The Chalice Wines

The Chalice Wine Group (CWG)

The group was owns two vineyards which is Chalice and Cimarron, and one-half of a third in Delta. It owns three wineries which are Chalice, Cimarron and Alicia, and owns Opera Valley for one-half of a fourth which is operates for a distribution fee on behalf of the joint venture owners. CWG has a cross-investment with a prominent French wine company for distribution in the US of its French and Chilean wines. CWG also owns a one-half interest in a vineyard in eastern Washington State with plans to build a winery at this site.

Chalice Wine Group structure

CWG
Vineyards
100% owns shareholder

Wineries
100% owns
Shareholder

Distributor
French wine company

Chalice
Cimarron

Delta

Chalice
Cimarron

Opera Valley

Alicia

The Chalice Wine Group (CWG) cont

Chalice is the flagship for CWG, Chalice winery was founded in 1969 and went to public in May 1984. Until June, 1993 with the initial public offering for Robert Mondavi Winery, Chalice was the only publicly-held company in the United States whose principle business is the production and sale of premium wines.

The company is somewhat less effusive in describing its financial results in the 1993 Annual Report
Assets 1990 1991 1992 $49 million $68 million $70 million Sales $14.2 million $15.0 million $17.3 million Net Earnings $650,000 $58,000 $(741,000)

1993

$74 million

$18.3 million

$(700,000)

The Project was coming up!

Bill Evanson, President and CEO of Chalice was thinking; What does it cost them to make wines the way they do? Many of their specific costs seem to get lost within their accounting system. He suspect they understate some and overstate others. Who making money in this industry, and how do they do it? But this is a complex industry because every winery has a unique approach, and every wines in different. And Chalice is a particularly complicated company. Would a VALUE CHAIN ANALYSIS be meaningful, or even possible for this company in this industry?

Value Chain Analysis

A value chain is a chain of activities. Products pass through all activities of the chain in order and at each activity the product gains some value. The chain of activities gives the products more added value than the sum of added values of all activities. It is important not to mix the concept of the value chain with the costs occurring throughout the activities. A diamond cutter can be used as an example of the difference. The cutting activity may have a low cost, but the activity adds much of the value to the end product, since a rough diamond is significantly less valuable than a cut diamond.

Visualization of Value Chain

CWG Distribution Channel

Each of its four California wineries is located in a different legally designated viticulture (grapevine growing) area. Each one is a separate profit center with its own president. The companys wines are sold in specialty wine shops and grocery stores, selected restaurants, hotels and private clubs. They even distributed via direct mail in those state where it is legal. Out if the USA, the company sells through the traditional 3-tier system; maker, distributor, retailer. In Northern California, a wine distributor is used as a broker. In Southern California, CWG own distribution network.

Exhibit 1: California Winery Shipments (000 Cases)*

Exhibit 2: Wine Production in Case Wquivalents

Exhibit 3: Consolidated Balance Sheets, The Chalice Wine Group, Ltd.

(Thousand)

The Winery

Complex production process Wine isnt produced in a day or a month but years Various pools of periodic production costs must be allocated among many different wines from different vintage years CWGs method was as straightforward as possible, given the complexity of the situation All costs were considered product costs and wound up as Costs of Good Sols for some particular wine Grape costs were easy to assign directly to particular wines

The Winery

Only the wines bottled in a year absorbed the bottling costs for that year. All wines held in bulk inventory absorbed their relative proportions of winemaking costs for that period. All wines held in bottled inventory absorbed bottle aging costs Exhibit 4 shows the yields and the product cost breakdown for 1991 Meritage White.

