Wine Case

This case is set in 1993 in Californias Sonoma Valley, home of many winemaking millionaires. This is where they spend their millions, not where they make them.

The Chalice Wine Groups brochures describe its Cimarron winery in the following terms:

Cimarron, A Place in Time

A pair of red-tailed hawks hovers in the thermal plume rising from the cliffs below the Feather Vineyard. In winter, you hear the muted roar of three creeks cascading down the canyons from the ridges above. Fog nestles like ocean foam over the bay and valleys. The rocky out crops and dense chaparral of madrone, oak, laurel and aromatic wild sage are the natural home of coyotes, rattlesnakes and mountain lions. The vineyards and winery of Cimarron are literally carved into the volcanic stone of the mountain--we are here for the long term. A great wine is not a commodity. It must artistically communicate its context, its place and time. We are dedicated to expressing the most beautiful and unique aspects of a place we love. We hope that you will share in our love of this place called Cimarron as we apply our skills each vintage to create for you a memorable sensory snapshot in a bottle of wine.

Things have been pretty much downhill, financially, for Chalice since 1990 as the following trend indicates:

	Assets	Sales	Net Earnings
1990	$49 million	$14.2 million	$650,000
1991	$68 million	$15.0 million	$59,000
1992	$70 million	$17.3 million	$(745,000)

The Project

Bill Evanson, President and CEO of Chalice, was sharing a bottle of his wine with former colleague Sam Davis. Sam was describing how the completion of his first year in an MBA program had changed his perspective on the wine industry. Personally, if a business has no hope of profit then Im just not interested. But its not at all clear to me that small wineries are a hopeless cause. Id hesitate to make that call without understanding whats happening along the entire value chain.

Of the retail price somebody pays for a bottle of your wine, where does the money go? How much is profit versus cost for each of the players involved in making the product and delivering it to the consumer? Is there room for a winery to maneuver upstream or downstream in the value chain? And what are the costs of each stage for each player?

If you dont understand the whole picture, then you may mis-assess the options when you develop strategies to cope with changing business conditions, or even decide to abandon the effort.

The value chain concept is a big deal at B-school these days.

Evanson looked intrigued. Thats interesting Sam. Ive been thinking along these same lines lately.

What does it cost us to make wines the way we do? Many of our specific costs seem to get lost within our accounting system. I suspect we understate some and overstate others. But also, who is making money in this industry, and how do they do it? This would be great stuff to know. Also, who is making money in this industry, and how do they do it? This would be great stuff to know. But this is a complex industry, practically every winery has a unique approach, and every wine is different. And Chalice is a particularly complicated company. Would a value chain analysis be meaningful or even possible for this company in this industry?

Sam Davis grinned. Why dont we find out, Bill? We can certainly set up the value chain for a particular wine and hopefully the process will reveal some generalizable insights. Ive got the time if youve got the interest. Were drinking one of your wines now, arent we? Why dont we track this one?

Bill Evanson watched the sun reflect through the delicate flaxen color of the 1991 Cimarron Meritage White in his glass. OK, hotshot, lets do it! Come to my office next week and Ill show you the numbers weve got.

The Chalice Wine Group (CWG)

Evanson had not exaggerated when he described Chalice as complicated. The group owns 2 vineyards (Chalice and Cimarron) and one-half of a third (Delta). It owns two wineries (Chalice and Cimarron) and one-half of a third (Opera Valley) which it operates for a management fee on behalf of the joint venture owners. It has a cross-investment with a prominent French wine company for distribution in the U.S. of its French and Chilean wines.

Of the 3 wineries, the Flagship is Chalice, founded in 1969. The Opera Valley Joint Venture was established in 1980. Cimarron was acquired in 1982. Chalice had a private financial placement with several investors in May of 1984. Among the serious patrons of the California wine industry, CWG enjoys a good reputation for producing consistently elegant wines. Each of its wineries are located in different legally designated viticultural areas. Each one is a separate profit center with its own manager, typically the winemaker.

