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SECURITIES & EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended December 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________________ to _________________
Commission file number: 0-13406
The Chalone Wine Group, Ltd.
(Exact Name of Registrant as Specified in Its Charter)
California 94-1696731
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
621 Airpark Road
Napa, California 94558
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: 707-254-4200
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes _X_ No ___
The number of shares outstanding of Registrant's Common Stock on February 11,
1999 was 8,698,226.
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The Chalone Wine Group, Ltd.
PART I. - FINANCIAL INFORMATION
Item 1. Financial Statements Page
Consolidated Balance Sheets as of December 31, 1998, and
March 31, 1998. 3
Consolidated Statements of Operations for the three months and
nine months ended December 31, 1998 and 1997. 4
Consolidated Statements of Cash Flows for the three months and
nine months ended December 31, 1998 and 1997. 5
Notes to Consolidated Financial Statements. 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
Item 3. Disclosures about market risk 13
PART II. - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 17
The Chalone Wine Group, Ltd.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
ASSETS
(unaudited)
December 31, March 31,
1998 1998
--------- ---------
Current assets:
Cash and cash equivalents $ 2,913 $ 2,232
Accounts receivable, less allowance for doubtful
accounts of $79 and $92, respectively 8,419 6,597
Notes receivable 99 197
Income tax receivable 279 --
Note receivable from officer -- 65
Inventory 41,063 34,277
Prepaid expenses 617 450
Deferred income taxes 1,754 14
--------- ---------
Total current assets 55,144 43,832
Investment in Chateau Duhart-Milon 11,228 9,480
Notes receivable, long-term portion 228 130
Property, plant and equipment - net 33,573 30,131
Goodwill and trademarks - net 6,205 6,473
Other assets 905 248
--------- ---------
Total assets $ 107,283 $ 90,294
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities $ 3,669 $ 3,425
Bank lines of credit 15,381 10,952
Other short term debt 5,000 952
Convertible subordinated debentures 8,500 --
Current maturities of long-term obligations 565 709
--------- ---------
Total current liabilities 33,115 16,038
Long-term obligations, less current maturities 8,357 9,624
Convertible subordinated debentures -- 8,500
Settlement advance 4,500 --
Deferred income taxes 1,528 2,049
--------- ---------
Total liabilities 47,500 36,211
--------- ---------
Minority interest 4,209 3,678
Shareholders' equity:
Common stock - authorized 15,000,000 shares, no
par value; issued and outstanding: 8,698,226
and 8,393,979, respectively 48,968 46,871
Stock subscription receivable (1,007) --
Retained earnings 9,042 5,993
Cumulative foreign currency translation adjustment (1,429) (2,459)
--------- ---------
Total shareholders' equity 55,574 50,405
--------- ---------
Total liabilities and shareholders' equity $ 107,283 $ 90,294
========= =========
<FN>
The accompanying notes are an integral part
of the consolidated financial statements
</FN>
3
The Chalone Wine Group, Ltd.
Consolidated Statements of Operations
(unaudited, in thousands, except per-share data)
Three months ended Nine months ended
December 31, December 31,
---------------------------- ----------------------------
1998 1997 1998 1997
-------- -------- -------- --------
Gross revenues $ 12,573 $ 11,178 $ 32,949 $ 28,715
Excise taxes (401) (243) (852) (697)
-------- -------- -------- --------
Net revenues 12,172 10,935 32,097 28,018
Cost of wines sold (6,565) (6,057) (17,567) (15,939)
-------- -------- -------- --------
Gross profit 5,607 4,878 14,530 12,079
Custom processing operations 43 186 66 303
SG&A expenses (2,703) (2,039) (7,849) (5,797)
-------- -------- -------- --------
Operating income 2,947 3,025 6,747 6,585
Other income (expenses)
Interest expense (439) (387) (1,281) (1,360)
Other, net 25 -- (11) 70
-------- -------- -------- --------
(414) (387) (1,292) (1,290)
Equity in Chateau Duhart-Milon 187 103 718 296
Minority interests (432) (401) (1,007) (799)
-------- -------- -------- --------
Income before income taxes 2,288 2,340 5,166 4,792
Income tax expense (936) (936) (2,117) (1,917)
-------- -------- -------- --------
Net income $ 1,352 $ 1,404 $ 3,049 $ 2,875
======== ======== ======== ========
Net income per common share:
Basic $ 0.16 $ 0.18 $ 0.35 $ 0.37
Diluted $ 0.16 $ 0.17 $ 0.35 $ 0.34
Average number of shares used
in income per share computation:
Basic 8,697 7,813 8,656 7,692
Diluted 8,718 8,398 8,828 8,368
<FN>
The accompanying notes are an integral part
of the consolidated financial statements
</FN>
4
The Chalone Wine Group, Ltd.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
Three months ended Nine months ended
December 31, December 31,
----------------------- -----------------------
1998 1997 1998 1997
------- ------- ------- -------
Cash flows from operating activities:
Net earnings $ 1,352 $ 1,404 $ 3,049 $ 2,875
Non-cash transactions included in earnings:
Depreciation 2,139 1,700 3,071 2,445
Amortization 106 41 268 124
Equity in net income of Chateau Duhart-Milon (187) (103) (718) (296)
Increase in minority interest 432 401 1,007 799
Loss (gain) on sale of equipment (63) 3 29 6
Changes in:
Deferred income taxes (2,261) -- (2,261) --
Settlement advance -- -- 4,500 --
Accounts and other receivable (124) (1,527) (1,822) (3,436)
Inventory (6,619) (2,512) (6,786) (4,641)
Prepaid expenses and other assets (679) (110) (1,103) (186)