Exhibit 4 1991 Meritage White Product Costs Tons Crushed 89.17

Gallons of Juice Fermented

Gallons Aged

14,713
13,984

Gallons of Wine Produced

Cases Bottled Production Cost Grapes Winemaking Bottling Bottle Aging Total $73,901 117,486 93,657 8,937

13,255
5,575 Per Case $13.26 21.07 16.80 1.60

Total

$293,981

$52.73

The Winery

The task now is to derive per case operating profit for this wine, and the per case Return on Assets (ROA). The profitability analysis for one case of 1991 Cimarron Meritage White demonstrated the contribution of that wine to the overall financial performance of the Chalice Group. Cimaron winery sold 37,205 cases Total Revenue $2.7 million Depreciable 4.9 million

The Vineyard

Cimarron Meritage White is a blend of Sauvigon Blanc and Semillion grapes, neither of which is grown at Cimarron Vineyard. All the grapes for this wine are purchased from Pinnacle Vineyards, CWGs partner in the Opera Valley Joint Venture. Grape cost = $13.26 per case Exhibition 5 and 6 describe the costs and assets involved in establishment and operation of 30 acre vineyard in Sonoma Country as of the end in 1992.

Exhibit 5 Cost per Acre to Establish and Operate a Vineyard Year 1 Yield (tons/acre) Total Planting Costs Total Cultural Costs Total Harvest Costs@$120/ton Total Overhead Costs 622 636 9 622 5,13 8 609 2,440 1,062 1,216 180 642 1,317 420 698 1,317 720 718 2 3 1.5 4 3.5

5& Forward
6

Total Cash Costs

Depreciation (see Exhibit6) Total

4,124

2,038

2,435
843 3,278

2,755
843

$3,598* *$3,598/Acre = $600/T = $9.59/case [62.5 cases per ton]

Exhibit 6: Assets Required to Establish and Operate a 30 Acre Vineyard Purchase Investment Land (30 plantable acres) Vineyard Establishment[A] Reservior Buildings Drip Irrigation System Frost Protection System Shop Tools Pruning Equipment ATV, 4WD Tractor Duster Mower [B] Price (new) 525,000 339,374 30,000 15,750 52,400 40,300 10,000 1,200 6,500 29,900 3,035 5,500 22 30 30 25 25 15 10 5 15 10 10 0% 0% 10% 10% 10% 10% 10% 10% 10% 10% 10% 15,426 1,000 473 1,886 1,451 600 108 1,170 1,794 273 495 Useful Life Salvage Value Annual Depreciation

Orchard Sprayer
Weed Sprayer Pickup Truck Total Investment,with new Equip. *Allowance for Used Equipment Total Investment,30 Acre Vineyard

4,560
2,000 16,500 1,082,019 -24,598 $1,057,421

10
10 7

10%
10% 10%

410
180 2,121 27,388 -2,110 $25,278

A) "Vineyard Establishment" is the accumulated cash costs for 1st 3 years,net of revenue earned in year 3 using the price paid by Cimaron in 1991 as a proxy value for each tone produced.

Exhibit 7 History of California Grape Prices Per Ton Variety (*) Chardonnay (18%) Cabernet (32%) Zinfandel (56%) Sauvignon Blanc (35%) Semillon (73%) 1983 $980 $467 $269 $487 $215 1984 $998 $527 $253 $486 $260 1985 $904 $533 $269 $441 $210 1986 $856 $550 $340 $401 $245 1987 $922 $631 $480 $414 $254 1988 $1,122 $822 $817 $474 $289 1989 $1,225 $1,032 $546 $571 $311 1990 $1,128 $977 $391 $518 $310 1991 $1,122 $918 $363 $541 $328 1992 $1,038 $872 $434 $552 $360

* The percentages in parentheses represent the premiums paid to Sonoma County growers over the state averages in 1992.

The Vineyard

Sam assumed revenue for vineyard would be $812.36/ton Although grape cost of $9.59 per case for this vineyard represented an improvement over the $12.99 the winery was paying now Should they change its make/buy policy on grapes for this wine?

The Distributor

Stellar wines is a typical East Coast wine distributor. In 1992 the company sold 225,000 cases of wine, roughly 50% imported and 50% domestic. Stellars product cost for Cimaron Meritage White includes $2.25/case to cover freight from California and state tax of $1.56/case. A wine distributor sells wine to both on-premise accounts and off-premise accounts. Since most of CWGs off-premise wine sales occur in a relatively small premium wine shops, it was decided that this type of business should provide the final piece of the value chain

Exhibit 8 Stellar Wines Financial Statements (in Thousands) Balance Sheets December 31, 1992 Assets Cash Accounts Receivable Inventory Equipment (net) $ 24 2,273 6,500 108 $ 9 1991