The companys wines are sold in wine shops and grocery stores, and selected restaurants, hotels and private clubs across the country and to limited overseas markets. Virtually every distribution channel in the industry is used by CWG in one market or another.

Its wines are distributed via direct mail and to some extent online in those states where it is legal and, in limited quantities, over the counter at the wineries. Out of state, the company mainly sells through the traditional 3-tier system (Maker, Distributor, and Retailer). In southern California, a wine distributor is used as a broker. In northern California, CWG owns and operates its own distribution network.

Because of aging, sales in any one-year do not match that years production. Total production and sales for the company for 1990, 1991, and 1992 are shown in Exhibit 1. Exhibit 2 shows the consolidated financial statements for the company for 1990, 1991, and 1992.

The big picture portrayed in these numbers was certainly not strong. Sams task was to break the numbers down in order to understand the financial story of one particular wine from one of the particular wineries of the company. Was it losing money? If so, where? Was anyone making money on it? How much? How? The inquiry would require tracing the path(s) followed by the 1991 Cimarron Meritage White, from the grape grower all the way through to the final consumer along the Meritage White value chain shown as Exhibit 3.

The Winery

The vineyard would be the logical place to start, but were here now, so lets start here. Its simple: I need revenues and costs, starting with cost of goods.

Bill Evanson glanced down at his most recent Report to Stockholders. No problem. Revenues - $17.3 million; cost of goods sold - $11 million.

Its not that simple, Bill. If we use per case values we can better compare performance across elements of the value chain. How much per case of the 1991 vintage Cimarron Meritage White?

I was kidding. Of course we track all of our wines separately. We sold the 1991 Meritage White to our distributors for $76.00/case. For the 1992 sales, this 1991 wine cost $52.73 to produce.

Heres the file showing where our numbers come from. Evanson gave Sam a thick file folder from his desk. The file was thick because of the complex production process. CWGs costing method was as straightforward as possible, given the complexity of the situation. All of the Cimarron Winerys costs were considered product costs and eventually ends up as Cost of Goods Sold for some particular wine. Grape costs were easy to assign directly to particular wines. Winemaking, bottling and bottle aging costs were collected into pools and allocated equally to specific wines according to the percentage of the total volume processed. Exhibit 4 shows the yields and the detail of the product cost for the 1991 Meritage White.

Sam Davis knew that eventually each of the components of product cost might warrant further analysis. But, for the purpose of constructing the first level of the value chain profitability analysis, he decided to accept CWGs numbers. If the results were at the margin one way or another, more careful attention to cost allocations would be appropriate.

The key task was to derive a per case operating profit for this wine, and a per case Return on Assets (ROA). ROA provided a reasonable measure of the profitability for one case of 1991 Cimarron Meritage White. This would show the contribution of that wine to the overall financial performance of the Chalice Group according to the cost accounting methods used by the winery.

In addition to revenue and cost of the wine sold, the winerys operating profit also requires a provision for SG&A expenses. An estimate of per case SG&A expenses could be derived by applying the percentage of CWG's sales revenue generated by Cimarron to the total corporate SG&A. In 1992 the Cimarron winery sold 37,205 cases for total revenues of $2.7 million. Thus Cimarrons percentage share of total 1992 SG&A expenses were $719 thousand. Cimarrons SG&A expenses would then need to be converted to a per case basis.

Next an estimate of the required assets per case was derived. It was assumed that a per case value for Cimarron as a whole would suffice. The fixed asset base for Cimarron winery was $4.9 million, including. This includes its bottling line and crushing/pressing equipment used during the short period for wine production each year. Operating the business also requires working capital assets. Davis decided to use the percent of sale approach to estimate the portion of CWG working capital assets employed by Cimarron. CWGs total working capital for 1992 was $30.6 million. Cimarrons percentage share of working capital assets was thus $4.8 million and the total winery assets required total $9.7 million. Cimarrons assets would then need to be converted to a per case basis.

