Future of the US Wine Industry

Interview with Rob McMillan of the Silicon Valley Bank

In an exclusive broad-ranging interview for Meininger’s, Rob McMillan of the Silicon Valley Bank offered Robert Joseph, editor at large of Meininger’s Wine Business International, a view of the current and future of the US wine industry from the perspective of an informed financial analyst.

Reading time: 12m 40s

Rob McMillan
Rob McMillan
Rob McMillan

Rob McMillan, ‘banker to the US wine industry’, launched the wine division of the Silicon Valley Bank’s wine division and became its managing director in 1991. Before that, he had received an MBA from the Santa Clara University Leavey Business School and worked at the bank of America. For the last 17 years, he has published an annual report on the US industry that is widely regarded as essential reading by producers and distributors (HERE). He is also a regular speaker at a broad range of events, and known for the frankness with which he expresses his views.

Meininger’s: Obviously, no one knows what the full economic impact of the Russia-Ukraine war will be, and the picture is changing from one day to the next but, as a banker, looking back to previous crises and knowing the state of the wine market now, what kind of informed outlook would you be sharing with your customers?

McMillan: War’s impact on alcohol consumption is country-specific, dependent on economic impact, government promotion or restriction of consumption, destruction of productive capacity, and the culture within the country. In alcohol-consuming countries, demand for alcohol often increases during a war, unless the resources of a country are stretched from the conflict.

During WWII, distillers in the US produced alcohol to fuel torpedoes. That in turn limited the availability of whiskey, driving up the price. Living in a world of rationing, a family in the US would need to make decisions between alcohol or food and obviously, food won out. But the front lines weren’t in America. Wine in occupied France during WWII was impacted by German looting, economic hardship, vineyard loss, and the occupier’s restrictions on consumption. Adding the military’s consumption to the calculation such as the provision of a ration of rum by the British, a ration of wine for French soldiers, or the availability of beer for American service personnel increases consumption. No matter the conflict, soldiers reliably seek coping mechanisms during the conflict, and alcohol historically has been one method.

The impact of this war has yet to play out fully. It could escalate, move to a stalemate, or hopefully end. The impact of the war on wine consumption will be like others – country-specific and dependent on how many resources are needed by combatants to fight it. It’s perhaps too clinical to talk about wine consumption, given the thousands of deaths and millions of lives impacted by this war. Nothing good is coming from it. But focusing on the narrow question of consumption, wine has always proven to be recession-resistant.

It’s perhaps too clinical to talk about wine consumption, given the thousands of deaths and millions of lives impacted by this war. Nothing good is coming from it.

But focusing on the narrow question of consumption, wine has always proven to be recession-resistant.

Ukraine is not a significant producer or consumer. Russia is a large country so economic sanctions could impact their consumption pattern. At this point however, I don't expect a negative impact on world wine consumption so long as the war doesn’t escalate.

 

Meininger’s: Wine tourism took a major hit during the pandemic but even in 2019, there were already indications that there were too many winery tasting rooms competing for the same visitors. Now, as fuel prices rise, we may be seeing people doing less travel. Will this be a factor for wineries?

McMillan: In the US, higher fuel prices will be passed on to consumers, but inflation shouldn't impact total demand if the economy remains resilient as has been the case during the pandemic.

If there is one thing the pandemic lockdown proved, it is that the wine consumer will still find the channel to get their wine. If there is a headwind to tourism in wine country during this endemic phase, it will likely come from competing tourist options opening.

2020 was the year consumers increased their savings rate. 2021 was the year people came out from lockdowns and started living life but in a still-restricted travel environment. With few alternative tourism options in 2021, tasting rooms in wine country benefited and were often reserved several weeks in advance. 2022 should lead to more competition from other venues as travel and entertainment options increase and travel restrictions gradually subside worldwide.

SVB Annual Winery Conditions Survey: Change in price (Source: Nielsen)
SVB Annual Winery Conditions Survey: Change in price (Source: Nielsen)

Meininger’s: Looking at the wine industry today, you have giant producers like Constellation that have a foot in the beer, spirits and even cannabis markets as well as wine, and small wineries that struggle to imagine doing anything other than ferment the grapes from their own vineyards. How do these businesses compete within the same market?