1,806 6,592 105

Other
Total Liabilities Note Payable, Bank Accounts Payable & Accruals Stockholders' Equity Common Stock Retained Earnings

333
$9,238

312
$8,824

$4,953 1,735

$4,794 1,544

10 2,540 2,550 Total $9,238

9 2,477 2,486 $8,824

Exhibit 8 (cont.)
Stellar Wines Financial Statement (in Thousands)
Income Statements
Year Ended December 31, 1992 Sales $17,078 1991 $15,389

Cost of Goods Sold

Operating Expenses Interest Expense Net Income Before Tax

12,771
3,394 425 $488

11,313
3,187 507 $381

The Retailer

Riverside Wide Company is one of Stellars best customers. As grocery chains and discount clubs have gained market share, Many small premium wine shop have been driven out of business. However, at the top end of the business there remains a demand for service and selection that is difficult to provide in a high volume setting.

The Retailer (cont.)

Exhibit 9 contains selected financial information for Riverside for 1992. As with the distributor, a case is a case. So one way of assigning operating expenses and assets among the cases sold is equal weight.

The Retailer (cont.)

Exhibit 9 Riverside Wine Company, 1992
Total Sales Cost of Goods Sold Operating Costs Profit (before tax) Cases Sold Total Assets $1,889,916 $1,412,000 $438,134 $39,782 14,776 $719,261 ($235,333 of inventory)

Overall Value Chain

Sam and Bill stepped back to consider what the numbers meant, and what were the strategic implications for Chalice. Sam put the profitability for the four participants in this value chain together to determine the overall profit margin and the overall return on assets for the industry on every case of 1991 Cimarron Meritage White sold to consumers in retail wine shops.

Winery Costs Revisited

Sam knew the production cost of $52.73/case from Exhibit 4 was a very crude aggregate average cost. Upon careful reflection, he concluded that the winemaking process can be viewed as involving three distinct stages: Stage 1 (crushing, pressing and fermenting) Stage 2 (fining, filtering, bulk aging) Stage 3 (preparation for bottling)

Winery Costs Revisited (cont.)

Exhibit 10 Winemaking Cost-ABC Approach
Stage 1 Stage 2 Stage 3 TOTAL 1991 $285,000 (1) 571,000 57,000 $913,000 1992 $268,000 559,000 (2) 56,000 $883,000

*The 1991 Meritage White vintage represented 18% of the wine made in 1991, 15% of stage 2 costs in 1992, and 28% of the wine prepared for bottling in 1992
(1)

(2)

Including $12,700 of barrel depreciation, because some white wines are barrel fermented Including $154,900 of barrel depreciation

Sam also discovered that the $16.80 per case for bottling was a very simple overall average allocation. Exhibit 11 shows a comparison of the average approach and the ABC approach to bottling cost. Exhibit 11 Bottling Cost--Per Case

Cost Category Labor Supplies .07 Bottles Corks Capsules Labels Wooden Boxes Taxes TOTAL

Average Cost 1.16 .07 6.43 2.39 1.19 1.99 .55 3.02 16.80

ABC Cost for Meritage White .75 5.00 2.39 1.19 1.50 0 3.02 13.92

Third, Sam discovered that barrel depreciation was a very complex issue, involving French oak barrels that had risen in cost from $362 in 1988 to $650 in 1993. White wines are both fermented (3 months) and aged in barrels whereas red wines are fermented in tanks. But, red wines are aged 2 years in the barrels versus only 9 months for white whites. Yet all barrels at the Cimarron winery are just depreciated, straight-line, over 4 years, with barrel depreciation as 1 line item in winemaking cost.

Of the $21.07 winemaking cost for the 1991 Meritage White, $4.03 (19%) was for barrel depreciation. Sam had no intuition about how a more accurate ABC assignment of barrel depreciation would affect the $4.03 number. Exhibit 12 was constructed to estimate actual consumption of barrel cost, using estimated market values and the actual barrel usage plan for the 1991 Meritage White

Lyford Winery

Sam was aware of Lyford Winery which had been founded in Sonoma County in 1981. It was constructed as a state of the art winemaking showplace with no expense spared in either the production of the wines or in the effort to build the brand in the marketplace. The brand name was sold to a French company. Wine for the brand was sourced from the bulk wine market.