Sam next went about the task of collecting financial data from other links in the value chain.

The Vineyard

Cimarron Meritage White is a blend of Sauvignon Blanc and Semillon 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. The price paid in 1991 for both varieties was $812.36/ ton (62.42 tons of Sauvignon Blanc and 26.75 tons of Semillon). Sam assumed revenue for the vineyard would be $812.36/ton, the price paid by Cimarron to Pinnacle Vineyards. This, of course, assumed production of better than average grapes. By extending this value by the required tonnage (89.17), and dividing by the cases it converts to (5575), a per case revenue estimate for the vineyard is derived as $12.99. The total hauling costs from Opera Valley to the winery in Sonoma Valley amounted to 27 cents per case are paid by Cimarron which is then added to the cost of the grapes at the winery.

A review of price information published by the California Department of Agriculture revealed that the average price paid for grapes grown in that district that year equates to $562.50 per ton. If Cimarron used average grapes in the district its grape cost, including hauling, would have been only $51,663 instead of $73,943. The potential $4 per case additional profit led Sam to ask, Bill, why are you spending so much money on grapes?

The simple answer, Sam, is you get what you pay for. We dont want to just produce average wines, so we dont buy average grapes. We also consider our contract for these grapes in the context of our long-term relationship with Pinnacle and the Opera Valley Joint Venture, which is very important to us. But we have to get our costs down, and youve raised a good point. Actually, weve been looking at a 30-acre vineyard in Sonoma County near Cimarron as a potential alternative source of supply. The price is right at $525,000. Thats tempting just as a real estate investment. And the land is clearly capable of producing the quality of grapes we need. But since the vineyard has phylloxera, it would have to be cleared and replanted.

Sam began thinking out loud. I need accurate revenue, cost, and asset information for a typical vineyard to complete that piece of the value chain, and you need to know if it makes sense for you to develop your own vineyard to provide grapes for the Meritage White. Including the land cost of $535,000 and other operating assets, the total assets required for the new vineyard would be approximately $1.056 million. Half that, $528,000, would be the assets required to produce the grape tonnage necessary for the 5575 cases of Meritage White we produced. The winerys required assets could then need to be converted to a per case basis. Relatedly, once mature, the operating costs (the cost of producing grapes) for a comparable vineyard would be estimated $9.59 per case.

With the above revenue, cost and asset numbers it is possible to derive a profitability analysis for the vineyard (in full production) in terms of each case of 1991 Meritage White sold.

Although the resulting grape product cost per case for this prospective vineyard represented an improvement over the $12.99 (13.26 - .27 freight) the winery was paying now, was it a compelling argument for CWG to invest in the vineyard and change its make/buy policy on grapes for this wine? Bill Evanson was pensive.

How should we look at this? I suppose we could plant about half the vineyard to supply the Meritage White at cost, and the rest to another variety to sell elsewhere. That would lower our product costs at the winery, and possibly generate an interesting grape business on the side, provided we can predict what the market will want in future years. From your data it looks like the total asset investment for the vineyard would be $1.056 million.

In light of our current financial situation, it would be a tricky proposition to present to our Board! The fact is that grape & wine production is a capital-intensive proposition, and the returns just arent overwhelming. What do the numbers look like downstream in the value chain?

The Distributor

Stellar Wines is a typical East Coast wine distributor and representative of the traditional wine distribution business. In 1992 Stellar sold 225,000 cases of wine.

Stellars total product cost for Cimarron Meritage White includes the price CWG charges them, $76.00/case plus $2.25/case to cover freight from California and $1.56/case for state excise taxes. On all premium wines, Stellar sets its wine prices using a 1/3 mark-up over total product cost, thus achieving a planned gross margin of 25%. Operating expenses and assets required would not vary significantly on a per case basis among the various wines that Stellar sells. From this information and Stellars financial statements, Sam determined the operating expenses are 3.394 million and total required assets are $9.238 million. These values would then need to be converted to a per case basis based on the total cases sold by Stellar.

