out of 611 acres at DC are producing grapes. The balance is leased out for vegetable farming.

We try to keep our analysis relatively simple.

  1. Use actual prices paid for last three acquisitions. $113M
  2. Value AS acreage at $80K an acre ($60K-$100K). $19M
  3. Implied value of PR 156 acres is $62M or $350K an acre.
  4. Readers can make their own adjustments to these numbers.

Bringing it all together, if we add the estimated value of the land of $175 million to net working capital of $62 million we get a total estimated value of about $235 million. Again there is no adjustment for the grape inventory. Using very rough estimates (guesses) and not checking a single winery listing on Zillow, we have come up with a valuation range of between $200 and $250 million. Coincidently, the enterprise value is at the low end at $200 million and the market cap is right in the middle at $228 million. Maybe the market has it about right?

Finally, two more sanity checks to our Pine Ridge estimate.  First of all, we calculated about a 40% increase in the value per acre since 2004. The chart of land values in Napa county shows about a 50% increase ($200K to $300K) over that same time frame. Secondly, the company disclosed that their investment in Pine Ridge and Archery Summit was $49 million in 1998. If we compound the value of that investment at 5% (yes you can use a higher or lower rate) and adjust for land sales in the last few years, we get a value today of about $70-$76 million. That is about $8-10 million higher than the calculation in our table, but close enough for this article. While this is by no means a definitive valuation and our estimates could be off by a significant amount, we think it is a reasonable starting point for future analysis.

The Winery Business

While investors (including us) have focused a great deal of analytical power trying to deduce the “hidden value” of the company’s assets, the fact remains that CWGL is in the business of producing and selling wine. And until recently, as Mr. Cummings has reminded us, it has been “difficult to make estate wineries profitable.” The only forward looking statement given by the company is that it would like to generate $100M in sales (hopefully profitably) by 2016. In this section, we will try and give investors a glimpse on how the company might achieve that “goal” and what type of profitability could be forth coming.

2013 YTD

2012 YTD

2012

2011

2010

2009

Revenue

$27.20

$21.80

$48.80

$39.30

$23.70

$21.70

Net Income

$2.20

$(0.50)

$0.20

$(4.30)

$(4.30)

$(7.20)

To state the obvious, the Seghesio Family Vineyard acquisition was transformative. To sum up the transaction briefly, in 2008, Leucadia purchased Seghesio Family Vineyards in Sonoma County for $86M.  For this price LUK acquired, 299 vineyard acres and a winery that was capable of producing 170,000 cases of wine a year. Production was only 120,000 cases a year and CWGL is spending only $2M this year to bring capacity up to 170,000 cases. The returns on this incremental investment are obviously very high. For those investors that are interested in the value CWGL assigned to those 299 acres, the company states that it assigned $21M to the value of the land or $70K an acre). If our 2012 calculations are correct, it appears as though the acquisition price was around 14-15X EBIT (before accounting for the 40% increase in production capacity this year which would lower the multiple to around 10X assuming similar margins).

2012

Total

SEG

Other

SEG Other
Rev  $    48.80  $    20.00  $    28.80
GP  $    24.10  $    10.70  $    13.40

53.5%

46.5%

S&M  $    11.50  $       2.30  $       9.20

11.5%

31.9%

G&A  $       7.00  $       2.60  $       4.40

13.0%

15.3%

EBIT  $       5.60  $       5.80  $    (0.20)

29.0%

-0.7%

2011

Total

Seg

Other

Seg Other
Rev  $    39.30  $    10.00  $    29.30
GP  $    15.90  $       3.60  $    12.30

36.0%

42.0%

S&M  $       9.30  $       1.60  $       7.70

16.0%

26.3%

G&A  $       6.70  $       2.20  $       4.50

22.0%

15.4%

EBIT  $    (0.10)  $    (0.20)  $       0.10

-2.0%

0.3%

2010

Total

Seg

Other

Seg Other
Rev  $    23.80  $           –  $    23.80
GP  $       9.10  $           –  $       9.10

38.2%

S&M  $       6.50  $           –  $       6.50

27.3%

G&A  $       3.50  $           –  $       3.50

14.7%

EBIT  $    (0.90)  $           –  $    (0.90)

