Silicon Valley Bank

Silicon Valley BankAmericans Are Thirstier . . .The average American drank 2.98 gallons ofwine last year, the highest consumption ratesince the heyday of wine coolers in 1989.Value-priced Australian wines accounted formuch of the 5.2 percent increase in 2003, anddomestic vintages fared better than Frenchcounterparts. Americans drank 11.1 percentless French wine while enjoying domestics ata modest 3.4 percent increase.(Washington Times)The French, ThirstiestMore than 6,000 concerned French vintnersheld demonstrations in mid-December 2004,pleading for government help in offsettingfinancial losses caused by a drop in Frenchwine exports, which dropped more than 5percent in volume (and 9 percent in value)through the end of August. Bordeaux wasparticularly hard-hit, with foreign sales down25 percent. Besides the strong euro, overproduction,and stiff foreign production, theFrench are partly responsible. The averageFrenchman drinks half as much wine as he didin 1961, but still holds onto first place by consuming13 gallons a year. (Los Angeles Times)Loi Evin Gets a MakeoverFrance's National Assembly has approved aneasing of the law regarding alcohol advertising.French wine producers can now advertisecollectively and describe "qualitative" attributes.The sponsoring Democratic Party (UMP)countered critics' concerns by saying that theamendment encourages consumption of qualitywines, not increased consumption overall. Tobecome law, the proposal faces a secondreading in the Senate expected in January 2005.(Media & Marketing Europe)Goodbye Barley, Hello GrapesAfter seven years of expanding sales, theUnited States' $78.1 billion beer market contracted0.3 percent in 2003 (to 2.8 billion, 2.25-gallon cases), while wine consumptionincreased 5.2 percent (to 258.3 million, 9-litercases). Heated competition from spirits andwine, anti-carbdiets, advertising that movedup a notch, and a sophisticated cocktail culturealso contributed to increased wine and spiritsales last year. (BusinessWeek Online)ForecastIn Punxsutawney Phil fashion, we're seeing our shadows today and would expectthe "wine winter" to last until spring arrives in 2006. That said (yes, we are at thebottom of the cycle looking up), trends are improving. Here's the good news:1. Excess supply is improving.2. Overall sales growth at the winery level has flattened for two years now, versusthe year-to-year declines in growth rates we were seeing in prior periods. Atthe high end, there appears to be good growth in sales through the year, andindication sales accelerated at the end of 2004 through the holiday buying season.3. Promotions and allowances are declining somewhat.4. Prognosticators and economic data point to a marginally improving economy,albeit with a weak confidence level.But there's bad news, too:Foreign ExchangeIs there any help expected from a weak dollar? Certainly, French wine exports arehurt by a strong euro. Does that foreshadow greater domestic wine sales at the highend? Only if you believe that European wines are a real substitute for domesticconsumers. In general, we don't think consumers routinely make that trade-off,so we wouldn't expect any help from that angle. Wineries with extensive exportprograms benefit from a weak dollar. Unfortunately, we don't see many West Coastwineries with such programs, so there's not much help there.The largest impact of the dollar's 2004 slide was negative, as demonstrated bywineries that left their euro-denominated purchases of French oak unhedged.Many found they had to pay more than expected when the bill became due.Though strikingly high today, it's still too early to say if the euro's strength willabate or begin to reverse course this year. The structural problems of the dollar,with twin deficits and high oil prices, still mean that, over time, the greenback'sfighting an uphill battle against outgoing cash flows. Investment inflows have togrow considerably for the dollar to be able to maintain this present rally. Fedaction in 2005 to raise the discount rate may attract more inflows, and that mayhelp — but that may not be enough.1. From our position, we still see too much wine inventory at the winery leveland need one more year of better sales to clear it out.2. There are short-term disruptions (arguably a structural problem, too) in distributionresulting from some of the recent large winery purchases. We hearthat some large distributors have lost millions in business because of the winerysales. As a result, some winery accounts are going to be shifting in 2005 toother distributors. That may have a limiting impact on sales velocity to a degree.3. In 2004, wineries are running at about a 2.5 percent, after-tax profit down from5.5 percent in 2003. (Q4 of 2004 is forecast in this estimate). That's enough tocover debt service but not much more, making investments in growth difficult.SummaryTwo things have to happen for the industry to fully recover. First, the growth insupply of grapes has to drop below the demand for wine. Though we are close,that still hasn't happened across all price segments. Second, the remaining stuckinventory has to be absorbed. Until that wine passes through, we will still seedepressed pricing, higher sales and marketing costs, lower gross margins, lowerprofitability, and an uneven recovery through 2005. Expect 2005 to feel eerily like2004 and hope that the harvest for this year is not huge.3svb.com