Accounts payable and accrued expense 868 1,827 244 3,746
------- ------- ------- -------
Net cash provided by operating activities (5,036) 1,124 (522) 1,436
------- ------- ------- -------
Cash flows from investing activities:
Capital expenditures (1,117) (1,197) (6,667) (5,736)
Proceeds from disposal of property and equipment 125 24 125 124
Net (increase) decrease in notes receivable 85 (1,413) 65 (156)
------- ------- ------- -------
Net cash used in investing activities (907) (2,586) (6,477) (5,768)
------- ------- ------- -------
Cash flows from financing activities:
Net change under line of credit agreement 3,850 1,411 4,429 5,237
Increase in short-term debt 5,237 -- 4,285 --
Distribution to minority interest (405) -- (476) (38)
Repayment of long-term debt (81) (79) (1,648) (1,177)
Proceeds from issuance of common stock 42 71 1,090 127
------- ------- ------- -------
Net cash provided by financing activities 8,643 1,403 7,680 4,149
------- ------- ------- -------
Net increase (decrease) in cash 2,700 (59) 681 (183)
Cash at beginning of period 213 122 2,232 246
------- ------- ------- -------
Cash at end of period $ 2,913 $ 63 $ 2,913 $ 63
======= ======= ======= =======
<FN>
The accompanying notes are an integral part
of the consolidated financial statements
</FN>
5
The Chalone Wine Group, Ltd.
Notes to Consolidated Financial Statements
NOTE 1 - Consolidated Financial Statements
The consolidated balance sheet as of December 31, 1998, the consolidated
statements of operations for the three months and nine months ended December 31,
1998, and 1997, and the consolidated statements of cash flows for the three
months and nine months then ended have been prepared by the Company, without
audit. In the opinion of management, all adjustments (which include only normal
recurring adjustments) necessary to present fairly the Company's financial
position, results of operations and cash flow at December 31, 1998, and for all
periods presented have been made.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. For further information, reference should be
made to the consolidated financial statements and notes included in the
Company's Form 10-K for the year ended March 31, 1998, on file with the
Securities and Exchange Commission.
NOTE 2 - Reclassifications
Certain prior period amounts have been reclassified in order to conform with the
current period presentation.
NOTE 3 - Comprehensive Income
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No.130 ("SFAS 130") - Reporting Comprehensive
Income. SFAS 130 requires the additional reporting of a new measure of income
which takes into account certain elements otherwise recorded as part of equity.
For all periods presented, the difference between net income and comprehensive
income consists of the changes in the cumulative foreign currency translation
adjustment included as part of the Company's equity.
The following is a reconciliation of net income and comprehensive income (in
thousands):
Three months ended Nine months ended
December 31, December 31,
----------------- -----------------
1998 1997 1998 1997
------- ------- ------- -------
Net income $ 1,352 $ 1,404 $ 3,049 $ 2,875
Change in cumulative foreign currency
translation adjustment 8 (127) 1,030 (576)
------- ------- ------- -------
Comprehensive income $ 1,360 $ 1,277 $ 4,079 $ 2,299
======= ======= ======= =======
NOTE 4 - Earnings per Share
The Company has adopted Statement of Financial Accounting No.128 ("SFAS 128") -
Earnings per Share. As a result of the adoption of SFAS 128, earnings per share
amounts for the three months and nine months ended December 31, 1997, have been
restated to conform to the new standard. This standard requires dual
presentation of two earnings per share ("EPS") amounts, basic EPS and diluted
EPS. Basic EPS represents the income available to common shareholders divided by
the weighted average number of common shares outstanding for the period. Diluted
EPS represents the income available to common shareholders divided by the
weighted average of common shares outstanding while also giving effect to the
potential dilution that could occur if securities or other contracts to issue
common stock (e.g. stock options) were exercised and converted into stock. For
all periods presented, the difference between basic and diluted earnings per
share for the Company is the inclusion of dilutive stock options and stock
warrants, the effect of which is calculated using the treasury stock method as
shown below. The Company's convertible debentures are excluded from the
computation, as these have had, and continue to have, an antidilutive effect.
6
The Chalone Wine Group, Ltd.
NOTE 4 - Earnings per Share (Continued)
The following is a reconciliation of the figures used in deriving basic EPS and
those used in calculating diluted EPS:
(in thousands, except per-share data)
Basic EPS Diluted EPS
--------- -----------
Effect of dilutive Income
securities available to
Income ------------------------ common
available to shareholders
common Stock and assumed
shareholders Warrants options conversion
------------ -------- ------- ----------
Three months ended December 31, 1998:
Income $1,352 -- -- $1,352
Shares 8,697 21 -- 8,718
------ ------
EPS $ 0.16 $ 0.16
====== ======
Three months ended December 31, 1997:
Income $1,404 -- -- $1,404
Shares 7,813 453 132 8,398
------ ------
EPS $ 0.18 $ 0.17
====== ======
Nine months ended December 31, 1998:
Income $3,049 -- -- $3,049
Shares 8,656 172 -- 8,828
------ ------
EPS $ 0.35 $ 0.35
====== ======
Nine months ended December, 1997:
Income $2,875 -- -- $2,875
Shares 7,692 515 161 8,368
------ ------
EPS $ 0.37 $ 0.34
====== ======
7
The Chalone Wine Group, Ltd.
