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Silicon Valley Bank: The 2014 State Of The Wine Industry Is … Forrest Gump?


2014 Silicon Valley Bank State of The Wine Industry Report
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Thursday Jan. 16, 2014 – 9:30 – 10:30 a.m. Pacific Time.
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IN A NUTSHELL:

Forget Millennials for a while, but they may be a good market later. Foreign wine is 30% and here to stay. Supply and demand are pretty much in balance. Political mismanagement of our economy means the middle class is sucking and that hurts wine sales. Only wines at $69 a bottle and up are really sizzling. And winery performance as a whole is just okay, which is only one point higher than Forrest Gump’s IQ.

THE REST OF THE STORY:

If Tom Hanks was an economic report, this is what he’d be: Silicon Valley Bank’s State of the Wine Industry 2014.

While this report could easily have been written as the usual dry economic data, report author EVP Rob McMillan — a Jerry Garcia wannabe moonlighting as a wine banker — has used Forrest Gump as a defining metaphor for the wine industry. And he uses that as a unifying narrative  — with many of the movie’s quotes more on target here than in the original motion picture.

This may well be history’s first economic report that is both informative and fun to read.

The quotes need to be read within the context of a tightly told tale that speaks well for itself. For that, you may download the entire 42-page report at this link.

AND:

Instead of trying to re-word what is already a  well-written report, the following non-article article, is a sort of Cliff Notes, exam cram sheet that extracts the points I found most important. Hopefully, it will make your colleagues think you are twice as smart in half the time.

Like most cram sheets, you can get the gist quickly, but the context and full meaning are available only by reading the full version.

For that reason, you can skip the rest of this non-article, article and download the annotated version of the full report which has all of the following summary passages highlighted, some with notes.

Everything below is excerpted as a direct quote from the report.

SUMMARY

  • Inventory is balanced in all segments as long as we look forward to the 2014 harvest which we expect to be average.
  • A third harvest of record or near record yield will have the industry in the position of being over-supplied again.
  • Grape planting is restrained compared to prior periods when supply was in balance. The Central Valley is at the greatest risk in planting ahead of demand.
  • The highest price point wines report particularly short inventory positions. The high volume and very small estate producers report inventory position slightly above their requirements.
  • There are broad expectations in the wine business that bottle price increases can be taken in 2014. Due to the higher volume of wine available for sale in a slow economy, we don’t believe the opportunity is there to take broad increases with the exception of selective increases in the higher priced luxury segment.
  • We believe we are trending to a transition point as Boomers hit retirement and the economic condition of the Millennials replacing them is burdened with high levels of student debt and weak job prospects.
  • In the current period we expect to see continued growth in overall demand but only limited pricing power for producers. Within the next five to seven years however, the evolution from Boomers to Millennials as dominant purchasers of wine will prove a significant headwind to sustained growth in the wine business.
  • In California we are estimating a 3.94 million ton harvest, making it the second largest harvest on record (2013).
  • Gross profit of wineries will be negatively impacted in 2014, economic weakness should restrain younger consumers.
  • Luxury wines and those wines priced between $10 and $18 should see the greatest growth in demand in 2014.
  • Sales in the fine wine business will increase six to 10 percent over 2013.
  • The euro will lag the U.S. recovery and the currency will weaken as QE eases in the U.S., leaving an opportunity for more bottled imports and additional pricing competition
  • The likely outcome of this trend is not positive for U.S. producers going forward.
  • A Marketing Order delivering a positive mass-market message to consumers about domestic wine quality is something the industry should strongly consider.
  • Grape pricing has hit a high mark and contracts could see a level of renegotiations downward in exchange for term.
  • Current supply has already led to a lower spot price reflecting current period heavy stocks.
  • With one of the driest winters on record as of this writing, following two drought years and an NOAA long-range forecast of below normal precipitation in California through end of March, water conditions entering this third year of drought may play a much larger role in planting and production decisions in 2014.
  • You should consider preparation for the worst case situation for your vines and winery. Remediation and hedging strategies should be developed at the earliest possible time.
  • Mergers and acquisitions of wineries and vineyards will continue at a record pace.
  • Massive bulk imports will continue to dominate the lowest price point wine categories, but bulk imports should be held back by the size of the 2013 harvest and bulk supply currently in the cellar.
  • Direct-to-consumer sales will continue as the largest growth channel for most wineries.
  • We remain in a period of lower GDP performance that should reset our view of growth opportunity, business returns and prices for years to come.

