While the idea of moving away from U.S. government debt to other AAA rated debt makes fundamental sense in an academic world where these fundamental theories assume “all other things being equal”, it lacks common sense.  Stepping back, I’m not sure how municipalities and their utility agencies can have less risk than the government that prints the money they use to pay down their debt.  I’m also not sure I can trust a rating agency that messed up so badly (starting at minute 2 in the Jon Stewart video) when it came to putting the same AAA rating on mortgage backed securities.  Even after adjusting for a $2 trillion mistake (yes that is with a “T”) brought up in “negotiations” with the U.S. Treasury, S&P stuck to their guns to downgrade U.S. debt based on its conclusion that it was now “pessimistic about the capacity of Congress and the administration to be able to leverage their agreement…into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics anytime soon.”

So what happened to the markets on the Monday after the downgrade?  Stock markets crashed and money went into (wait for it…) U.S. government securities.  This “flight to quality” perpetuated by the actions of S&P resulted in lowering (not increasing) the yield for government debt.  Maybe Moody’s and Fitch (the other two rating agencies) got it right when they maintained their ratings on U.S. government debt for now with the hope that the recent debt ceiling debate would be a wake-up call to control deficit spending.

No matter how you look at the last week, one thing is crystal clear; the financial world as we know it has changed.  Regardless of the intent or rationale, the consequence of a downgrade is clear.  For the first time in our history, the risk of default has been brought into the equation when it comes to investing in the United States.  Based on our recent spending history, I reluctantly agree that this outcome was all but certain.  But as is almost always the case, it is the means to the end that raises my eyebrows.  Why would our politicians play “chicken” with our credit rating and barely stable economy to push through partisan policy?  How could one rating agency, the leader of a broken system already in line for reform, go it alone on this downgrade and create such a panic selloff of equities (followed by panic buying and then more selloff and…)?  And how, in a financial world ripe for regulation of hedge funds, could investors profit from such a move?  Blogs point to an $850 million bet that was made on the Thursday before the downgrade that, at the end of trading on Monday may have been worth 10x the bet.

Today we got our answer:  The SEC announced that they will investigate S&P over its downgrade.  Now, having my thoughts distracted away from the fundamental issues surrounding risk-free rates, I’m going to head to the microwave, put in some popcorn and watch the drama that will unfold as the plot thickens to one of political wrangling among a debt “super committee” charged with future budget cuts or, quite possibly, the biggest insider trading scandal in the history of financial markets.  Either way, the mood looks pretty sober for the next few years until we digest the events of one crazy summer in 2011.

The short answer is absolutely.  Our economy is so focused on smartphones (talking with our thumbs, updating our Facebook pages and tweeting the details of our last meal) that we can’t get enough technology in our lives.  Does this mean that there is a valuation bubble in our future?  It depends on how you like your coffee.  Let me explain…

It is my feeling that a market bubble occurs when fundamentals are replaced by froth.  By “froth” I mean the alternative definition of “being unsubstantial, worthless, or light and airy.”  The froth of a bull market hides the lack of fundamental value.  As a result, the investor makes a bet that the valuation of a company will either catch up to its value today (i.e. over time LinkedIn should be worth $7.0 billion but at that point, will it be trading for $14.0 billion?), sell for more than they paid for it (i.e. the Greater Fool Theory) or provide them with a capital loss to offset other gains.

So what is this about coffee?  I see fundamental valuation as a cup of black coffee, no sugar, no milk.  In the words of Bill Belichick “it is what it is”; just coffee.  A value based on fundamentals has the support of its underlying assets, its earnings capacity and its comparison to the market in which it competes.  A frothy market is a cappuccino; one third espresso, one third milk and one third foam.  The one-third espresso is fundamental but in concentrated form needs the milk to be mellow it out.  The foam is the “light and airy” component that sets the stage and helps tell the story of what is below.  But once the foam dissipates, your left with just a half cup of milky coffee.

