Whoa, Nelly!

The economy and the wine industry are charging ahead at a breakneck pace. However, some data suggests that what lies ahead might spell trouble for those without a clear strategic plan.

The broader economy: gross beats

Here are some technical data to consider as related to the economy: 1) The gross value-added of non-financial companies after inflation has turned negative. 2) Auto sales have fallen every month this year following seven straight years of record-setting volumes. 3) There is currently zero alpha in the beats for the first time since mid-2000. Let me explain.

The gross value-added of non-financial companies is a measure of the value of goods after adjusting for the costs of production, and it has now turned negative on a year-on-year basis, according to Bloomberg.

Historically, when this happens a recession is soon to follow, such as prior to the Great Recession of 2007 but also prior to all the major recessions since the 1950s. What this measure can mean is that inventory is becoming more expensive to keep and less valuable to sell. As an example in the wine business, many wines have to be aged, so it is particularly expensive to hold for long when its potential future value is declining.

As of Aug. 1, 2017, according to Business Insider, all three major car manufacturers in the United States have turned negative: GM, -15 percent (-8 percent expected); Ford, -7.4 percent (-5.5 percent expected); and Fiat Chrysler, -10.5 percent (-6.1 percent expected).

Of course, this comes after seven years of impressive growth, but these declines are wildly out of alignment with what were previously lowered lower expectations. When consumers do not purchase cars, they are often holding back on other discretionary or delayable items, and wine is such an item.

What the heck are alphas and beats? Basically, the point here is that investors are not rewarding companies that actually beat expectations vs. companies that do not beat expectations. This has not happened since mid-2000, when the technology market collapsed.

This means that investors are not looking at the health of a company but are instead just investing in what many refer to as momentum in the market. Such investing strategies often signal overvaluations and the increased likelihood of companies failing. There may not be a direct correlation in wine-related investments, but much of the money for wine comes from such investments.

Indicators for the wine industry suggest a bumpy ride ahead.

Here’s a summary for the wine business: wine companies missing expectations, restaurants’ wine sales trending down, an explosion in the number of wineries and a shrinkage in the number of distributors.

According to Wall Street estimates, Constellation, the second-largest wine company in the U.S. with a market cap of more than $33 billion, was expected to have an 18 percent growth rate in 2017, but it is expected to lower in 2018 to 14 percent.

And there are worries that even these numbers are too high, especially as they relate to the wine business since Constellation’s quarter ending March 31, 2017, showed wine sales dropping lower by 3.8 percent, as Rob McMillan, executive vice president and founder of Silicon Valley Bank’s Wine Division, recently highlighted in his blog.

McMillan also points to data suggesting that many restaurants are shifting their attention away from family-owned wineries, and beyond that discouraging trend, wine sales in restaurants in general have slowed.

Back in the 1990s, family-owned wineries were able to sell much of their wine through restaurants, but because of many factors, including the rapid expansion of the number of wineries and the reduction in the number of distributors, the percent of wine sold in restaurants by family-owned wineries has dropped dramatically.

Since 2006, the number of new wineries in California has grown nearly 200 percent, and the current estimate for wine producers in Napa County stands at around a mind-blowing 1,200.

According to the Wine Institute, the number of bonded wineries in California has grown from 2,447 in 2006 to 4,653 in 2016. A bonded winery premises includes licensed production facilities of single firms or individuals, licensed warehouses, experimental wineries and wineries with no case-good production or fermentation capacity. If we look beyond California to the broader United States, there were only 5,416 such wineries in 2006, but that number had grown to 11,496 by 2016.

I’ve previously reported that, based on painstakingly visiting wineries in Napa County, people like David Thompson of the Napa Wine Project have contributed to the idea that there are far more wineries than have been previously reported. At present, the number seems to hover at around 1,200, which include about 500 physical wineries (e.g., Mondavi or Castello di Amorosa) but also nearly 700 “virtual wineries,” (e.g., Schrader and the Prisoner, but these have recently been purchase by Constellation, so they no longer count in the ranks of virtual).

Beyond the rapid growth of wineries, the ratio of wineries to distributors has been flipped on its head in the last couple of decades. Whereas there were only 1,755 wineries and well over 3,000 distributors in the U.S. in 1996, by 2016 the number of distributors had dropped to around 700 while the number of wineries had bloomed to 11,496, dramatically shifting the ratio and limiting access for smaller wineries.

Just a flesh wound?

We have a collection of data all pointing to trouble for both the broader economy and especially for the wine business. Because of the nature of the wine business, the many new wineries that are starting up will result in burgeoning inventories of expensive Napa Valley cabernet.

As I’ve reported before, the bigger players are buying up some of the sources of these iconic cabs (Constellation’s purchase of To Kalon and Gallo’s purchase of the Stagecoach Vineyard), so one would expect the wines from these popular vineyards to increase in number and decrease in price. The jury is still out on whether they will maintain quality levels, but I have my doubts.

So here’s the deal: If you are a small to midsize player in the Napa Valley wine industry I encourage you to look at the data and determine three things: 1) What are the unique qualities that might allow you to compete in what is an ever-changing market? 2) What is your competition doing that you need to copy or shore up against? 3) What are your customers thinking and how loyal are they to your brand?

Do not get me wrong here: I am not predicting the end of the world. What I am suggesting is that there are data that you might want to consider before you expand your production or build that new winery. But trust me, if you become wildly successful in the years to come and chide me at one of your standing-room-only wine events for being completely wrong back in late 2017, then I will be the first to toast your success.

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Originally published in the Napa Register, September 2017