Exhibit 13 gives the per case cost structure for one of Lyfords more recent releases, a 1991 Meritage White. The final blend was 85% Sauvignon Blanc, 13% Semillon, and 2% White Muscat. Exhibit 13: 1991 Lyford Meritage White Product Costs per Case
Bulk Wine Cost Bottling Corks Capsules Labels Bottles Lyford Overhead & Supplies Wine Tax Total $ 9.26 2.28 2.37 1.16 0.70 4.60 2.02 3.02 $25.41

The product costs shown in this exhibit tell nearly the entire story of this wine. The winery has virtually no capital assets beyond leased office and warehouse space and working capital (assume 30% of sales). An allocation of marketing expenses added only about $1.09 to the per case cost of the wine. Leased space and equipment added about another $5 per case.

Lyford sold the wine to wholesale distributors for $45.00 per case, with a target retail price of $7.50 per bottle. *Lyford WineryThe Value Chain Sales 45 Costs ? Margin ? Assets ? ROA ?

Price to Distributor + Freight & Taxes Delivered

Price to Retailer (/.75)

45.00 + 3.81 = 48.81

= 65.00

Price to Consumer (/.75) = 86.67 = ~7.22/Bottle (~$7.50 with sales tax)

Exhibit 14: The Value Chain1991 Cimarron Meritage White (per case)
Vineyard Revenue Operating costs Margin Assets Winery Revenue costs Grapes Winemaking Bottling Bottle Aging SG&A Margin Assets Distributor Revenue Wine Cost Operating Cost Margin Assets Retailer Revenue Wine Cost Operating Costs Margin Assets
12.99 9.59 3.49 18.97 72.57 13.26 47.33 13.92 1.60 19.32 (22.86) 131.70 114.32 76.38 15.08 22.86 41.06 142.46 114.32 29.65 (1.51) 48.68 P/S = 0.26 S/A = 0.685 ROA = 0.184 +$2.7 handling cost P/S = (0.32) S/A = 0.551 ROA = (0.174) +$2.25 handling cost +1.56 tax P/S = 0.19 S/A = 2.78 ROA = 0.56

P/S = (0.016) S/A = 2.93 ROA = (0.031)

The Overall Value Chain

Revenue Profit Assets

342.34 1.89 240.41

P/S = 0.0055 S/A = 1.424 ROA =0.0079

Vineyard, CWG is paying way more that the industry average price for grapes. If it paid the industry average price, there is a potential an incremental $5.o per case profit. Should it keep on sacrificing profit for quality? The cost to establish and operate a vineyard is $9.59 per case, whereas CWG is paying $12.99 per case, plus handling. It has to decide if it will continue to buy grapes or start growing grapes. Winery Product costs were assigned equally to various wines when no two wines were the same. This was done based on the average cost system. ABC analysis better reflected the winemaking, bottling costs than average costing did. The winery is unprofitable, losing $22.86 per case. CWG has a lot of money tied up in inventory. The winery has 4.9 million in depreciable assets, while Lyford winery has virtually no capital assets.

Distributor The most profitable part of the value chain with a margin of $22.86 per case sold. It also has the highest ROA (56%) in the value chain. Retailer Make a loss of $1.51 for every case sold. It has the highest wine cost in the value chain, a big reason why it is unprofitable. Overall value chain The overall total profit is $1.89 per case and overall ROA is .77%. There numbers suggest that this is not a profitable business.

The Lyford Wines Value Chain

The Lyford winery has virtually no capital assets beyond leased offices and warehouse space and working capital this enables it to have a high ROA of 100%. Lyford winery also purchased its processing service from customs suppliers, and all of the services required to bring the product form the bulk wine market to distribution was also purchased form custom winemaking operations. This resulted in a low product cost of $25.41 and a margin of $18.5 per case. Lyford winery shows an alternative, more profitable approach towards winemaking. Lyfords value chain suggests that CWG might be better off outsourcing some of its activities and reliving on custom suppliers to keep its product cost low.

Thank you!