Market froth expands valuation in a similar way.  Over time, once it dissipates, the $45 IPO will trade on its fundamentals which may not support that $45 price tag.  The IPO graveyard from the .com bubble is filled with deflated cappuccinos like pets.com, etoys.com and mp3.com.  Some of their exits were able to capture some fundamental value for its investors while others just faded away.  So when the “foam” settles five years from now which one of these current IPO hot shots will exceed its IPO value?  Will they be a:

• “Google” – IPO valuation was over $24.0 billion in August 2004; current market capitalization is $163.7 billion,
• “PortalPlayer” – $376 million IPO valuation in November 2004; bought by NVIDIA for $362 million two years later, or
• “Arbinet” – $423 million IPO valuation in December 2004; merged with Primus Telecom in an all stock transaction valued at $28 million.

Time will tell how much foam is in their coffee….?

If you are older than 40, you remember the New Normal as the Old Normal.  That Old Normal is the daily default for a good percentage of our population.  My 95 year-old grandmother lived through a Great Depression, two World Wars but not a credit card to her name and a perpetual smile on her face.  Her husband was injured in World War II and lived the rest of his life with a brace on his right leg, care of a bullet that severed his sciatic nerve and sent him home on a stretcher.  My father’s parents emigrated from Italy and his father took whatever work he could to raise his family of eight in a house he owned outright at the time of his death.  My parents lived under this umbrella of fiscal responsibility and simple common sense; don’t spend what you don’t have.  Somewhere along the way, my generation, and others that followed, missed that lesson.  We over extended ourselves with credit cards, homes we couldn’t afford, stuff that we didn’t need and little concern for how to pay for it.  We saw our savings rate dip below 0%!

Granted, that excess fueled a great boom in our economy but it also filled the air for the technology bubble in the beginning of the last decade and the real estate bubble in the middle of it.  Our government followed suit (or maybe even led us down the path).  Except for a flash of sanity at the end of the Clinton administration through to the beginning of the GW Bush administration, we have been funding growth (and paying for simultaneous wars) with debt since JFK (our parent’s President).  The future doesn’t look any better.  And while the Great Recession is over, the hangover is still felt today.  The recovery is jobless and while the numbers don’t support it; there is still a fear of a double dip recession.  And you only need to look as far as the price of gold to see how investors have responded.  Gold prices are at all-time highs but more disturbing is the desire of high net-worth individuals to have that gold close to them.  JP Morgan has just reopened gold vaults that were closed in the late 1980’s and, as the Financial Times reports a crisp confirmation of our generation’s focus on excess, “Many historic vaults cannot be reopened as they have been converted into restaurants: one New York vault built in 1902 for John Pierpont Morgan is now home to a steakhouse.”

So welcome back.  Welcome back to the Old Normal where hyper-growth seemed like science fiction; saving for a rainy day wasn’t so “un-cool;” individual, corporate and government fiscal responsibility were the ultimate goals; and nothing was taken for granted.  Welcome back to a time where businesses are valued on actual, not forecasted, cash flows and market multiples are down as a result of slower growth and an extended recovery from the last Great Recession.

Ok, politics aside, let’s get to the meeting I took part in a while back with several ultra-premium Napa and Sonoma winery owners and operators.  The topic du jour was selling direct, specifically to consumers and also trade.  To sum it up, everyone obviously wants to sell more direct because of the financial merits, but many wineries are finding it is not as easy as it sounds (or to simply model out).  Due to these tough economic times wineries are being forced to get creative and come up with different marketing programs other than the usual case/price discounting and free shipping to generate increased direct sales.  More wineries are becoming (and need to become) more involved with their current and prospective customers.  Exclusive events like winemaker dinners and wine club soirées are more popular, but also new programs like concierge services and VIP referrals are being used.  The bottom line though seemed to be that everyone I talked to was basically trying to get more involved in the customer experience and more closely track what programs and channels are working. 

Increasing the number of customer touch points seems to be everyone’s modus operandi.  Or at least it needs to be.  Wineries need to continue furthering their brand image and the easiest way to do that is keep doing what they do best and stay consistent.  Consistency in communication, winemaking, customer service — in everything.  Consumers want to feel special.  We want to feel like we are important and at the same time get that warm fuzzy feeling of finding a great deal or talking directly to the owner or winemaker.  We need to be drawn in and trust that you will give us a great bottle of wine and possibly even a great experience, either on-premise at the winery or tasting room, or just at home with your wine.  As one person put it, “if you don’t have a value exchange, you have nothing.”  This lends itself to more interactive experiences such as special consumer events, VIP programs, phone calls, pouring at public wine events, by-the-glass programs and not surprisingly, an increase in social media outreach.