-3.8%

Source: SEC Filings

Path to $100M in sales

Including the recent upgrades to winery capacity, the company now has the capacity to produce 365,000 cases of wine. The increase in capacity is already showing up in the company’s financials. For the first six months of the year, revenue has grown 25% on a 27% increase in cases sold. In the second quarter, as capacity was completed, revenue grew 31% on a 41% increase in cases sold. Assuming sales per case stay around $190 (see table below), CWGL could generate approximately $70M in revenue with its current capacity. It should be noted that the company has been permitted for an additional 46,000 cases at its Pine Ridge facility that is has to upgrade to use. The company has not formally stated a timeline for making the capital investments necessary to achieve its maximum capacity, but we would expect it to be completed in the next few years for perhaps $2-$4M. Again, assuming $190 a case in revenue, CWGL’s estimated revenue would be around $80M a year.

Option 1: Boost revenue per case

If the company does not make another acquisition between now and 2016 (highly unlikely in our view), the only way the company can reach $100M in revenue is by boosting its revenue per case. It would take revenue per case of about $240 to achieve $100M in revenue assuming the company sold its capacity of 417,000 cases a year. The company does produce some cases off-site, but for this example we are just going to use the rated capacity. Based on recent price and competitive trends, it seems highly unlikely that CWGL can achieve that type of revenue per case. Wineries have little pricing power and a strong dollar has allowed cheaper imports to flood the market. In addition, the number of wineries in the U.S. has increased from 1,817 in 1995 to 7,116 in 2011 which has boosted domestic competition as well.

 $ Mil

2012

2011

2010

2009

2008

Cases

260

212

111

92

90

Rev/Case  $0.188  $0.185  $0.214  $0.236  $0.253

The other option is to sell more cases direct-to-the-consumer (DTC). Because the company can sell cases DTC for closer to retail price, the dollars per case the company receives is substantially higher than what it receives by selling to wholesale distributors. The company receives about $120 per case wholesale and almost $500 a case retail. In 2012, 14% or approximately 36,000 cases were sold DTC. If we apply that ratio to the 417,000 case run rate (58,000) and look at the difference in price per case, CWGL would have to almost DOUBLE its DTC sales to over 110,000 cases a year to reach the $100 million revenue run rate. Again, this scenario seems highly unlikely.

Option 2: Acquisition

It appears as though the company is about $20 million below the $100 million run rate in revenue as it is currently configured (assuming 100% utilization of capacity). Since the chances of raising prices or selling significantly more wine to consumer directly appears remote, the company will have to make an acquisition in order to get to $100 million in revenue. However, we do not believe that investors should just pencil in $100 million in revenue in 2016, assign some margins to that revenue and attempt to derive a valuation for the company by discounting that figure to the present. Ian Cumming and Joseph Steinberg, former LUK executives and current Board members and shareholders of CWGL are very prudent and patient when it comes to acquisitions. Considering they have only made five acquisition since 1993 (although 2 in the last 5 years), we think conservatism is warranted when it comes to relying on a growth by acquisition story in CWGL.

The Seghesio acquisition was transformative and clearly brought scale and profitability to the company.  CWGL has stated that growing volume is necessary to boost profitability and once the expansions are completed this year and perhaps in 2014, the only way to grow volume is by acquisition. We have no expertise in the winery for sale market and have no ability to predict when or where or at what price a transaction will occur. There is a publicly traded winery, Willamette Vineyards (WVVI), located in Oregon that we can use as an example. While it is possible that CWGL could acquire WVVI in the future, we are not suggesting that a deal is imminent. We are only using it as a point of reference of the operations of another winery.

Willamette Vineyards

  • Location Oregon
  • 99K cases a year Pinot Noir, Riesling and Pinot Gris @ $140 a case. 125K case capacity
  • $25M enterprise value
  • $12M in revenue
  • 58% gross margin
  • $2.2M in EBIT
  • EV/EBIT = 10X
  • Insiders own 14%

What if they get to $100 million, what could they make?

Acknowledging our previous comment about not penciling in $100 million in revenue by 2016 as automatic and everything that could happen between then and now including, but not limited to, a “weak consumer”, bad harvests, good harvests, more competition from importers, no reasonable acquisition candidates etc. here is a quick look at what might be, not necessarily what will be.