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations
FORWARD LOOKING STATEMENTS
From time to time, information provided by the Company, statements made by its
employees or information included in its filings with the Securities and
Exchange Commission (including this Form 10-Q) may contain statements that are
not historical facts, so called "forward looking statements," which involve
risks and uncertainties. Forward looking statements are made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
When used in this Form 10-Q, the terms "anticipates," "expects," "estimates,"
"believes," and other similar terms as they relate to the Company or its
management are intended to identify such forward looking statements. For
example, statements made herein relating to the 1998 harvest, conversion of a
majority of the currently outstanding convertible debentures, the Company's
working capital requirements, the anticipated future results of Edna Valley
Vineyard joint venture and Canoe Ridge Vineyard, LLC, and the Company's
expectation that sufficient cash flow will continue to be provided from
operations, are forward looking statements. Factors that may cause actual
results to vary include, but are not limited to: (i) future and past weather and
general farming conditions affecting the annual grape harvest; (ii) variations
in consumer taste and preference; (iii) changes in the wine industry regulatory
environment; and (iv) changes in the fair market value of the Company's common
stock. Each of these factors, and others, are discussed from time to time in the
Company's filings with the Securities and Exchange Commission including the
Company's annual report on Form 10-K for the year ended March 31, 1998.
DESCRIPTION OF THE BUSINESS
The Chalone Wine Group, Ltd. is a Napa, California-based company that produces,
markets and sells primarily super and ultra-premium white and red varietal table
wines. In California, the Company owns and operates Chalone Vineyard(R) in
Monterey County, Acacia(TM) Winery in the Carneros District of Napa County,
Carmenet(R) Vineyard in Sonoma County and Edna Valley Vineyard(R) in San Luis
Obispo County (in conjunction with its 50% joint-venture partner, Paragon
Vineyard Co.). In the State of Washington, the Company owns a 50.5% interest in
Canoe Ridge(R) Vineyard. In the Bordeaux region of France, the Company owns
23.5% of the fourth-growth estate of Chateau Duhart-Milon in partnership with
Domaines Barons de Rothschild (Lafite) ("DBR"), which owns the remaining 76.5%
interest in Chateau Duhart-Milon.
With a view to introducing new consumers to its wines, the Company recently
expanded its product line with the launch of the "Echelon(TM)" brand. Taking
advantage of the Company's diverse vineyard resources, the Echelon label is
expected to reach a larger and entirely new market segment due to its lower
price point (relative to the Company's other wines). During the nine months
ended December 31, 1998, 64,000 cases of Chardonnay, 25,000 cases of Pinot Noir,
and 7,500 cases of Merlot under the Echelon label were made available for sale.
Additionally, a 1998-vintage Echelon Syrah is planned for release during the
fall of 1999.
In addition to, and as a result of, an investment in the Company by DBR, the
Company receives an allocation of DBR wines for resale, including an allocation
from Chateau Lafite-Rothschild, a first growth Bordeaux chateau, which is
generally regarded as one of the world's most exclusive wine producers.
8
The Chalone Wine Group, Ltd.
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations (Continued)
RESULTS OF OPERATIONS
The following table sets forth the percentage relationship to net revenues of
certain items in the Company's statements of operations for the three months and
nine months ended December 31, 1998, and 1997, and the percentage change in such
items between the comparable period in those years:
Three months ended Percent Three months ended Percent
December 31, Change December 31, Change
------------------------ ---------- ------------------------ ------------
1998 1997 98 vs 97 1998 1997 98 vs 97
----------- ----------- ---------- ----------- ------------ ------------
Net revenues 100.0 % 100.0 % 11.3 % 100.0 % 100.0 % 14.6 %
Cost of wines sold (53.9)% (55.4)% 8.4 % (54.7)% (56.9)% 10.2 %
----------- ----------- ----------- ------------
Gross profit 46.1 % 44.6 % 14.9 % 45.3 % 43.1 % 20.3 %
Custom processing operations 0.4 % 1.7 % (76.9)% 0.2 % 1.1 % (78.2)%
SG&A expenses (22.2)% (18.6)% 32.6 % (24.5)% (20.7)% 35.4 %
----------- ----------- ----------- ------------
Operating income 24.2 % 27.7 % (2.6)% 21.0 % 23.5 % 2.5 %
----------- ----------- ----------- ------------
Other income (expenses):
Interest (3.6)% (3.5)% 13.4 % (4.0)% (4.9)% (5.8)%
Other, net 0.2 % -- n/a (0.0)% 0.2 % (115.7)%
----------- ----------- ----------- ------------
(3.4)% (3.5)% 7.0 % (4.0)% (4.6)% 0.2 %
Equity in Chateau Duhart-Milon 1.5 % 0.9 % 81.6 % 2.2 % 1.1 % 142.6 %
Minority interests (3.5)% (3.7)% 7.7 % (3.1)% (2.9)% 26.0 %
----------- ----------- ----------- ------------
Income before income taxes 18.8 % 21.4 % (2.2)% 16.1 % 17.1 % 7.8 %
----------- ----------- ----------- ------------
Income tax expense (7.7)% (8.6)% -- (6.6)% (6.8)% 10.4 %
----------- ----------- ----------- ------------
Net income 11.1 % 12.8 % (3.7)% 9.5 % 10.3 % 6.1 %
=========== =========== =========== ============
Net Revenues
Net revenues for the three months and nine months ended December 31, 1998
increased approximately 11% and 15% respectively, over the comparable periods in
the prior year, as a result of increased case-sales volume in part due to the
new Echelon brand name, and increases in the average sales prices per case due
to (i) changes in product mix and (ii) selected price increases.