A wine distributor sells wine to both on-premise accounts (restaurants, bars, hotels) and off-premise accounts (grocery stores, liquor stores, wine shops). The profitability of wine sales in on-premise businesses varies considerably with the type of business and the wine pricing philosophy. Since most of CWGs off-premise wine sales occur in relatively small premium wine shop retailer, it was decided that this type of business should provide the final piece of the value chain.

The Retailer

Riverside Wine Company is one of Stellars best customers. As grocery chains and discount clubs have gained market share, many small premium wine shops 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. As with the distributor, Riverside marks up its wine to achieve a 25% gross margin. Also, as with the distributor, a case is a case. That is, a reasonable way of assigning operating expenses and assets among the cases sold is to assume equal weight across all wines on a per case basis. By reference to Riversides 1992 financial statements Sam noted that Riversides operating expenses were $438 thousand and total assets required were $719 thousand. Riverside sold 14,776 cases of wine in 1992.

Overall Value Chain

With this last piece of the value chain in place, Sam and Bill stepped back to consider what the numbers meant, and what the strategic implications for Chalice were. Remembering the original question, Can this be a good business?, Sam put the profitability figures 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.

Well, sighed Evanson. At least it is a beautiful way of life!

Yes, but these numbers dont necessarily prove that it cant be profitable. Obviously, some parts are more profitable than others. But this is only your story. Different companies in the same industry may manage their value chain quite differently. Perhaps we should look at how some other wine producer manages theirs?

Lyford Winery

As one example of a very different approach to the value chain, 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. After the untimely death of the founder, the company was sold to a consortium of several other winery properties which ultimately failed. The winery was sold out of bankruptcy to another California wine company. The brand name was sold to a another company. Wine for the brand was sourced from the bulk wine market. Processing services were purchased from custom suppliers under the direction of the original winemaker who was retained by the new company.

Exhibit 5 gives the per case cost structure for one of Lyfords more recent releases, a 1991 Meritage White. The wine was a blend of three different varieties, each purchased on the bulk market. The final blend was 85% Sauvignon Blanc, 13% Semillon, and 2% White Muscat.

The product costs shown in this exhibit tell nearly the entire story of this wine. The winery has virtually no capital assets as it leases its office and warehouse space. Its only assets requiring investment are for working capital (which is estimated to equal 30% of sales). All of the services required to bring the product from the bulk wine market to distribution can be purchased either from wineries with surplus capacity or from custom winemaking operations. Marketing expenses are estimated at about $1.09 per case of the wine. Expense for leased space and equipment are about $5 per case.

Lyford sold the wine to wholesale distributors for $45.00 per case, with a target retail price under $7.50 per bottle.

Sam knew the Chalice winemakers would totally reject this approach to winemaking. But somebody was buying the wines and apparently enjoying them. Sam had to admit that even he thought the 1991 Lyford Meritage White showed very well tastings. Could Chalice learn anything from the Lyford story?

EXHIBITS

Exhibit 1:	Chalice Wine Production in Case Equivalents
	1992		1991		1990
Variety	Cases	% Total	Cases	% Total	Cases	% Total
Chardonnay	141200	68%	131600	71%	117900	71%
Sauvignon Blanc	4000	2%	4100	2%	10100	6%
Pinot Blanc	6700	3%	2800	2%	3100	2%
Other White	5800	3%	5600	3%	5700	3%
Total White	157700	76%	144100	78%	136800	82%
Pinot Noir	26100	13%	23100	12%	20200	12%
Cabernet Sauvignon	16900	8%	17600	9%	6600	4%
Other Red	5500	3%	1600	1%	1600	1%
Total Red	48500	24%	42300	22%	28400	17%
Total	206200	100%	186400	100%	165200	99%
Chalice Wine Sale in Cases	1992		1991		1990
By Channel	Cases	% Total	Cases	% Total	Cases	% Total
Company Direct Sales
US	61100	35%	45400	33%	42000	31%
International	9100	5%	5600	4%	8700	7%
	70200	40%	51000	37%	50700	38%
Independent Distributors Sales
California Retail	90200	51%	76000	55%	71800	53%
Mailing List	15300	9%	11500	8%	12000	9%
	105500	60%	87500	63%	83800	62%
Total	175700	100%	138500	100%	134500	100%