What Gross Profit to use?

Investors seem to want more certainty in investment outcomes than is actually possible. One way in which this manifests itself is the obsession with earnings estimates and Wall Street analyst models. We believe that models should be used as a tool to help investors understand a company’s business model and the sensitivities of income statement, balance sheet and cash flow statements to various external factors. Investors should never rely on them as the definitive answer to future earnings, nor should they ever use just one scenario in their analysis.  Trying to determine CWGL’s gross margin in three years is a case in point.

Below is a table that shows CWGL’s gross margins over the last five years. It is highly unlikely that anyone modeling the company in 2006 would have accurately modeled in the wide swings in gross margin due to good and bad grape growing seasons and an acquisition over the next seven years. But that is the nature of the wine business. It does seem reasonable however that using 47-49% for one scenario (call it steady state) might be appropriate.

2013 YTD

2012

2011

2010

2009

2008

Rev

$27.20

$48.80

$39.30

$23.70

$21.70

$22.80

GP

$12.70

$24.10

$15.90

$9.10

$5.10

$11.2

GP %

47%

49%

40%

38%

24%

49%

It is important to understand that there is a rather large discrepancy between the wholesale gross margin and the DTC gross margin. This means that depending on the future mix and any changes relative to today, the gross margin could vary significantly from the current 47-49% combined gross margin. For obvious reasons, the gross margin on DTC revenue is much higher than wholesale revenue. DTC gross margin has been relatively stable in the 55-60% range. The wholesale gross margin has varied widely between 32-50%. Since CWGL makes 5X the gross profit per case from the DTC channel, management would certainly love to increase DTC sales relative to wholesale. But wholesale volume is so large relative to DTC that it still produces more gross profit dollars. Trying to guess the “correct mix” a couple of years out seems to be a daunting task indeed.

An optimist could use even higher gross margins if he so choose. The industry seems to average about 53% and as we noted before, WVVI runs a gross margin in the 58-60% range. So depending on how well management can improve existing operations and what the gross margin is of an acquired winery is, there is yet another layer of complexity to trying to model a gross margin in the relatively near future.

Even if an investor can get the gross margin correct, there are general, selling and marketing expenses to estimate as well. Due to the length of the article, we will just take a short cut and use a range of EBIT margins that seem reasonable. What our “simple” model shows is that there is a very wide range of potential outcomes in terms of the earnings power of the company depending on its success in boosting gross margins through a mix shift, an acquisition or simply running the business better. What this range of scenarios also shows is that at its current enterprise value of around $200 million, the company is being valued generously on its future earnings capacity. Our enterprise value of $200 million is probably too low because the company will probably have to spend between $20 and $80 million to acquire the additional $20 million in revenue to get to $100 million in revenue.

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Revenue

$100.00

$100.00

$100.00

$100.00

$100.00

Gross margin

47%

49%

51%

53%

58%

Gross Profit

$47.00

$49.00

$51.00

$53.00

$58.00

G&S&M

$38.00

$38.00

$35.00

$37.00

$40.00

EBIT

$9.00

$11.00

$16.00

$16.00

$18.00

EBIT Margin

9%

11%

16%

16%

18%

EV

$200

$200

$200

$200

$200

EV/EBIT

22.2

18.2

12.5

12.5

11.1

Conclusion

As noted in the title, a shareholder can buy wine directly from any of the company’s wineries for a 20% discount. When we began our investment analysis we were hoping we would be able to buy the company at a similar discount to its intrinsic value. It appears as though the 30% run in the stock since it was spun out has eliminated much of the theoretical discount to the “mark to market” value of its land holdings. The current valuation also seems to more than fully discount the probability that the company can reach its goal of $100 million in revenue and a significant boost in profitability by 2016. As value investors we try to buy stocks in companies at discounts to fair value and wait for others to pay us at least fair value. An investment in CWGL at the current valuation would seem to provide some margin of safety if we are close to the theoretical value of its land assets. However, the valuation also seems to more than fully discount the future earnings power of the company even using optimistic assumptions in a notoriously difficult business.

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About Tim Heitman