SUPPLY BALANCE

  • Based on conversations with AVA Associations, wineries, growers and survey information, we believe 2013 will probably come in around 3.94 million tons making it the second largest vintage ever in California. But even with a second near-record harvest, the industry appears balanced with current supply. That is not to say we in 2012 reported that we were “trending to a wine shortage.” Then we ended up getting Forrest Gump kind of luck with the 2012.
  • While most know that China is a rather large producing country now (number five in the world), even Vietnam with its French colonial roots has gotten into the act with about a six percent CAGR in its wine production. That said, China and Vietnam will likely not surpass the European states as dominant producers anytime soon.
  • Imported foreign bulk wine is here permanently in the US.
  • Through October of 2013, there were over 30 million equivalent cases of foreign bulk wine imported into the U.S. over the prior 12-month time frame with Australia, Chile, Argentina and South Africa leading the way.
  • The 2012 harvest presented a record yield in all the West Coast winegrowing states. California hit a record 4.02 million tons at harvest with the states of Oregon and Washington experiencing equally outstanding vintages in both quality and volume. 2013 harvest will probably come in around 3.94 million tons making it the second largest vintage ever in California.
  • …inventory positions sorted by bottle prices, in Figure 3, we see those producers selling wine above $69 per bottle report being short on wine, yet those who sell wine below $15 a bottle report being slightly long.

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  • With the record from 2012 still filling cellars, bulk wine readily available, and 2013 contracts being fully met from the outset of harvest, some excess grapes were left hanging longer than needed just to clear tank space, overage contract options were declined, some excess couldn’t find a home, and enforcement of quality standards at delivery was the norm.
  • growers quickly changed gears and worked to their traditional fallback positions doing things like offering grapes for half the price of the met contracts. In some rare cases, they offered to give the fruit away in exchange for “future considerations,” but often found even then price wasn’t the issue. Tank space just wasn’t available.

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DEMAND FORECAST

For the wine business to experience the same kind of growth that we saw through the 1990s and early 2000s, we need to see the middle class participate in the recovery. After all, the upper 10 percent can only drink so much, or store so many bottles in a cellar.

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Those who stop looking for work are just removed from the equation. Those people removed from the unemployment rate still don’t have jobs even with the metric showing improvement. They still can’t buy your wine, so it’s less meaningful in this case to use the unemployment population but some due to the fact real job growth for the middle class hasn’t rebounded.

We don’t believe we will return to GDP growth exceeding three percent per year for at least the next several years, unless we start to see higher levels of inflation. The period of time we are entering is one where current financial returns will be modest, which will support heavier risk-taking by entrepreneurs willing to take risks.

THE AFFLUENT CONSUMER AND LUXURY MARKETS

As emerging growth countries continue to influence world trading patterns, and domestically as the Boomers start to retire and evolve their tastes and spending habits one more time, you will need more than eyeballs to spot a potential client because they will start to look very different from what you are accustomed to seeing over the past 20 years. You will need real information and will need to beef up your CRM and technology platform in order to pick out the affluent shopper and focus your direct marketing efforts. The investment will be worthwhile because the top 20 percent of wage earners presently account for 40 percent of consumer spending and that number is even higher when it comes to fine wine.

Chinese leader Xi Jinping’s policy to restrain displays of power and wealth in the ruling class has led to a cooling of luxury buying in China. French wines have lost some of their earlier luster as the Chinese start to experiment with wines from other countries. The BRIC Countries aren’t dead but are experiencing growing pains in consumer demand, governance, their financial systems, education and economic policies.

North America is now estimated to grow four percent in luxury spending through year-end 2013, surpassing the estimated 2.5 percent growth rate for China.

EVOLUTION OF LUXURY MARKETS IN THE U.S.

Today we find ourselves at a crossroads, one in which the younger consumer is being trained to believe luxury purchases should come with a discount, and wine is as good or even better coming from foreign sources. With Boomers hitting retirement age, we have a real question about the ability to increase wine sales when older generations who are willing to pay for a good bottle simply can’t consume the volumes they used to, and younger generations can’t afford a good bottle but could consume more.

The under 30-year-old crowd is currently responsible for only six percent of current online wine sales which is a surprising stat for the internet generation consumer in using that channel.

For current period marketing purposes the Matures and Millennials aren’t your cohort. It demonstrates that Boomers are overwhelmingly the cohort to pursue today to maintain sales.

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Perhaps the most interesting conclusion from the chart to me is the neglected Gen X has a lower correlation to wine purchases versus the other cohorts. That to me says clearly that Gen X is your growth cohort … that 35 – 55 year only consumer.