Gross Profit
Gross profit for the three months and nine months ended December 31, 1998
increased by approximately 15% and 20% respectively, over the comparable periods
in the prior year. The increased gross profit in the current quarter was a
result of increased case sales and higher prices (as mentioned above) without
corresponding increases in production costs.
Custom Processing Operations
Custom processing revenue consists of revenue obtained from third-party
wineries, net of related expenses, for grape crushing or wine bottling. The
Company cannot predict the materiality of such operations or future operating
results, as this source of revenue is highly unpredictable and entirely
contingent on other wineries' demand for extra production capacity, which can
and does vary significantly from year to year.
The decrease of 77% and 78% respectively, in the three months and nine months
ended December 31, 1998 from the comparable periods in the prior year were
attributable to less custom crush demand (driven in part by the relatively lower
1998
9
The Chalone Wine Group, Ltd.
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations (Continued)
harvest tonnage throughout California as compared to the 1997 harvest tonnage),
partly offset by increased custom bottling demand.
Selling, General and Administrative (SG&A) Expenses
SG&A expenses for the three months and nine months ended December 31, 1998
increased by approximately 33% and 35%, respectively, over the comparable
periods in the prior year. These increases were attributable to (i) planned
increases in selling expenses, (ii) marketing costs related to the launch of the
Echelon brand, and (iii) certain non-recurring charges in connection with
organizational changes.
Operating Income
Operating income for the three months ended December 31, 1998, decreased by 3%
compared to the comparable period in the prior year due to the decrease of
$143,000 in custom processing operations.
Operating income for the nine months ended December 31, 1999, increased by 3%
when compared to the same period in the prior year due to increased Net Revenues
which generated higher gross profits, partly offset by increased Selling,
General and Administrative Expenses and decreased Custom Processing Operations.
Other Income (Expenses)
Interest expense comprised more than 90% of Other Income (Expenses) for all
periods presented.
Interest expense for the three months ended December 31, 1998 increased by 13%
from the comparable period in the prior year due to borrowing demands resulting
from increased 1998 production.
Interest expense for the nine months ended December 31, 1998 decreased by 6%
when compared to the same period in the prior year primarily due to lower
interest rates on outstanding indebtedness.
Equity in Net Income of Chateau Duhart-Milon
The Company experienced record results during the nine months ended December 31,
1998 from its investment in Societe Civile Chateau Duhart-Milon
("Duhart-Milon"). The Company's 23.5% equity interest in the net income of
Duhart-Milon for the three months and nine months ended December 31, 1998, was
$187,000 and $718,000, respectively, as compared to $103,000 and $296,000,
respectively, during the comparable periods in the prior year. The 82% and 143%
increases, respectively, are primarily attributable to exceptionally high demand
for the 1996 vintage of Bordeaux wines. The 1996 vintage is expected to be one
of the Bordeaux region's most successful vintages in the past twenty years. Due
to the exceptional nature of the 1996 vintage, this quarter's net income from
the Company's investment in Duhart-Milon may not be indicative of future
results.
The Company monitors its investment in Duhart-Milon primarily through its
on-going communication with Domaines Barons de Rothschild (DBR). Such
communication is facilitated by the presence of the Company's chairman on DBR's
Board of Directors, and DBR's representation on the Company's Board of
Directors. Additionally, various key employees of the Company make frequent
visits to Duhart-Milon's offices and productions facilities.
Since the investment in Duhart-Milon is a long-term investment denominated in a
foreign currency, the Company maintains a reserve for currency translation which
was valued at $1,429,000 as of December 31, 1998. This reserve was reduced from
$2,459,000 as of March 31, 1998 and $1,437,000 as of September 30, 1998 due to
the increase in the relative worth of the French Franc when compared to the U.S.
dollar during the nine months ended December 31, 1998. Although the transition
to the "EURO" currency became effective as of January 1, 1999, the Company does
not anticipate that this transition will have a material impact on its
investment in Duhart-Milon. Currency fluctuations will, as in the past, be
recorded in the "Cumulative foreign currency translation adjustment" in the
equity section of the Company's consolidated balance sheet, and be included in
comprehensive income as defined by the Statement of Financial Accounting
Standards No.130 ("SFAS 130") - Reporting Comprehensive Income.
10
The Chalone Wine Group, Ltd.
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations (Continued)
Minority Interest
The Edna Valley Vineyard ("EVV") and Canoe Ridge Vineyard, LLC ("CRV")
individual financial statements are consolidated in full within the Company's
financial statements. The interests of parties other than the Company in the net
earnings of EVV and CRV are accounted for as "minority interests." The minority
interests for the three months and nine months ended December 31, 1998, and
1997, were as follows (in thousands):
Three months ended Nine months ended
December 31, December 31,
Minority ---------------------- ----------------------
Venture Minority Owner Percent 1998 1997 1998 1997
- ----------- ----------------------------- ---------- ----------- ---------- ----------- ----------
EVV Paragon Vineyard Co., Inc. 50.0% $ 333 $ 339 $ 733 $ 695
CRV Various 49.5% 99 62 274 104
=========== ========== =========== ==========
$ 432 $ 401 $ 1,007 $ 799
=========== ========== =========== ==========
The approximately 8% and 26% increase in the minority interests of EVV and CRV
for the three months and nine months ended December 31, 1997, and 1998,
respectively, reflects improved net income of EVV and CRV during those periods.