It seems that practically every winery is on Facebook or Twitter these days, but the reality is that many are not effective in their use of social media.  Several of the owners I heard from mentioned they either “don’t get it” or “don’t believe it’s a good use of their time.”  The underutilization and misuse of social media is only one reason some wineries are struggling to generate increased sales in this uber-competitive market where consumers are constantly bombarded with new labels and new wines.  One big allure of wine is this notion of romanticism and the opportunity for a consumer to get to really know a winery and its wines on a more personal level.  People want to share in this wonderful wine country lifestyle that combines beautiful surroundings, great food, terrific people and of course, superb wine.  Social media is one easy way to accomplish this.

The biggest disconnect I see though is that many wineries don’t embrace the concept of the “aspirational consumer.”  Using social media is widely viewed “a kid’s activity” and “not important for my target demographic.”  However, the fact that slips by many owners is that these younger social media users in their twenties (Millennials) are the same people that are not only driving increased wine consumption in the US but are going to be the target demographic in the future if you are an ultra-premium winery selling expensive wine.  Wineries would be wise in spending more time reaching out to these consumers that are maybe drinking cheaper wines right now and building brand equity in anticipation of these individuals moving up in economic and social status.  It is comparable to sports teams scouting young athletes at an early age when there is a lot of unrealized potential there.  They are making a bet that these athletes will continue to develop and reach a point of maximum utility, where there will be many more suitors and more opportunities for them.  The best minute one can spend is the one you invest in people.  What better people to spend time with than people who love wine?!

Non-accelerated filers must measure their market capitalization on the last business day of the end of their second fiscal quarter.  If the market cap is below $75M, they are considered non-accelerated filers and therefore not subject to the SOX 404(b) requirements, which require a company’s external auditor provide an opinion on the design and effectiveness of internal controls.   If your company is hovering near the $75M mark mid-year then planning for an internal controls audit is wise.

However, non-accelerated filers have been complying with SOX 404(a) for many years, which requires management’s assessment of internal controls, and they must continue to provide this assessment.  For many smaller companies this assessment was a rudimentary review of controls accompanied by a memo, at best.  But the requirements for 404(a) clearly state that a company must document its control structure and test the effectiveness of those controls.  In the past, the SEC has not commented on the thoroughness of management’s assessment based on the understanding that eventually an audit of the control structure would occur.  However now, with the exemption passed, it is likely that a non-accelerated filer will receive some evaluation from the SEC on the completeness of this work.  

In other words, a simple internal control memo may not be enough for the non-accelerated company.

• The finance contingent of the group, representing commercial banks and private equity and debt investors, all agreed that they don’t often see a complete, detailed business plan in the wine industry.  When they do, these plans usually do not include an analysis of the industry or market or contain detailed marketing and development/production plans.  While most of the winery executives represented have a budget or financial plan, rarely do these forecast beyond two to three years in a detailed, financial model that addresses income statement or balance sheet metrics, such as a proper calculation of cost of wine sold. 
• The process of creating a detailed, written business plan is an onerous one, especially in light of the need for integrated marketing, production and financial plans.  However, future success is often associated with the work and thought considered during the business planning process. 
• The discussion of long-term forecasts centered on the discipline and intellectual exercise of the process rather than the success of meeting long-term targets.  This discipline presents the winery owner with the opportunity to understand key revenue drivers, optimal cost structures and financial levers when managing their business over time.
  • This understanding of key business metrics in the current economic downturn and constant revisiting of the plan on an annual basis will allow a winery to capitalize on its successes.  Simultaneously, the winery can learn from its failures, identify opportunities and avoid overreaction to market gyrations.
• There is significant value in creating a 5-year (at a minimum) financial forecast model because it forces the winery to consider the effects of the industry’s multi-year operating cycles and make decisions now that will affect its business 3-5 years in the future.
  • Similar to writing a comprehensive business plan, the discipline and process of Management analyzing their business can help identify key issues and quickly serve as a warning in case anything goes wrong.  This could be the difference between surviving (or thriving in) the current economic downturn in the wine industry and possible dissolution.
• Successful financial models incorporate the following characteristics:
  • Done on both a cash and accrual accounting basis
  • Tracked against a budget and updated on a consistent basis, but not changed entirely to continually start over (to always hit your budgets)
  • Includes all facets of your business (accounting policies, revenues, costs, inventory, financing, sales channels, etc.)
    • Need to consider how sales grow and where customers will come from as well as incorporating a marketing plan or strategy into your model
    • Don’t plan on borrowing more than a projected borrowing base will allow
  • Show your model to others – CPAs, consultants, bankers
  • Plan for a worst case scenario – maybe an obvious statement now, but not so obvious two years ago
• It’s never too early to think about or plan for a potential exit, whether that is a sale, cashing out current investors or a generational transfer.  Successful transactions often involve wineries that started the transaction readiness process sooner rather than later, ultimately maximizing value or at a minimum, achieving liquidity.