Silicon Valley BankEconomically SpeakingWine M&A Activity GrowsConstellation, the biggest wine companyin the world, grew bigger with the purchaseof the Robert Mondavi Winery for $1.3billion. That news, which had percolatedfor months, was followed by the announcementof Diageo's intent to buy the ChaloneGroup for about $260 million. By industryestimates, Constellation sold about 66million cases of wine in 2003 under variouslabels. Diageo's wine business will add 13wine properties to their portfolio with theChalone purchase. Golden State Vintnersaccepted an $82 million buyout by theWine Group last April.(Los Angeles Times)Early Harvest DownThe early California grape harvest wasforecast at 2.7 million tons, down 7 percentfrom 2003.(California Department of Food &Agriculture)Raisins Aren't RaisingCalifornia will harvest 11.4 billion poundsof grapes in 2004, just 0.1 percent shy oflast year, forecasts the USDA. It's the 5percent drop in raisin production thatpulled down the stats - with wine grapesonly slightly down (-0.3 percent).(ERS/USDA)A long-range look today indicates that 2006 might be the year when the marketfeels the winter will over and that spring will finally come. Then, those winerieswith appropriately capitalized balance sheets, those who are more profitable, andthose able to access capital will be the ones able to make necessary investments tosupport forecasted growth. Weaker wineries will lag the market strength, as theywill have a more difficult time building inventory.StrategyFor 2005, wineries should consider production plans for 2007 to 2008 with an eyetoward having appropriate inventory levels to take advantage of the expectedchange in the market starting in 2006. That means you may want to start to planyour growth strategies now and determine what risk you are financially able totake in your growth projection. It may be advisable to look at the vineyardcontracts that have the potential to make higher-margin wines — and then extendthose into longer terms.Second, determine the appropriate level of sales and marketing expenses in 2005.Some may be able to reduce those expenses, but in your budgeting consider thatthis may not be the year to expect the wine to sell itself like the "good old days."For many wineries, we would recommend maintaining your sales forces and buildingyour distributor relationships by supporting their sales efforts with your own.For vineyard operations, this is probably the right time to make sure you finishoff vineyard development earlier planned. For existing vineyards, you might wantto remain short on contract duration in 2005 to take advantage of higher-thanexpectedcontract prices in the next couple of years. Locking in longer contractswill be more appropriate in 2006 and, perhaps, later. Our affiliate, Turrentine WineBrokerage is an effective ally in working through a process for your medium- andlong-term contract planning. (Contact Bill Turrentine at 415.209.9463.)Take a look at your French oak purchases to determine the need for new oak versusthe opportunity to use a higher proportion of neutral oak. It may also make senseto blend a higher percentage of American oak barrels with French oak this year -and also to consider hybrid barrels (French barrels with American heads).Additional strategies and alternatives exist and might need to be considered forsome wines at certain price points. Our client, Seguin Moreau, is available to workwith you to select the best strategies for your barrel programs. (Contact JohnForster at 707.252.3408 or jforster@seguinmoreau.com.)Hedging your euro-denominated oak purchases would also be advisable, unlessyou are convinced that you can predict the favorable movement of the euro thisnext year. Most wineries are not equipped to predictably include foreign exchangeincome/loss as a consistent income center, so hedging is a safe and inexpensivealternative to taking on that additional risk. (SVB can help here. Contact yourrelationship manager for details).For all, it appears that we are in an increasing rate environment. This is probablya good time to fix some of your vineyard term debt — particularly now while theshort- and long-term rates are close in range. I would add that it might be advisableto term out some of your working capital positions into long-term real estate toposition your liquidity for the next uptick. (Again, your SVB relationship managercan offer custom solutions for you.)4svb.com

Silicon Valley BankContact UsCall me or drop me an e-mail at any time.Rob McMillanDivision ManagerWine Group707.967.1367rmcmilla@svbank.comOur 11thYearWhat about the Silicon Valley Bank? How did we do? I am pleased to say that weare consistently growing our portfolio of high-end clients, continue to add highlycompetent people to our staff, and are adding new services in Peer Group AnalysisTools, and an Intranet Wine Sales Tool. Both will be of significant value to ourclients. We continue to successfully partner with our affiliate Turrentine WineBrokerage and have entered into a strategic alliance with a company that will assistour clients in their Web-based sales strategies.In 2005, we hope to find bigger accommodations both for our St. Helena and ourSonoma operations to support our growth. (If anyone knows of 10,000 square footof CL1 office space in St. Helena coming up for lease, please let us know.) We arealso working on a plan to have a full time presence in the Pacific Northwest andhave strengthened our commitment to the Central Coast with a fully focused teamof lenders in that market.While many banks have been like the tide in the wine business — announcing theyhave a "Wine Group" during the improving years and then remaining silent in thebad markets — it's with a great deal of pride, as we enter our eleventh year of afocused business, that we can say we are here to stay and prove it daily by workingwith our clients in good and bad times.- The Silicon Valley Bank Wine TeamStatement of the ObviousWe would be remiss if we did not mention that the above comments amount to oureducated guess. We think it's a pretty good one, but we could be entirely wrong. Wecould have missed important facts, and events might yet occur (or future facts cometo fruition) that would entirely change the opinion expressed. Furthermore, much ofthis is a generalization taking averages. Most wineries are not "the average winery,"nor in the same place financially — and not all wineries have the same model orcompetitive pressures. Each person needs to evaluate his or her particular strategyusing his/her own judgment and that of other advisors; do not rely on this alone. Weknow this is not correct. No forecast is, and our data are far from perfect. But, wehope this dialogue helps you plan and evaluate in the coming year.5svb.com