The Company expects the net income of EVV and CRV to continue to improve from
year to year, and for the minority interests to increase accordingly.
Net Income
Net income for the three months ended December 31, 1998, was $1,352,000,
reflecting a decrease of approximately 4% from the comparable period in the
prior year. As with the Operating Income, this decrease was largely attributable
to the decrease of $143,000 in Custom Processing Operations.
Net income for the nine months ended December 31, 1998, increased 6% to
$3,049,000 from the same period in the prior year. This increase was due to
increased gross profit and the return on the Company's equity in Duhart-Milon,
offset by higher Selling, General and Administrative Expenses and lower Custom
Processing Operations.
"EL NINO"
The weather phenomenon commonly referred to as "El Nino" produced heavy rains
and cooler weather during the Spring of 1998, which resulted in colder and
wetter soils than are typical during California's grape growing season.
Consequently, the 1998 harvest was postponed by approximately four to six weeks
- - depending on the geographical location and varietals. Although, the primary
risk associated with such a delay is possible exposure to early winter rains
resulting in rot, the Company believes that rot was largely avoided.
Nevertheless, the unusual weather conditions resulting from El Nino impacted
quantity and quality of the Company's 1998 estate harvest. The size of the
Company's most significant crops ranged from normal-sized yields to 50% of
normal yields (depending on the varietal and the particular estate).
Despite the foregoing reduction in the yield of certain crops, the harvested
estate crops, in combination with contracted grape purchases (most of which are
tonnage-based), are expected to permit the Company to meet originally
anticipated sales-projections in its 1998 vintage Chardonnay, Cabernet and
Merlot varietals which, together, have historically comprised between 80% and
85% of its aggregate annual production.
11
The Chalone Wine Group, Ltd.
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations (Continued)
LIQUIDITY AND CAPITAL RESOURCES
Working Capital:
During the nine months ending December 31, 1998, working capital decreased by
$5.8 million, or 21%, from $27.8 million to $22.0 million. This was primarily
due to the following: (i) a change in classification for $8.5 million of
convertible subordinated debentures from long-term debt to current debt; (ii)
capital expenditures of $6.7 million incurred both as a result of normal
operations and selected expansion of certain Company production facilities;
(iii) payment of $1.7 million in taxes relating to proceeds received from
Pacific Gas and Electric ("PG&E") (which are recorded as an advance as of
December 31, 1998 - refer to discussion of PG&E below); offset by 4) $1.0
million received from the net proceeds of warrant exercises (which resulted in a
purchase of 142,857 shares of the Company's common stock); 5) an advance of $4.5
million from PG&E related to the Carmenet Vineyard fire of July 1996; and 6) net
inventory increases of $6.8 million.
Convertible subordinated debentures, with a face value of $8.5 million, are
convertible to 965,098 shares of the Company's common stock and will mature in
April, 1999. The Company believes that the majority of the holders of these
debentures will elect to convert into common stock when due. The convertible
debentures were more fully described in the Company's Form 10-K for the year
ended March 31, 1998, on file with the Securities and Exchange Commission.
Cash Flows:
During the three months ended December 31, 1998, cash flow from operations
decreased by $6.1 million vs. the comparable period in the prior year. This was
primarily a result of (i) an increased inventory levels of $4.1 million, (ii)
payment of $1.7 million in taxes relating to the $4.5 million advance from PG&E
(discussed below), offset by (iii) timing differences in payments of payables
and receipts of receivables. Cash used in investing activities decreased by 65%
from the comparable period in the prior year, primarily due to non-recurring
increases in notes receivable of $1.4 million which occurred in the quarter
ended December 31, 1997. Cash flow from financing activities were $7.2 million
higher than in the comparable period in the prior year due to increased
short-term debt attributable to new bridge financing of $5.0 million obtained in
December of 1998, combined with increased borrowing under the Company's existing
lines of credit. The bridge financing will mature on March 31, 1999. The Company
presently plans to refinance the bridge loan at maturity.
During the nine months ended December 31, 1998, cash flow from operations
decreased by $2.0 million, or 136%, compared to the same period in the prior
year. This was primarily the result of (i) receiving $4.5 million from PG&E
(discussed below), offset by (ii) increased investments in inventory resulting
in a net inventory change which is $2.1 million higher than in the prior year
and (iii) payment of $1.7 million in taxes relating to the $4.5 million advance
from PG&E, and (iv) timing differences in payments of payables and receipts of
receivables. Cash used in investing activities was $709,000 or 12% higher than
during the nine months ended December 31, 1997 due primarily to increased
capital expenditures. Cash provided by financing activities was $3.5 million or
85% higher than during the comparable period last year mostly due to an increase
in short-term debt primarily attributable to the bridge financing.
General:
As of February 2, 1999 the Company had lines of credit totaling $16.3 million,
of which $14.9 million had been drawn.
