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04.15.2010

The Coming Carnage in the California Wine Industry

"The shitstorm is just beginning," he says, with a gravitas that makes it sound like the end of the world for the California wine industry. And while it may be the end of an era, rather than the end of the industry as we know it, my conversations with the man that I will refer to as Deep Tank leave me with a hollow feeling in the pit of my stomach.

I wanted to get to the heart of what is really going on in the California wine industry as a result of our great recession, so I found the most connected person I could. A guy who's walked through more wineries and talked with more winemakers than anyone else I could think of. Deep Tank has his finger on the pulse of what's going on in nearly every major wine region of California, and that pulse, he says, is faltering.

"It's a huge game of chicken out there -- between the wineries, the distributors, the retailers, and the lot of other people who have a vested interest -- and it's really ugly," he says. "Right now, no one wants to be the first person to buy a wine, only to find that two months later, it's selling for 30% less. But wineries desperately need to sell, and if they don't they're screwed."

I spent several hours talking with Deep Tank, trying to unpack just exactly why so many people were, as he put it "so fundamentally screwed" and was surprised at how quickly the conversation ceased to be about wine, and how quickly it became about fundamental business finance and economics. You can also have a look at this forex trading website in order to learn about how to trade wine and get used to trading forex principles.

We all tend to forget (those of us who knew in the first place) that wine is a business, and like any business it has to operate within key principles of accounting and economics. The idea of a winery being run by balance sheet rather than by passion and philosophy doesn't make for very good marketing, but at the end of the day, if a winery isn't run like a business, and a good one, it will fail.

And that's just what Deep Tank says is going to happen to literally hundreds of wine labels in California in the next 18 months. "There are a ton of these little custom crush wine labels that are literally going to vaporize."

The explanation for this grim fact lies in understanding the fundamental economics of owning and running a wine label, even one that includes no vineyards, no winery buildings, and no full time employees.

You may have heard that wine is a capital intensive business? This means that you have to put a ton of money in before you get much of anything out. Leaving aside for the moment all the suitcases of money required to buy land, build a winery, plant vineyards and everything associated with being a real physical winery, the costs of making wine without any of that stuff is still pretty steep. You need to buy barrels (new French oak runs somewhere between $800 and $1100 per barrel depending on the exchange rate and type of barrel). You need to buy grapes (if you want to make really good wine, that's somewhere between $4000 and $8000 per ton). You need to rent space in a custom crush winery. You need to buy bottles, and labels, and boxes, and that's all before you sell a single bottle of wine. To make matters worse, you have to age wine for some time before you sell it, so not only do you have to buy all those things, you have to buy them all for probably two to three years in a row before you sell a single bottle of red wine. Ever wonder why so many wineries in California sell Sauvignon Blanc? Because it goes from grape to $$ in about 6 months, instead of 28 months for a fine Cabernet.

But back to the point. You need boatloads of cash to start and operate a winery, and even if you've got a lot of money to start, most people finance the operation. Which is to say, they go to a bank and take out a loan.

When the bank lends a winery money, it's a relatively risky bet, especially for a small operation. As anyone knows who has taken out a loan or a line of credit before, the bank wants to protect itself in the event of the borrower not being able to pay back the loan. So they ask for security in the form of collateral. This means they need something that they can seize if for some reason you don't pay back the loan. When you get a mortgage or a home equity line, that thing the bank will take is your house. When you get a loan to start or run a winery, the collateral you put up to securitize your loan is your wine.

And that is why, says Deep Tank, "you're about to see a shitstorm of epic proportions."

"Let me play it out for you," he says.

"You've got maybe hundreds of these little virtual wine labels running out of custom crush outfits. They've got two or three vintages in really expensive oak (and another vintage sitting around in case boxes) where they've paid $6000 a ton for some fancy big name Pinot fruit, a bunch of really expensive corks and heavy glass bottles, and a couple of years ago they would have been looking forward to selling 4000 cases of their tricked up wines for $60 a bottle, no problem. That's the financial picture they took to the bank in 2008 to get another loan to buy barrels and more fruit. But now, their wine isn't worth shit. They'll be lucky to sell it at all, let alone for a discount. From a balance sheet perspective, there's a single word that describes this situation: fucked."

What used to be hundreds of thousands of dollars of inventory assets that the bank could sleep easy over, knowing they could swoop in at any time, scoop up the wine and sell it on the market, is now a near worthless pile of wood, wine, cardboard, and glass bottles.

Of course, banks don't value these assets at anywhere near their full retail value (they use a set of bulk wine pricing guides that are closely held secrets by big wine brokerage houses like Ciatti), but that doesn't matter. The value of these assets is solely dependent upon being able to sell them, and these days, almost no one is buying.