For your benefit, this link provides a list of some very helpful resources for writing/updating winery business plans.  In terms of financial forecast models, we develop those for many winery clients at Frank, Rimerman + Co. so please contact me directly at dgroff@frankrimerman.com with any questions or requests for our assistance.

Moving on, I had the opportunity to attend the Napa Valley Grapegrowers “Ahead of the Curve” seminar at Solage in Calistoga, CA.  I won’t reiterate everything discussed there as it was one of the more gloomy seminars I’ve been to, but I want to highlight some of the takeaways regarding key success factors for the future of the US wine industry, California specifically.  I have listed them below. 

• Wineries need to brand themselves better.  In an increasingly competitive and global marketplace, the use of the internet and social media to market and better disseminate key information to potential customers is critical.
  • Napa Valley in particular needs better brand recognition outside of the U.S.  Most Americans equate Napa Valley to great wine, but internationally, Napa is just one of many great wine regions.  Bordeaux has done this quite successfully – better than any other wine region in the world.
• US wineries need to be more cognizant of the increased globalization of the wine industry and the overall impact on its constituents.  Wineries may want to consider spending more time focusing on exporting wine (or at leat planning for it), particularly to countries like China that are showing increased interest in making and consuming wine.  Currently, China only consumes rougly .7 liters of wine annually per adult, as opposed to the US where we consume approximately 10 liters per adult, or 3 liters per person (#3 globally behind France and Italy).
  • Additionally, the current exchange rate works out favorably in terms of international demand as the Euro represents approximately 30% more purchasing power when buying American products like wine. 
• More winery owners need to run their wineries as professional businesses, as opposed to hobbies.  I mentioned this in a previous post and it still amazes me that many wineries do not operate with maximum economic returns as one of their primary goals.  Of course, I’m a finance guy first and wine guy second, so that probably explains my ignorance here.
  • The wine industry is uber-competitive (there are over 7,000 wineries in North America alone).  If that is something winery owners or grape growers do not want to do or cannot do, then achieving success is probably going to be quite difficult. 
  • In order to effectively compete, especially on an international scale, there needs to be a certain amount of cooperation with fellow competitors to successfully penetrate new markets (See:  Silicon Valley, Bordeaux, the music industry).  It will be interesting to see if the wine industry ever comes around to this fact. 
• Keep investing in R&D and innovation.  Innovation breeds success.  Things like solar panels, sustainable farming practices, oak alternatives and winery CRM software have all benefitted the industry.  This kind of forward-thinking approach to continually improving quality and overall processes can consequently lead to lower costs and carbon footprints as well.
• Last, and probably the most important point: wineries need to not lose sight of what they do best.  That is, keep making great wine and focusing on quality.  These days, if you do not have a quality product, you will not even get invited to the party, let alone have a seat at the table.

These ideas are by no means all-inclusive or the end all be all, but other winery owners I have spoken with recently seem to more or less agree.  Now, if we can just get them to agree on who makes the best wine!

So far, there has been no further extension for SOX from the SEC or Congress and the current bill from Senator Dodd doesn’t even mention an exemption from the SOX Act.  There is still a chance for amendments to be made to the current Senate bill but will that happen before the June 2010 deadline, it’s doubtful.  Keep a close eye on the Dodd bill for updates, which is summarized on Senator Dodd’s website.

To be honest, I think every company should employ good internal controls.