The Company is not aware of any potential impairments to its liquidity and
believes that its capital resources are adequate to meet current and historic
levels of capital expenditures and liquidity needs of the Company, including
repayment of the $8.5 million convertible subordinated debentures due in April
1999. This belief is based, in part, on currently on-going bank negotiations
which have lead the Company to be confident about its potential to borrow
adequate funds from prospective lenders as well as to refinance its current
bridge financing loan.
As previously stated, the Company does not expect to have to repay most of the
convertible subordinated debentures when due. Rather, it expects holders thereof
to convert such debentures into common stock. Based on this assumption and other
factors set forth herein, the Company anticipates that the funds available from
the bridge financing and its existing lines of credit will be sufficient to meet
its liquidity needs for the foreseeable future. However, if all holders of the
convertible subordinated debentures elected to redeem such debentures upon
maturity, or if the foregoing borrowings cannot be secured on
12
The Chalone Wine Group, Ltd.
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations (Continued)
terms favorable to the Company because of general market conditions or the
Company's operations, the Company might be required to scale back its operations
unless alternative sources of capital can be obtained.
PACIFIC GAS AND ELECTRIC SETTLEMENT
In January, 1999, an agreement was reached with Pacific Gas and Electric
("PG&E") regarding a fire which occurred on July 31, 1996 at the Company's
Carmenet Vineyard, located in Sonoma, California. This event was more fully
described in the Company's Form 10-K for the year ended March 31, 1998, on file
with the Securities and Exchange Commission. A final settlement agreement is
expected to be signed by the parties in February. As part of the settlement,
PG&E agreed to pay the Company an additional $150,000, of which $140,000 has
been received by the Company. The balance of $10,000 is expected to be paid on
March 5, 1999. These amounts, together with the $4.5 million advance discussed
above will be recognized in the Company's income statement during the three
months ending March 31, 1999.
Since this settlement did not occur until after December 31, 1998, the proceeds
of $4.5 million received in April of 1998 were still reflected as a "Settlement
advance" on the Company's December 31, 1998 consolidated balance sheet. Since
the Company is likely to keep the proceeds as part of a final settlement,
however, a payment of related taxes was required in the 1998 calendar year by
applicable Treasury regulations promulgated under the Internal Revenue Code of
1986, as amended.
YEAR 2000
The year 2000 issue ("Y2K") is the result of computer programs being written
using two digits rather than four digits to determine the applicable year. As
presently programmed, the Company's computer programs and systems that have time
sensitive software would recognize a date using "00" as the year 1900 rather
than the year 2000. Unless reprogrammed, in the future this could result in
miscalculations causing disruptions of operations, including, among other
things, temporary inefficiencies in processing transactions, sending invoices,
or engaging in similar normal business activities.
Nevertheless, the Company has an ongoing program designed to ensure that its
operational and financial systems will not be adversely affected by Y2K software
failures. The Company believes that its exposure to Y2K issues remains
relatively minor in comparison to most industrial enterprises because of its
relatively low reliance on computerized systems. The Company is doing everything
technologically possible to assure its computers function properly upon the turn
of the century. Compliance is to some extent dependent upon vendor cooperation.
Preliminary estimates of the compliance-related costs, based on internal
projections, are approximately $15,000. The Company recognizes that any Y2K
system related compliance failures could result in additional expenses to the
Company, the materiality of which cannot be predicted at this time.
13
The Chalone Wine Group, Ltd.
Item 3. Disclosures About Market Risk
You should carefully consider, among other factors, the matters described below
before purchasing any Chalone common stock. This list of factors is not
exhaustive.
Our Revenues and Operating Results Fluctuate Significantly from Quarter to
Quarter
As a result, we believe that period-to-period comparisons of our operating
results are not necessarily meaningful, and cannot be relied upon as indicators
of future performance. In addition, there can be no assurance that our revenues
will grow or be sustained in future periods or that we will maintain our current
profitability in the future. Significant factors in these quarterly
fluctuations, none of which are within our control, are changes in consumer
demand for our wines, the affect of weather and other natural forces on growing
conditions and, in turn, the quality and quantity of grapes produced by us,
interest rates and other business and economic conditions. Additionally, our
sales volume tends to be affected by price increases, distributors' inventory
levels and the timing of releases for certain wines, among other factors.
Consequently, we have experienced, and expect to continue to experience,
seasonal fluctuations in revenues and operating results.
A large portion of our expenses are fixed and difficult to reduce in a short
period of time. In quarters when revenues do not meet our expectations, our
level of fixed expenses tends to exacerbate the adverse effect on net income. In
quarters when our operating results are below the expectations of public market
analysts or investors, the price of our common stock may be adversely affected.
Our Profits Depend Largely on Sales in Certain States and on Sales of Certain
Varietals
In the nine months ended December 31, 1998, approximately 70% of our wine sales
were concentrated in 20 states. Changes in national consumer spending or
consumer spending in these states and other regions of the country could affect
both the quantity and price level of wines that customers are willing to
purchase.
Approximately 92% of our net revenues in the nine months ended December 31, 1998
were concentrated in our top four selling varietal wines. Specifically, sales of
Chardonnay, Pinot Noir, Cabernet Sauvignon and Merlot accounted for 58%, 11%,
16% and 7% of our net revenues, respectively, for the nine months ended December
31, 1998.
Our Competition May Harm Our Business
The premium table wine industry is intensely competitive and highly fragmented.