Exhibit 2
The Chalice Wine Group, Ltd.
Consolidated Balance Sheet
(in Thousands)
	1992	1991	1990
Assets
Cash	74	78	185
Accounts Receivable	3464	2650	2516
Inventories	26091	24298	19601
Other Current	1007	1154	89
Investment in French Wine Co	12524	12524	3176
Property, Plant & Equipment,	22454	22290	19582
Goodwill (net)	3297	3394	3492
Other	1503	1540	509
Total	70414	67928	49150
Liabilities
S/T Notes & Current Maturities	15512	12593	7906
Accounts Payable & Accruals	3522	2236	2352
Longterm Debt	30414	31945	19658
Other	3935	4073	3643
	53383	50847	33559
Shareholders' Equity
Common Stock	16633	15942	14215
Retained Earnings	398	1139	1376
	17031	17081	15591
Total	70414	67928	49150

The Chalice Group
Consolidated Income Statements
	1992	1991	1990
Wine Sales	17319	14951	14182
Cost of Sales	11011	8096	7296
Selling, General & Administrative Expenses	4610	4119	3760
Interest Expense	2757	2334	1679
Other Expense	9	139	293
Income Tax (credit)	(323)	104	504
Net Earnings	(745)	159	650

Exhibit 3

Chalice Wine Value Chain

Vineyard > Winery > Distributor > Retail

Exhibit 4
Chalice Wines
1991 Meritage White
Production and Product Cost
Tons Crushed	89.17
Gallons Fermented	14713
Gallons Aged	13984
Gallons of Wine	13255
Cases Bottled	5575
Production Cost
Grapes	73943
Winemaking	117486
Bottling	93657
Bottle Aging	8895
Total	293981

Exhibit 5:
1991 Lyford Meritage White
Product Costs per Case
Bulk Wine Cost	9.26
Bottling	2.28
Corks	2.37
Capsules	1.16
Labels	0.7
Bottles	4.6
Lyford Operating Costs	2.02
Wine Tax	3.02
Total	25.41

Lyford Winery-The Value Chain
Sales	45
Costs	?
Margin	?
Assets	?
ROA	?
Price to Distributor		45.00
+ Freight & Taxes		3.81
Delivered		48.81
Price to Retailer	133%	64.92
Price to Consumer	133%	86.34
		$7.25 /bottle

QUESTUIONS

1. Identify your view of the salient aspects of Chalice Wine Group (CWG) such as its competitive context and recent performance.

2. Identify the major elements in CWGs value chain and their respective financial results.

3. From your work in 2. identify where the profits are made in this business and what are the required investments (assets) are.

a. Find Revenue for each part of the value chain

b. Find the major cost items for each

c. Based on this analysis what do you think of CWGs position in the value chain?

d. Do you have any recommendations based on what you see?

e. What makes one piece of the value chain more or less costly (or requires smaller or larger investments in assets

4. Convert numbers such as

a. Revenue to revenue per case amounts.

b. Assets to assets per case.

c. Convert or estimate a number (such as operating costs or sales and administrative costs) as a portion of a larger number.

5. The case gives us some information on another winery, Lyford Winery.

a. How does its value chain and financial performance differ from CWG?

b. Does that say anything about CWGs situation?

6. How does all of this suggest Chalice may want to move or act strategically?

7. What is the Working Capital Asset amount for the Meritage Wite Winery. This could be estimated by assuming working capital requirements are a function of sales volume. Hence, the amount we need is the proportion (percentage) of Meritage White wine sales to total sales times total working capital for Chalice Wine Group.