I have seen the affects of well controlled companies getting rewarded, starting early in my career.  I worked during college at a VC backed start-up company and in typical fashion I wore many hats – receptionist, office manager, accountant, and executive assistant.  I distinctly remember the breaking point when the company grew big enough to require more structure and my role focused on accounting only.  A CFO was hired and I was trained by him to implement controls.  Oh, the drama of telling people they needed approval for purchases. Gone were the days of yelling across the hall for verbal approval of a $10,000 check (works fine when there are 10 employees, not so good when there are 100 employees). Adding these procedures while the company was growing was not a huge additional expense and controls quickly became embedded in the culture of the company and now the company was ready for an exit – be it IPO or acquisition.  In the end, the company was acquired by a Fortune 500 company.  Would this have happened without the strong control environment—maybe.  But was the acquisition process easier, was the value of the company higher, was the buyer more confident—definitely!

 So what’s all the fuss about Sarbanes-Oxley, good controls have been around for a long time?  The SOX requirement to document and test the controls takes time, and auditor review of those controls causes companies big headaches, the end result is increased costs.  But believe it or not, control documentation can be done efficiently.  Start early with control optimization and use the right people and the right compliance tool, and the process is painless!  Experience really counts when documenting controls since experts are familiar with 1) focusing on the risk of misstatement; 2) documenting controls succinctly; 3) using a tool for testing, workflow, and reporting; and most importantly, 4) interacting with auditors. 

Whether you’re public or private, get started now on a good control environment – just do it!

First, it would help to define what I mean by a virtual winery.  Depending on who you ask, the definition may vary, but my take is that virtual wineries are those that do not actually own any vineyards or grapes and have no tasting room.  Instead, they typically source grapes or juice from other wineries or grapegrowers, sometimes locking in contracts if they are fortunate enough. 

There are several reasons why these types of wineries are becoming more popular, but the most appealing is that they offer a much more affordable alternative to starting a fully licensed and bonded winery.  Those require a substantial amount of start-up capital for vineyards and equipment and a business plan that, depending upon the varietal, can take five to seven years from unplanted land to first revenue dollar.  Essentially one can start a virtual winery by simply writing a check to the production facility and ensuring it is properly licensed and permitted to sell and market wine by the ABC and TTB. Virtual wineries often have little overhead, little to no vineyard ownership/maintenance and (potentially) no production equipment. They frequently start out using custom crush facilities to make their first vintage(s). 

What is interesting about virtual wineries is that not only can they be created quickly and sell wine effectively, there is legitimate value (mostly in the form of brand and direct to consumer wine club member lists) that can be created as the winery grow and establish themselves in the industry.  Generally, there are three key stages of development for virtual wineries.

Stage 1:  New winery created with very little start-up money.  There are likely no production facilities as wine is often made at a custom crush facility from “bin to bottle” with little revenue, no initial brand presence and probably only one or two varietals.  The greatest challenge for these wineries is taking the next step from a small hobby to a sustainable and profitable business.  Examples include wineries like Three Rights Left (early stage) and Athair (later stage). 

Stage 2:  Expansion of an existing brand or wine label, where market presence is established and sizeable revenues are generated.  These wineries likely have a few varietals with potential contracts with vineyard sources and possibly leased/owned production facilities.  It is at this point where these wineries will start to ramp up production significantly and expand margins (or become profitable) by leveraging economies of scale.  Creating a meaningful wine club or mailing list is a strong possibility and often the winery’s majority source of revenue.  Carefully managing grape sources is critical to ensuring consistent and exceptional quality grapes.  This challenge is usually handled by the head winemaker who is often the sole or majority owner.  It is quite possible additional capital may be needed to fund the growth needed to build the brand.  Successful examples include Auteur, Wind Gap Wines and Carlisle.

Stage 3: Significant revenue generation, brand recognition and a well-established wine club/mailing list have created significant value as production is thousands of cases by this point.  It is at this stage where wineries often consider a potential sale of the brand or look to achieve liquidity for its owners and original investors by carving out equity for new investors.  There are few great examples of wineries that have truly succeeded in building significant enough brand equity to sell a winery without any vineyards, but the most obvious and glowing example is that of Kosta Browne, who recently sold a majority of its winery to Vincraft after building it from scratch just over ten years earlier. 