Our wines compete in all of the premium wine market segments with many other
premium domestic and foreign wines, with imported wines coming primarily from
the Burgundy and Bordeaux regions of France and, to a lesser extent, Italy,
Chile, Argentina, South Africa and Australia. Our wines also compete with
popular-priced generic wines and with other alcoholic and, to a lesser degree,
non-alcoholic beverages, for shelf space in retail stores and for marketing
focus by our independent distributors, many of which carry extensive brand
portfolios.
Additionally, the wine industry has experienced significant consolidation. Many
of our competitors have greater financial, technical, marketing and public
relations resources than we do. Our sales may be harmed to the extent we are not
able to compete successfully against such wine or alternative beverage
producers.
Our Business is Seasonal
Our business is subject to seasonal as well as quarterly fluctuations in
revenues and operating results. Our sales volume tends to increase during the
summer months and the holiday season. Our sales volume typically decreases after
the holidays. As a result, our sales and earnings are typically highest during
the fourth calendar quarter and lowest in the first calendar quarter. Seasonal
factors also affect our level of borrowing. For example, our borrowing levels
typically peak during the winter when we have to pay for harvest costs and may
have to make contractual payments to grape growers. These and other factors may
cause fluctuations in the market price of our common stock.
14
The Chalone Wine Group, Ltd.
Item 3. Disclosures About Market Risk (Continued)
Bad Weather, Pests and Plant Diseases Could Harm Our Business
Winemaking and grape growing are subject to a variety of agricultural risks.
Various diseases and pests and extreme weather conditions can materially and
adversely affect the quality and quantity of grapes available to us. This could
reduce the quality or amount of wine we produce. A deterioration in the quality
of our wines could harm our brand name, and a decrease in our production could
reduce our sales and profits. Future government restrictions regarding the use
of certain materials used in grape growing also may also increase vineyard costs
and/or reduce production.
Grape growing requires adequate water supplies. We generally supply our
vineyards' water needs through wells and reservoirs located on our properties.
We believe that we have adequate water supplies to meet the needs of all of our
vineyards. However, a substantial reduction in water supplies could result in
material losses of grape crops and vines.
Many California vineyards, including vineyards in Northern California, have been
infested with Phylloxera, a root louse that renders a vine economically
unproductive within a few years after infestation. The current strain of
phylloxera primarily affects vines of a certain type. Our vineyard properties
are primarily planted to rootstocks believed to be resistant to Phylloxera.
However, we cannot be certain that our existing vineyards or the rootstocks we
are now using in our planting and replanting programs will not in the future
become susceptible to current or new strains of Phylloxera, plant insects or
diseases, any of which could harm our business.
We May Not Be Able to Grow or Acquire Enough Quality Grapes for Our Wines
The adequacy of our grape supply is influenced by consumer demand for wine in
relation to industry-wide production levels. While we believe that we can secure
sufficient supplies of grapes from a combination of our own production and from
grape supply contracts with independent growers, we cannot be certain that grape
supply shortages will not occur. A shortage in the supply of wine grapes could
result in an increase in the price of some or all grape varieties and a
corresponding increase in our wine production costs.
Industry trends point to rapid plantings of new vineyards and replanting of old
vineyards to greater densities, with the expected result of significantly
increasing the supply of premium wine grapes and the amount of wine which will
be produced in the future. This expected increase in grape production could
result in an excess of supply over demand and force wineries to reduce or not
increase prices.
We Depend on Third Parties to Sell Our Wine
We sell our products primarily through independent distributors and brokers for
resale to retail outlets, restaurants, hotels and private clubs across the
United States and in some overseas markets. To a lesser degree, we rely on
direct sales from our wineries, our wine library and direct mail. Sales to our
largest distributor and to our nineteen largest distributors combined,
represented approximately 5% and 36%, respectively, of our net revenues during
the nine months ended December 31, 1998. Sales to our nineteen largest
distributors are expected to continue to represent a substantial portion of our
net revenues in the future. We use a broker in order to sell our wines within
California. Such sales represent 31% of our net revenues during the nine-month
period ended December 31, 1998. The laws and regulations of several states
prohibit changes of distributors, except under certain limited circumstances,
making it difficult to terminate a distributor without reasonable cause, as
defined by applicable statutes. The resulting difficulty or inability to replace
distributors, poor performance of our major distributors or our inability to
collect accounts receivable from our major distributors could harm our business.
New Regulations or Increased Regulatory Costs Could Harm Our Business
The wine industry is subject to extensive regulation by the Federal Bureau of
Alcohol, Tobacco and Firearms and various foreign agencies, state liquor
authorities and local authorities. These regulations and laws dictate such
matters as licensing requirements, trade and pricing practices, permitted
distribution channels, permitted and required labeling, advertising and
relations with wholesalers and retailers. Any expansion of our existing
facilities or development of new vineyards or wineries may be limited by present
and future zoning ordinances, environmental restrictions and other legal
requirements. In addition, new regulations or requirements or increases in
excise taxes, income taxes, property and sales taxes or international tariffs,
15
The Chalone Wine Group, Ltd.
Item 3. Disclosures About Market Risk (Continued)
could reduce our profits. Future legal or regulatory challenges to the industry,
either individually or in the aggregate, could harm our business.