McMillan: I don’t see heavy production companies that manufacture and sell inexpensive wine as full competitors for small wineries producing higher-priced premium wine. Wines sold for less than $11 are falling in volume by 10% today. Wines above that are seeing a remarkably strong operating environment. The customers buying more expensive wine aren’t generally the same as those buying cheaper wine.

If spirits continue to take share from those wine companies, they are more likely to move more of their operation into spirits or beer and away from wine.

The advantage large beverage companies have though is the ability to increase advertising to stimulate demand. They also can roll up wineries producing higher priced wine such as the Prisoner and move away from segments that are failing. For example, if spirits continue to take share from those wine companies, they are more likely to move more of their operation into spirits or beer and away from wine.

Smaller wineries on the other hand are committed to remaining with wine and thank goodness they have direct-to-consumer sales options and good consumer demand.

 

Meininger’s: As the trend to DTC – Direct to Consumer - grows, and away from traditional retail and on-premise, will this affect the nature of the wines and the businesses selling them? For example, does the hand-selling this involves allow greater moves towards experimentation with unfamiliar grapes, and more blends, for example?

McMillan: DTC for US wine companies has been a godsend for the small producers over the past 20 years, but the strongest growth in DTC today comes from larger wine companies. They have the money to invest in systems, find efficiencies and improve customer engagement using analytics.

Total volume declines also are changing companies. Wines under $11 retail are seeing double-digit drops in volume in the US. That will impact margins in large production facilities if they are not fully utilized. But the reduction in volume sold may in the final analysis have an even larger impact with distributors who aren’t set up to take advantage of DTC and see that channel as a competitor to three-tier sales. Large distributors need volume to fill their trucks and trains to see growth.

 

Meininger’s: In the 2008 recession, many people suggested that the days of the conspicuous spending on astronomically-priced luxuries like $300 bottles of wine were over. They were obviously wrong, but do you believe price elasticity is inexhaustible?

McMillan:

Wine as a product is an economic paradox as it acts both as a commodity and a luxury good. At the low-price part of the business, wine is inelastic. A small increase in price can lead to a large decline in volume, and those wines are more prone to change from competitive shifts in substitutes. The demand curve for those goods is almost horizontal. On the other hand, for collectible and luxury wines the demand curve is almost vertical, such that an increase in price has no impact on volume sold.

What we are witnessing is declining sales below $11 and improving sales above that by value. Those high-priced goods are largely purchased by consumers who have established wealth and income. We will always have the wealthy so there should be demand for wines that are rare and possess a strong brand. Today that wealth skews to the large cohort of ‘baby boomers’ [born 1946-65]. But as those older wine-loving consumers sunset and are replaced by younger consumers who see beer and spirits as pure substitutes for wine, we should expect price pressure even on expensive bottles.

Plans to mitigate drought (Source: SVB Annual Winery Conditions Survey)
Plans to mitigate drought (Source: SVB Annual Winery Conditions Survey)

Meininger’s: And at the other end of the scale – the bit of the US wine industry we don’t like to talk about as much – there are the entry-level wines that are produced in the Central Valley. Given the increasing challenges of water provision, how sustainable do you think those businesses really are. Wouldn’t it make more sense to import those kinds of wines from elsewhere?

McMillan: Some businesses are sustainable, and others aren’t. In the decades I’ve been in the wine business, I’ve watched the volume of imported wine move from 12% of domestic consumption to about 40% today. At the commodity end of the business, chardonnay from the US, Australia, or Chile is all the same. But with US labor and land prices significantly higher in the US, many large producers import foreign wine in bulk to put into their domestic brands. The impact is a reduction in acres planted to grapes in those regions producing grapes that compete with commodity wine from elsewhere. Those vineyards are not sustainable in the current model.

Water is a huge issue not only for wine but for all crops. Many factors can be mitigated in farming, but no water is not one of them.

California has always had to deal with drought, but the past ten years have produced more drought years than wet years. 2021 was the driest year in California since 1924, and the first two months of 2022 are the driest on record. In what is shaping up to be the 3rd consecutive year of drought in California, water deliveries are being reduced to 15% of contracted supply. But surface water isn't the only issue. There are well-documented issues with the aquifer in the region.