We will continue to see more of these kinds of wineries for the reasons discussed above, particularly in this tough economic environment.  It remains an attractive option for people looking to build their own brand on the cheap and evolve to either a more traditional model or later stage virtual winery.  The “I could do that” mentality is actually feasible as companies like Crushpad have created a user-friendly blueprint for making wine and creating your own brand.  This business model has now been replicated by other companies across the U.S. (Judd’s Hill in Napa and City Winery in New York to name a few), marking an increased interest in this kind of winemaking process.  Who knows, the next great cult wine may be getting made right now…

I mention the concept of change and evolution because it is one aspect of the wine industry that will define its future success.  This belief has recently become more important than ever with different winemaking and grape growing methods and the emergence of both social media and technology (Wine Library TV).  So I wonder why the capital structures of wineries can’t ride that wave of change in the 21^st century and beyond.  How come almost all wineries continue to be owned by a small group of family members and a few key executives, but they rely on so many more to ensure the company succeeds?  It would seem to me that motivation breeds success and there is no greater motivation than potential financial gain in the form of annual cash flows or the eventual sale to the next “generation” of owners.  For proof, look up capitalism and the rise of the United States or listen to Gordon Gekko’s speech in Wall Street. 

Let me step back for a second and add a disclaimer that may help you understand where I’m coming from.  I was trained as an investment banker out of college and currently focus most of my time on fundamentally valuing companies, several of which are technology companies located in Silicon Valley.  I constantly work with companies backed by venture capitalists that often have complex capital structures involving preferred shares, warrants and stock options.  And honestly, this approach seems to work out pretty well for the technology industry in terms of creating a desire to succeed and continually innovate.  I do not see why a simpler version of that structure could not work in the wine industry.

Let’s take a hypothetical situation where a seasoned executive or well-trained professional in another industry is considering taking a new position at a winery and has two separate job offers.  Both wineries are successful family-run businesses with a long history in the industry.  Let’s say the only difference between the two is that one offers a stock option, employee ownership or profit sharing plan where current and prospective employees are granted or otherwise given the opportunity to purchase a small piece of ownership of the winery.  If the wineries are virtually identical, the candidate would likely take the offer from the winery with the option/ownership plan nine times out of ten, even if it included a salary lower than the competing offer.  With this assumption in mind, the option plan then becomes a key differentiator in terms of recruitment at only a marginal cost to the winery itself (depending on how many shares offered versus how many shares are outstanding).  With a structure like this in place, a winery essentially increases its chances of hiring the best and brightest among the candidates available.  Furthermore, it incents the new employees to work harder by giving them an ownership stake.  It is true that employees would likely only realize an eventual return upon a specific liquidity event, but I’m sure if you asked people whether they’d love to own a piece of a business that could be worth some money one day (in return for work they are already doing or going to do), the answer almost unanimously would be yes.  Finally, it is a fact that many wineries are actually created as a result of winemakers not having any upside or financial interest in the success of a previous winery where they worked.  As a result, they start their own winery and often compete directly with their former employer.  I know for a fact that several of these enterprising winemakers would have stayed with their former wineries had they been offered stock or profit ownership.

Now, let’s dig a little deeper into this concept of recruiting and differentiation.  It seems pretty apparent to me that one of the things that separate the wine industry from most other industries is that it largely continues to be operated and embraced here in the US as a family-run, cottage industry despite its overall size and vast number of competitors.  While Northern California is home to some of the best wineries in the world, the majority are purchased as lifestyle choices, third or fourth careers or inherited or purchased from a prior generation.  They are operated professionally with dedicated winemaking and operational staff but in most cases run as a small business.  While most businesses are created and designed to maximize profits, the “return” to an owner (or family members) are salaries and annual distributions.  If profitable, capital is not usually “retained” and is reinvested in the business.

If wineries want to grow and build a financial (or family) legacy they will need to realize that there comes a point of inflection where they need to open up the opportunity of growth and share the success with their investors and employees.  Equity ownership and stock option plans facilitate this end game and as mentioned earlier, you only have to drive around Silicon Valley to see that the model works.

In light of today’s global recession, now, more than ever, it is important for every business (wineries especially) to begin thinking of new ways to spur growth, creativity and continue paving the way for future success.  As Ralph Waldo Emerson once said, “Do not go where the path may lead, go instead where there is no path and leave a trail.”