Do the Disappointing Scheid Vineyards Results Show a Bad Business in Decline?

Scheid Vineyards is an idea that was posted on the blog exactly six years ago (July 2013) when shares were trading for about $25. Here was the simple thesis at the time:

Earning $9.13 a share is significant given their most recent share price of $24.23.  Not all of the company's recent earnings can be attributed to continuing operations, the company reported a $5.7m gain on a $7.5m sale of a 238 acre vineyard. Backing out the one time gain lowers operating income to $4.5m or $5.17 per share.  The company's operating cash flow was $4.08m which tracks nicely with their adjusted income, meaning this company is trading with a P/E of 4.68.

The stock hovered around $30 a share for several years after that before exploding higher during the summer of 2017. So it has been a good investment when purchased at opportune times. David Tepper owned it in certificate form in the late 90s when he was posting on The Motley Fool.

Scheid stock reached a peak of $108 in March 2018, but has lately collapsed and after announcing results on June 26th it is down to the $60 range. (The summer of 2017 was when a fund called Maran Capital Management published a short write-up of the idea. In January 2018 they published a much longer and more detailed presentation.)

Opening the shareholder letter last week, our eyes jumped to the sentence, "it was not for the faint of heart to take this leap" which appeared in a section discussing Scheid's efforts to become "a fully vertically integrated company and [producing] our own estate branded wines for the national and international marketplace". Uh oh. Here was the upshot:

The wine grape harvest of 2018 was larger than average throughout the state of California. This contributed to depressed grape and bulk wine prices which represent about half of our sales. It also reduced the value of our unsold bulk wine inventories. We decided to write down of those inventories by $2 million in order to reflect more accurately its true market value. These events contributed to our loss for fiscal 2019.

Was it a warning sign that Pardee Resources, a hard commodity producer, had gotten into agricultural investments including grapes? We decided to do a reality check on the quality of the business, taking into account the past fifteen years from the end of 2003 until present.

The shareholders' equity was $38 million at the end of 2003 and it's $43 million now. They haven't paid any dividends. In 2003 they had 449,751 outstanding A shares and 645,223 outstanding B shares (reverse split-adjusted; a total of 1.09 million) and now they have 735,617 of the A and 147,469 of the B (total of 883k). So, no dividends but they have shrunk the float by 19% - about 1.27% per year. Certainly some capital has been returned.

But here is what seems crazy to us. In 2003, they had sales of $26 million, gross profit of $12 million, and pre-tax income of $5 million on an asset base of $68 million. Most recent fiscal year, they had sales of $58 million, gross profit of $12 million, and an $11 million pretax loss - on an asset base of $159 million.

Sales/assets has remained somewhat steady (but low), but gross margin has fallen from 46% to 20% over 15 years. And it is not clear why their asset turns are so low when they are selling low (and falling) margin bulk wine. Bulk wine and grapes were 44% of revenue last fiscal year versus all of revenue fifteen years ago - some how gross margins are lower despite deploying significant capital into the cased wine business.

So because of the lower gross profit, higher SG&A, and lower incomes, return on equity has fallen even as leverage has gone up! In 2003, equity/assets was 56% and now it's only 27%. In fiscal years 2018 and 2017 (since the company had a loss for FY 2019) the annual net incomes were less than $3 million, which was less than the 2003 level.

Look at the Scheid Vineyard writeups by other investors and they seem to focus on the sum-of-the-parts asset valuation. And we do not doubt that Scheid could be liquidated or sold at a profit. But they aren't going to sell or liquidate, just as Pardee is not going to sell or liquidate its overpriced timber. That leaves investors with just the earnings power, not asset value.

Nobody who has done an asset valuation writeup of this has commented on the deteriorating profitability and margins, or the fact that management has responded to it by taking on more leverage to make much bigger investments in the business.

At December 31, 2003, they had $67 million of gross investment in PP&E. At February 28, 2019 (most recent), they had $174 million of gross investment. Inventories have increased from $7 million to $50 million. But the gross profit is lower and net income is lower!

Let's look at the inventory. At the end of 2003 they had $1.9 million of bulk and bottled wine inventory followed by $5.7 million of bulk wine sales the following year. At the end of fiscal 2018, they had $40 million of bulk and cased wine inventory versus $47 million of sales the following year. And that understates the slowing inventory turns because in 2003 and 2004 more of the sales were of raw grapes, which are sold when harvested.

Here is the acid test of whether this is a good business or not: how did they fund that massive asset expansion from $68 million to $159 million? (Those are the figures net of depreciation; which required over $150 million of gross investment.) Did they bootstrap with cash flows, denying shareholders dividends but building the business with retained earnings?

The answer is that total liabilities grew from $28 million in 2003 to the present level of $116 million. And in case you think that this was low cost float from vendors or something (almost none of their liabilities are this type) the truth is that long term debt went from $13 million to over $100 million. That is why book value is flat; that is why retained earnings plus treasury stock repurchased was $27 million at the end of 2003 and is $44 million today.

So what happened here, really? Is this a nine-figure malinvestment, and if so why did it happen? One of our astute correspondents writes in,

Most of these firms [like Pardee and Scheid] exist because of institutional loyalty and for no other reason. If they were rational, they would have sold to better, larger, more scaled operators long ago. Managements here lack vision and ambition, but get to work with their friends and they value that highly.

Also there is much more stature in owning the local "big business" than just being a local rich guy. There is much more power in owning the local business with employees who depend on your firm for their livelihoods. Chances to sponsor local sporting events and attend various "power broker" meetings. Rich people are not respected. Business people are.

We will be writing about this theme in much more detail for subscribers of the Oddball Stocks Newsletter. Also see our June post, Small Companies (like Small Banks) As "Jobs Programs".