"What you're looking at," says Deep Tank, "is a foreclosure mess just like this housing debacle we just went through. Banks will not be renewing lines of credit, they'll be pulling them, and all these little wineries won't be able to buy fruit, they won't be able to buy barrels, they can't honor the contracts they've made to buy grapes at outrageous prices, and even worse, they'll be lucky to sell the wine they've already made for half price. They won't be able to finance their debt and they'll default on their loans. They're just going to vaporize."

According to Deep Tank, the handful of impending winery foreclosures already announced in a recent San Francisco Chronicle article are just the beginning.

The scary thing about that Chronicle article is that the wineries referenced there have way more going for them than the average little virtual label. They have land and buildings, assets that have much more inherent value than wine in barrel. But even those assets have taken a huge beating in terms of value, and they are not enough to satisfy banks that have suddenly gotten extremely risk averse.

It's at this point that Deep Tank introduces me to another character in the calamity. His name is Workout Winemaker.

"These guys' phones are ringing off the hook," says Deep Tank. "Any winery in financial distress is a ticking time bomb for the bank. These workout winemakers work for the bank. Their job is to come in and look at all the assets and contracts going forward and figure out whether the entity is viable, or whether it's toast. They reassess the bank's valuation of the asset, and they either find some way to better collateralize the loan, or they take over the inventory."

"Yep," says Workout Winemaker, "I'm kind of like that guy The Wolf in Pulp Fiction, except instead of dead bodies, it's dying wineries."

I knew Workout Winemaker long before I was introduced to him again by Deep Tank. He's a well known winemaker for a solid, very profitable mid-range winery in Napa who also happens to have gone to business school.

"What I'm most surprised at," he says, "is just how many banks aren't freaking out as bad as they should be. A number of them don't seem to want to admit just how bad the situation is. These banks have been giving away money according to a stupid mathematical formula about how much your wine should theoretically be worth but those numbers have no basis in today's reality. Eventually the banks are going to realize, 'Holy Christ, what have we done. We've been putting money into the shittiest industry possible for the last 10 years.'"

But for those banks that do understand the mess already, Workout Winemaker is out trying to make bad situations a little less painful. He walks into a winery and ignores the beautiful barrels. He doesn't stop to taste the wine. He walks into the back office and looks at the balance sheet, the contracts, the inventory of goods, and the current (dismal) pricing for wine on the bulk market, and then pronounces his verdict.

I ask him what his most recent verdict was, and he pauses before saying, "I'm not sure you should quote me on this, but I told them they were fucked."

"So how bad is it out there?" I ask.

"Nobody really wants to know," says Workout Winemaker. "Let me tell you the scariest thing I have seen in a long time. A few weeks ago I was walking through one of California's largest wine warehouses, and it was unbelievable what a shitpile of wine is sitting in there. I'm talking big name wineries with unbelievably huge levels of stock. I looked closer and it's 06's, 05's, and rows and rows, pallets and pallets of this stuff. Wines priced anywhere from thirty to a hundred dollars, mostly Napa but a lot of Sonoma too. Hundreds and hundreds of thousands of cases. And I'm thinking to myself, 'God, this is not good.' People are waiting for some big day to come when they'll be able to sell this wine, and it's just not going to come. It's never going to come. And I'll tell you another thing. There's no way Wine 'Til Sold Out or any of those other places could possibly sell all this stuff. It was that much wine."

It sounds like a very bad time to be the accountant at a winery, or worse, a winery without an accountant.

"Tell me about it," says Workout Winemaker. "There's not nearly a high enough level of skill in this industry when it comes to the basic finances of the business for people to survive. Mix a lifestyle business with a downturn and all you get is a big fucked up soup. The sharks are circling and just waiting as the deals get better and better. It's gonna be a bloodbath and we're all just waiting for it. All of these small wineries are going to be destroyed, and the mid-tier wineries that are highly leveraged too. And roughly 80% of them are highly leveraged."

Both Deep Tank and Workout Winemaker are in the guts of the turmoil caused by the downturn. They may even stand to profit from it, especially Workout Winemaker, so their predictions of the sky is falling have to be understood in that context. Having said that, I trust both of their judgements, as do many in the wine industry. I've been trying to figure out what they might have to gain by selling the situation to me as worse than it actually is, and I can't really come up with anything.

But as I reflect on our conversations, the most sobering thought I am left with remains that even if these guys are half right, the California wine industry is in for some seriously troubled times in the next couple of years.

If there is a silver lining to any of this, it might be that there will be a lot of very good wine available for incredible prices. So if by chance you haven't been hurt as badly by the recession, or if your personal recovery leads the wine industry's recovery, you'll have an opportunity to stock your cellar at rock bottom prices, as dozens of sites like Cinderella Wine and Wines 'Til Sold Out that Deep Tank calls "dumping grounds" pop up like Spring crocuses.

Bad time to be a winery, good time to be a bargain hunter.

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