Interpreting the Scheid Vineyard 2019 Results

This week shareholders in Scheid Vineyards received the annual report in their email inbox. They've had a few rough years, but this year was a wallop to the gut for shareholders. Initially I was going to break down their results in a Twitter thread, but decided a blog update was more appropriate. Let's dive in...

Scheid Vineyards ($SVIN) is an over-the-counter micro cap that owns and operates vineyards and wineries in California. They produce both bulk grapes and cased wines under a variety of brands.

The company reported a loss for 2019 of $12.8m on revenue of $51m. Revenue was down from $58.5m in 2019. The primary driver of revenue decline was a decline in bulk wine sales. This is important because historically their business was built on selling bulk grapes.

Most wineries do not grow their own grapes. Like most industries wine making consists of compartmentalized functions and various suppliers, with everyone balancing the advantages and disadvantages of vertical integration to come up with a model that they think is optimal.

Wine makers tend to enjoy making wine, that is blending yeast and grapes. Wine making is very different from farming grapes. Because of this it is rare for a winery to both specialize in growing and blending. Wineries that do both bottle and sell what are called "estate wines". The estate wine designation means the grapes in the wine were grown on site.

A quick trip to the local liquor store to browse wine will confirm that most wine is not estate wine, but rather blended from bulk grapes. This isn't a bad thing, it's just how it works. A wine maker can choose the type of grapes they want so they can control the taste and quality of what they produce.

When you're running a bulk wine operation you're running a company similar to a corporate farm.  There is a lot of land involved, and expensive machinery to harvest and package grapes for sale.  Contrast this to a winery that only needs a building to store the wine in process that they're producing. This is why most wineries that you might have visited all have a similar resemblance.  They appear to be a warehouse with a tasting room attached and a few rows of grapes growing outside for decoration.

A company can capture a lot more margin selling bottled wine vs bulk wine. Like anything, the margin on the raw material is small compared to the margin on the finished good. With this Scheid decided a few years back to focus on selling bottled wine vs bulk wine sales. They would be completely vertically integrated, from growing to blending, to bottling. In this way they should be capturing the entire margin from making wine.

For years the business did well, it even traded for a few times earnings when I first wrote about them in July of 2013. They were selling for 63% of book value and 6x earnings. Shares were trading for around $31 at that point and had just earned $4.59 per share. A year earlier the company earned $9.13 per share. There was a lot to like about the company!

Shares eventually skyrocketed from $31 to $108 on the back of solid earnings and a great narrative about value and future growth. Subsequently shares crashed as earnings turned negative and losses accelerated.

I initially tempered my bull case to Sheid with the quote 

"Scheid Vineyard’s flaw is found in their balance sheet -more specifically, their debt. The company is highly levered, and is exposed to both agricultural cycles and market cycles. The wine market cycle peaked right before the 2008 recession and has slowly recovered. The company produced a record harvest this past year that requires capital to process, but should also result in higher earnings next year. The company’s bank is Rabobank, which an industry contact related is known throughout the industry as the best bank for wineries. They are willing to work with wineries when downturns occur, and will drag their feet on calling loans until there are no other options. So while their debt could be a stumbling block for investors there is a small silver lining in that Scheid’s bank is very winery friendly."

It turns out that this quote was quite prescient. We wrote another post last summer about developing concerns with the Scheid results.

In 2020 the company had $83m in long term debt, and $30m in operating debt, for a whopping $113m in total debt against equity of $30.3m.  

The company earned $51m in revenue and had $41m as cost of goods sold for a pre-write down gross profit of ~$10m. The problem is interest costs were $4.7m, or 47% of gross profit. This past year the company wrote down $4m of inventory leaving them with a GAAP gross profit of $5.6m, meaning interest costs along were 83% of gross profit. To say that's concerning is an understatement.

A retort could be that GAAP gross profit isn't a cash number, so this isn't a true picture of their ability to serve their debt. The problem is when you look at their cash flow statement it's even more ominous.

The company had a negative $4m in operating cash flow, $5m in cash interest expense and had to borrow an additional $14m to make ends meet.

The sad thing here is the company does have true value. They mortgaged their land for $100m to Prudential Financial. The problem is the land is generating a negative return for shareholders, and to fund that negative return the company needs to continually increase their debt load.

If Prudential were to take the land and sell it off they would almost surely realize more than $100m.  Unfortunately shareholders would get nothing.

So what's the bull case here? It would be that the company increases their case sales at a really high rate while figuring out a way to manage their debt. IF they can pull this off and start to pay down debt this becomes a private equity type scenario where as the debt is repaid the equity becomes more valuable. Additionally as the debt is paid down earnings would accelerate as interest costs were reduced.

The bear case is that the pandemic hits their sales hard and they have to restructure. In the company's annual letter they noted that sales are down and they are expecting a difficult year. I'm not sure the Prudential credit team should be sweating much, but shareholders sure should. Scheid's financial statements disclose that their debt has financial covenants, including "debt service coverage ratios, and the amount of total liabilities to tangible net worth." From what I've heard, Scheid is not willing to tell people what the threshold ratios are or how close the company is to tripping them.

On the bright side I believe shareholders still qualify for discounts at the company tasting rooms, and tasting rooms opened June 12th. I'm not sure the discount will compensate for shareholder losses, but maybe you wouldn't feel as bad about them afterwards...

Disclaimer: I own a single share of the stock