Millennials spent a higher percentage of their income on wine versus other generations. That’s great news because this generation will be the future of wine buying. It would be even better news if they weren’t weaning their palates on imports, That point is a concern, but as Millennials age if they develop the capacity (income)to buy wine, their appreciation for wine is indeed something to anticipate in the business out past 2020.

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SETTING THE CONTEXT FOR PREDICTED DEMAND CHANGE

This is important to consider: By 1985 the WWII vet who was 20 at the start of the war was hitting retirement age, and the median Boomer who was just 25 and less interested in wine wasn’t ready to pick up the corkscrew and continue the growth pattern in fine wine consumption. That began the last secular decline in wine consumption starting in the middle 80s as you can see in Figure 15. It’s an important note because the median Boomers will hit retirement age in seven years. Will the Millennials be able to replace them or will we have another flattening in demand like that period? Because of that, it’s worth looking a little closer at what happened when consumption dropped last time.

Another critical component of wine business growth was wealth creation in the decade of the 1990s and the strength of the economy, which set a record for consecutive years of growth without a single quarter of GDP decline. Unlikely anyone will ever know for sure, but we do know the wine market found its bottom in 1994, which, not coincidentally, was the point in time when the median Boomer hit 35 years of age: the beginning of their biggest spending years.

Large production wineries can source bulk foreign juice directly as a first option in their sourcing strategy. If the landed costs are cheaper than domestically produced juice, the domestic brand can be filled with foreign wine.

That has already made the most southern districts of California largely un-economic for wine production and the U.S. has surrendered the least expensive wine segments to foreign suppliers. Unless we want to see foreign wine continuing to increase their market share, the next domestic iteration in the US commercial wine industry will have to include a greater willingness by large wine companies to source from less established areas that have lower costs of land, greater availability of water, and more accommodative regulations.

PLANTING DECISIONS

While grape prices are now finally up to the place growers can find a fair economic return today and vineyard production is balanced, we aren’t that far off from being over-supplied again

We still consume virtually all the wine we produce in our own country, but we are importing more bulk supply now from offshore than we used to. We don’t need to wait five years for non-bearing to hit a fully mature yield. We can just call Chile.

To the last point, in 10 months through October there were 27.1 million cased equivalents of bulk wine imported to the U.S. and 79.0 million cases of finished wine making, 282.9 million cases of imported wine destined for U.S. consumers. That represents about 30 percent of existing consumer demand.

The market share of imported wines at the bottom of the most recent growth cycle was just below 12 percent of total share, so in the last two decades we’ve lost about 20 percent of the US consumer market to foreign wine sales. That competitive change in consumer demand impacts the planting equation too.

Page 34, Note: blue and gold colors IN FIGURE 19 (below) are reversed .

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FINANCIAL PERFORMANCE OF WINERIES

And while the economy is improving, financially wineries are really just holding their own. Wine Handbook, the wine industry grew 1.9 percent last year to reach 318.0 million nine-liter cases, although almost all of the growth was due to volume growth which moved up 1.8 percent for the year.

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Taken as a whole, the financial performance of wineries in 2013 was … well … just OK, much like what we are seeing in the U.S. and world economies.

APPENDIX

I realize that, under usual circumstances, the only people who read footnotes and appendices are wonks, geeks and data groupies (I plead guilty to all charges). But this appendix is liberally salted with irony, sarcasm, schafenfreude and humor. Here are a few examples to entice you into those pages:

xlii “just O.K.” is defined in generally accepted accounting principles as financial performance that is one percentage point better than Forrest Gump’s I.Q.

xvii I know everyone hates bankers, but I am really a musician and I’m playing in the SVB House Band: The Exploding Warrants. We play some nice covers, but our CD sales aren’t that great right now so I’m just moonlighting as a banker. If it’s any consolation though, I barely like myself when I’m at work.

xx Remember in the movie Tom Hanks said he and Jenny got along just like “peas and carrots.” I don’t know about you but I hate peas and carrots mixed up. That’s a horrible combination, especially when they are boiled until they have the texture of mashed potatoes and are tasteless. My mom used to make … oh never mind.

 xxvi Solid state meant the elimination of tubes to run televisions and radios … not counting the picture tube. It allowed the size of televisions to shrink in half and reduce electrical consumption and heat dramatically. It was a fantastic achievement and advancement for everyone, unless you were a radio and television repairman like my dad, who like so many before and since had to change careers over technological obsolescence. As an aside – he was able to get Federal Job Retraining and worked another 25 years as a biomedical service engineer, fixing hospital and operating room equipment. So while we’ve recovered in the stock market, why haven’t there been any significant programs offered for job training and development for the long term unemployed? Just asking …