That combination of factors leads to fewer or more costly water options for farmers. You can see the impact of the water policy and drought with acres of dead trees along Highway 5 in Southern California.

All that said, properties are not all water deficient. For those with water, water-saving farming techniques are more critical, as is the choice of crop to plant. If there is water available, that ground can be used for several different tree crops specifically, almonds, pistachios, and pomegranates. It’s a math calculation for those properties with the inputs being the cost of farming different permanent crops, the water demand from those permanent crops, offset by the tons per acre produced and the price per ton.

Sales channels (Source: SVB Annual Winery Conditions Survey)
Sales channels (Source: SVB Annual Winery Conditions Survey)

Meininger’s: US wine distribution is in a very small number of hands. Is this sustainable? And do you see the three tier system surviving?

McMillan: The three-tier system in the US is a vestige of the repeal of Prohibition. Consolidation in the past 20 years has led to distributors capable of satisfying nation-wide demand from chains. But with lower-priced wine volumes coming into a period of decline, those large firms are now at a disadvantage. Other factors that will impact the wholesale tier are DTC sales, automation, and online sales.

Three-tier will always have a place because large wine companies need their abilities to move boxes. The channel will undoubtedly evolve over the next decade though.

 

Meininger’s: Many of the wineries we all know in California were founded by boomers whose children may not be as eager to take on the long-term responsibility of running them. Are we going to see a growing number of sales? And will the buyers include a growing number of overseas players like the Korean business that recently bought Shafer?

McMillan: Twenty years ago, I wrote a piece that predicted within 10 years, half of the industry would transition to new ownership or the next generation. That turned out to be true, but the remainder have been transitioning over the past decade.

2021 was probably the most active year in M&A in the US wine business. 2022 should continue to see good transaction volume.

Passing a winery down to the next generation is impacted by having heirs, their willingness to take over, and their ability to operate the business. Those are difficult hurdles. We’ve seen more examples of wineries going to a new owner compared to seeing the next generation taking over.

Over the past decade, buyers have been foreign strategics, domestic strategics, and wealthy individuals. The addition to that has been a large increase of investor pools of money into the vineyards, as well Private Equity.

 

Meininger’s: US wine producers potentially have three sets of customers. The ones in the US they supply directly; the US ones they supply through the Three Tier system – and exports. How do you see that pattern evolving looking forward into the short and medium term?

McMillan: Increasingly the larger wineries will move toward DTC as a channel. Smaller wine companies will continue their focus on DTC with enhanced electronic systems supporting improvement in engagement and efficiencies.

Exports have largely been driven by larger companies selling inexpensive wine. Smaller domestic wineries have had the home-court advantage of making wine in a dominant consuming country so haven’t dedicated significant time on the export market. If you can sell everything locally, why export?

The pandemic was a trying teacher. One lesson it had to teach was the risk of depending too much on any one channel. Developing all the channels is become something smaller companies are perusing. With changes in demand patterns and population, we see smaller wineries develop more export business.

 

Meininger’s: Philip Bowman, former head of the 1990s drinks multinational Allied Domecq, once told me that public ownership – with the need to present annual and quarterly results to fickle shareholders – worked well for spirits but was basically incompatible with the wine business. How do you feel about that?

McMillan: Public ownership of wineries has been at odds with the wine business historically.

  • We aren’t a quarter-to-quarter business while Wall Street is.
  • There are limits to growth in the wine business. If you run out, unlike spirits you can’t just turn on the tap. And when consumers want better wines in smaller lots, production is narrowed into increasingly smaller regions.
  • Return on assets in the wine business isn’t great because of the high costs of vineyards and to a lesser extent equipment that goes idle for long periods of time. Public companies try and balance control of vineyards with the need for ownership. If they can have no vineyards but retain control of fruit required for a skew, that is the best outcome.
  • The winery probably doesn’t need to own vineyards if they are making commodity wines, but if you are chasing the consumer into higher quality wines, those often require ownership of land to retain consistent flavour profiles.
  • There aren’t many stock analysts that can focus on the wine business.

 

Meininger’s: Venture capitalists get a bad rap for their short-term approach, but it could be argued that their ability and readiness to pump cash into the businesses they acquire can be precisely what the wine industry often needs. Does this make any sense to you?