We Will Need More Working Capital to Grow
The premium wine industry is a capital-intensive business which requires
substantial capital expenditures to develop and acquire vineyards and to improve
or expand wine production. Further, the farming of vineyards and acquisition of
grapes and bulk wine require substantial amounts of working capital. We project
the need for significant capital spending and increased working capital
requirements over the next several years, which must be financed by cash from
operations or additional borrowings or other financing.
Adverse Public Opinion About Alcohol May Harm Our Business
A number of research studies suggest that various health benefits may result
from the moderate consumption of alcohol, but other studies suggest that alcohol
consumption does not have any health benefits and may in fact increase the risk
of stroke, cancer and other illnesses. If an unfavorable report on alcohol
consumption gains general support, it could harm the wine industry and our
business.
We Use Pesticides and Other Hazardous Substances in the Operation of Our
Business
We necessarily use pesticides and other hazardous substances in the operation of
our business. Although we take many precautions to minimize and manage the risks
of contamination, if hazardous substances are discovered on, or emanating from,
any of our properties and their release presents a threat of harm to public
health or the environment, we may be held strictly liable for the cost of
remediation. These costs could harm our business and reduce our profits.
Contamination of Our Wines Would Harm Our Business
We also are subject to certain hazards and liability risks, such as potential
contamination, through tampering or otherwise, of ingredients or products.
Contamination of any of our wines could result in the need for a product recall
which could significantly damage our reputation for product quality, which we
believe is one of our principle competitive advantages. We maintain insurance
against these kinds of risks, and others, under various general liability and
product liability insurance policies. However, our insurance may not be adequate
or may not continue to be available at a price or on terms that are satisfactory
to us.
The Loss of Key Employees Would Damage Our Reputation and Business
Our success depends to some degree upon the continued services of a number of
key employees. Although some key employees are under employment contracts with
us for specific terms, the loss of the services of one or more of our key
employees could harm our business and our reputation, particularly if one or
more of our key employees resigns to join a competitor or to form a competing
company. In such an event, despite provisions in our employment contracts which
are designed to prevent the unauthorized disclosure or use of our trade secrets,
practices or procedures by such personnel under these circumstances, we cannot
be certain that we would be able to enforce these provisions or prevent such
disclosures.
Shifts in Foreign Exchange Rates or the Imposition of Adverse Trade Regulations
Could Harm Our Business
We conduct some of our import and export activity for wine and packaging
supplies in foreign currency. We purchase our foreign currency on the spot
market on an as-needed basis and engage in limited financial hedging activities
to offset the risk of exchange rate fluctuations. There is a risk that a shift
in certain foreign exchange rates or the imposition of unforeseen and adverse
trade regulations could adversely impact the costs of these items and have an
adverse impact on our operating results.
In addition, the imposition of unforeseen and adverse trade regulations could
have an adverse effect on our imported wine operations. We do not believe that
our foreign exchange risk and international operations exposure is material at
this time, but the volume of international transactions is increasing and may
increase these risks in the future.
16
The Chalone Wine Group, Ltd.
Item 3. Disclosures About Market Risk (Continued)
Infringement of Our Trademarks May Damage Our Brand Names or Our Business
Our wines are branded consumer products, and we distinguish our wines from our
competitors by strong and vigilant enforcement of our trademarks. There can be
no assurance that competitors will refrain from using trademarks, tradenames or
trade dress which dilute our intellectual property rights, and any such actions
may require us to become involved in litigation to protect these rights.
Litigation of this nature can be very expensive and tends to divert management's
time and attention.
We May be Harmed by "Year 2000" Hardware and Software Problems
Many currently installed computer systems and software products are coded to
accept only two-digit entries in the date code field and cannot reliably
distinguish dates beginning on January 1, 2000 from dates prior to the year
2000. Many companies' software and computer systems may need to be upgraded or
replaced in order to process correctly dates beginning in 2000 and to comply
with the "Year 2000" requirements. We are reviewing our information systems for
any potential problems that might arise as a result of these requirements and do
not believe such systems will be affected by the upcoming change in century.
However, we use third-party equipment and software that may not be Year 2000
compliant. If such third-party equipment or software fails to process dates for
the year 2000 and thereafter properly, such a failure could cause us to incur
unanticipated expenses to remedy any problems, which could harm our business. In
addition, we rely on various service providers, including banks and
distributors. The software and computer systems of any of these entities could
have Year 2000 problems. A disruption in the supply of services or products we
receive from any of these entities due to Year 2000 problems could harm our
business.
The Market Price of Our Common Stock Fluctuates
All of the foregoing risks, among others not known or mentioned in this report,
may have a significant effect on the market price of the our shares.
Additionally, stock markets have experienced extreme price and volume trading
volatility in recent months and years. This volatility has had a substantial
effect on the market prices of securities of many companies for reasons
frequently unrelated or disproportionate to the specific company's operating
performance. These broad market fluctuations may reduce the market price of our
shares.
17
The Chalone Wine Group, Ltd.
PART II. - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
Exhibit Number
--------------
27 Financial Data Schedule
(b) Reports. None.
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Dated: February 12, 1999 The Chalone Wine Group, Ltd.
- ------------------------ ----------------------------
(Registrant)
/s/ Thomas B. Selfridge
------------------------------------
Thomas B. Selfridge
President and Chief Executive Officer
Dated: February 12, 1999 /s/ Francois P. Muse
- ------------------------ ------------------------------------
Francois P. Muse
(Acting) Chief Financial Officer and
Treasurer
18