McMillan: The growth in Private Equity ownership has done a couple of positive things for the business.

  • When they come into a business, they focus on making the business run better. That raises the bar for everyone and improves the quality of the labour pool when trained employees move between wineries.
  • With wineries becoming more expensive and the industry more difficult, it’s increasingly hard to find buyers with enough money and capital to make the investment.

The days of a doctor, dentist or attorney buying wineries from farmer/founders is long gone. Private Equity with large pools of cash provides the perfect solution.

Meininger’s: Labour is an ongoing problem for all forms of agriculture. As a banker, looking forward, are you seeing growing investment in automation – both in viticulture and winemaking, and in sales and marketing?

McMillan: The circumstances of expensive and available labour is meeting up with automation. Countries such as New Zealand have had to deal with this issue for decades in farming and are already ahead of the US. That provides a tested path. The other piece of this is the timing of technology advances. Ag-Tech has never had so many problems they can solve and make a profit. The combination of need by the wineries and solutions by technology companies means more automation is coming in all disciplines within the winery.

WineRamp
WineRamp

Meininger’s: You are part of an initiative called WineRAMP to try to “help build “brand wine” in the US marketplace and promote the positive attributes of wine to current and new legal consumers”. Could you say a little more about that?

McMillan: I had been writing about some headwinds the industry is coming upon for many years now, specifically the declining growth rate in sales. Speaking to another analyst friend of mine, we decided to see if we could get 30 executives in a room to discuss the problem. That was in December of 2019. 

The result of that first meeting was near unanimity that a demand issue did exist and even more importantly that something needed to be done. Four analysts who all were seeing the same thing banded together and over the past two- and one-half years, worked with vendors, large wineries, and other important stakeholders, to come up with solutions. 

After raising money for a feasibility study, the larger group settled on a program run under the USDA. It called for an industry-run organization that voted itself into existence and set mandatory assessments. The success rate of this type organization has been impressive in other industries. 

With the project demanding increasingly more time, are we four analysts operating with donated time, the project required some full-time staff. So, we started raising money that could pay staff for the time needed to get this new organization in place. We were able to raise commitments for close to the $1,000,000 needed for the two-year startup period.

The initiative was announced at the back of the SVB State of the US Wine Industry Report and via a live videocast. The response to the initiate was varied, but new persuasive voices emerged and were able to convince a majority to move away from the idea of mandatory assessments.

Today the four analysts are signing up converts on www.wineramp.org and are listening to all the new voices to see if there can be an industry-wide move toward finding a path to promote brand wine. The jury is still out regarding success. 

We aren’t sure if the industry will come together and pick up the challenge the four of us have started and so far, there aren’t other solutions for finding a different structure that can work, but there have been many who’ve been willing to pitch in, and some movement to have more discussion about potential solutions.

 

Meininger’s: In your 2022 report, you talk about the “better for you” health message that wine owned in the ’90s and ’00s having vanished from the consumer’s mind. Some might argue that the recent boom in overtly ‘better for you’ brands like the Clean Wine Co, FitVine and Cameron Diaz’s ‘Avaline are addressing this head-on. To the consternation of the rest of the industry.

McMillan: There is no question wine has lost the mantle of ‘better for you’ that was established for the boomer generation during the 90s. That view came from the 60 Minutes piece on the French Paradox, research on the Mediterranean Diet, and the work of Dr Arthur L Klatsky on the J-Shaped Curve and benefits of moderate consumption. The anti-alcohol movement has done everything possible since then to discredit all positive science and replace the narrative, in some cases with biased science. During the past 20 years, new potential consumers have not had the benefit of that information.

The challenge for the industry is to reinvigorate the message and the positive science about moderate wine consumption. But many of the current ‘better for you’ entrants make the mistake of defining their product as clean, pure, natural, etc., and comparing it with all other wine being made. The message implies that wine other than those self-appointed ‘better for you’ brands is bad for you. That can only lead to a more confused consumer, lower demand for the category and at some point, will backfire on the messengers.

While I appreciate these brands taking action on a message that really needs to change, the approach being used is at best a net-sum-zero game and could lead to worse outcomes for the category as a whole.

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