Impact of Trade War on American Wine

In light of our upcoming case discussion covering the potential export of American wine into the growing Chinese market and looming March 1 trigger for additional tariff introductions, I wanted to dig into the impact on domestic wine producers and exporters. As many of us have been following, the Chinese government has tactfully targeted American export industries to exert maximum political influence in an escalating tit-for-tat trade war (think Harley-Davidson or dairy / beef / corn farmers, all largely based in the battleground upper-Midwestern states). Despite domestic wine production's concentration in the largely left-leaning states of California, Oregon and Washington (of course, setting aside the "emerging regions" discussed earlier!), the industry has actually found itself ensnared in the trade war as well.

In April 2018, China implemented a ~15% tariff increase on American wine in April 2018, which raised the effective China import tax to ~66-68% (N.B.: this compares with the statistic in the case that the fully-burdened import tax in China was 48%, which was written prior to Apr '18). [1, 2] Later last year, as a part of China's $60bn tariff announcement in September 2018, wine was among the subjected goods (joining meat, crops, and industrial products), which was vaguely reported as an incremental ~5-10% hike, accompanied with the threat of it rising to 25% by 2019 (presumably if the current "cease-fire" sunsets on March 1 without a trade deal or bilateral extension). Simple arithmetic would suggest a current "all in" tariff on American wine of ~71-78%, with potential of increasing to ~90%+.

As the case discussed, the combination of a 48% import / consumption tax and VAT significantly ate into wineries' profit, "making Chinese market entry financially unviable for more moderately priced wines". Despite the macro / political overhang, US wine exports to China rose 14% YoY in value for the first six months in 2018, suggesting the continued attractiveness of the rapidly growing Chinese market. [3] However, I'm curious to see how the numbers look for 2H'18 (and more importantly, 2019), as tariff fears have shifted from tail risk to a real financial headwind. Tangentially (though related), I'm also interested in the impact of the more recent shifts in the Chinese domestic market (i.e. crackdown on guanxi as part of anti-corruption measures, as discussed in the case, as well as early indicators of the luxury consumption environment rolling over).

[1] https://www.sfchronicle.com/business/article/California-wine-among-60-billion-in-U-S-goods-13239467.php
[2] https://www.bizjournals.com/sanfrancisco/news/2018/09/19/california-winemakers-china-tariffs.html
[3] https://www.farmprogress.com/grapes/wine-industry-frets-over-additional-chinese-tariffs

Is Older Wine, Better Wine?

Interestingly, most wines produced in the world today are made to be consumed in the near rather than far future. On the other hand, the most expensive vintages tend to be aged. Clearly, there is a correlation between wine age and shelf price - but does this correlation also follow with regards to wine quality?

The most critical factor in the aging of wine are tannins, which alter chemically in response to small amounts of oxygen seeping through the cork over time. Temperature, light exposure, and humidity also play a role, resulting in a limited time window within which a given wine is at its peak. Many aged wines stored in cellars and brought out years later for special occasion have passed this peak, and yet consumers continue to be excited by and pay top dollar for older vintages despite their not necessarily being in the optimal taste phase.

Wine can taste better with age, but only in combination with the right creation processes and storage techniques. If there is a connection between age and wine quality, it is more likely to be found in the concept of scarcity: older wines are rarer, and price follows this traditional demand-and-supply driver accordingly.

Taste For Yourself (some spoilers ahead…)

 I always love to extend this class right on into the weekend – and so last weekend, I watched Somm III (the movie). I was a big fan of the first two, naturally. The third installment brought in several of the themes we’ve learned in class: emerging wine regions, the importance of terroir, warming up too-cold wine with your hands, and the challenges that producers face shipping out of state.

The film focuses on three of the most famous and established oenophiles, Jancis Robinson, Fred Dame, and Steven Spurrier. Steven Spurrier is the merchant who organized the “Judgment of Paris” in 1976 – an event famous for putting California wines on the map, when California wines beat out French wines for both white and red categories (a huge surprise at the time). And Jancis Robinson did for wine what Julia Child did for food.

What was interesting is just how much of a pull these three wine experts have had in the past four decades on global perception of wine, and on just what “quality” means. Critic Jancis Robinson even said that she hated blind tastings, because she was afraid she wouldn’t like a wine, say so, and completely tarnish that producer’s reputation. These experts uncovered totally unheard of wines and launched their producers into prominence with the publishing of a single article!

But at the same time, the three get together to open and taste the original bottles that first spurred their own loves of wine. They blind taste all three, and rank their favorites – each ends up with a different favorite, and each describes the wines in uniquely personal ways.

Even if you listen to the critics, remember that wine is a deeply personal experience – make sure to taste for yourself!

In case you’d like to watch, either come to my place, or find Somm 3 on Amazon Video, YouTube or Google Play. You can watch the first 2 installments on Netflix.

When wine doesn't need descriptors

I came across a great piece in Forbes this weekend about a wine writer's experience stepping away from the nuanced tasting components of a wine to embrace its emotional side.  The story made me think about my own memories.  My grandpa in Taiwan is getting up in age, and when I do have the chance to visit him, there's usually some red wine with the meal.  The wine's usually not paired well with the Chinese cuisine we have nor does it really have a lot of depth, but it doesn't matter to me since I realize my grandpa is enjoying it.

Other times, I recall being deep into a meal and enough glasses of wine in that I probably couldn't land a single descriptor if I tried.  Yet the wine's attitude or personality still sticks with me - I feel the transformation of the wine especially if it's an old one as new sensations emerge with time.  It makes me think about how there remains more opportunities for the industry to adjust its tourism packages to bring about wonderful associations even with cheaper, more accessible wines.

Business in China and Risk Pricing

Unfortunately, I have to miss class this week. So, I wanted to do a bit of research on the China topic, since I found it interesting. I reached out to one of the Napa wineries mentioned in the case (not Frederick) and spoke with the person who runs their export business. This winery had chosen the logistics partner option and worked with Gliding Eagle for a couple of years when they first entered China. After some disappointing performance, they moved to Napa Reserve as their logistics partner for a spell. Turns out that the China performance was only partially due to the partners and that a lot of the problem was China itself and trade with the country. The winery end up pulling out of the country entirely about four years ago when China imposed a 14% tariff on U.S. wines. This has since risen to 29%. Even before the latest tariff, U.S. share of China's wine declined in actual (volume) and relative (share) terms significantly -- the winery I spoke to was not alone in its pain. (source)

Bringing it back to the case, I'd point out that the difference between discounted cash flows of the (high or ~100% probability) bulk grape sale cash flows and the potential China cash flows becomes negligible when you use appropriate discount rates. Specifically, there's no difference in NPV when you price China ~15% higher (in discount rate terms) than the bulk option (depending a bit on your probability-weighting for the China scenarios). Such a gap in discount rate is fair, in my opinion, given the different risk profiles, which you see play out in the above winery’s experience.

To round things out, I would be curious to hear how grape prices in Napa have trended. There’s not more land being added to the Napa AVA, as far as I’m aware, and I was surprised to see flat prices in the bulk forecast at ~$5,900 per ton. A friend at a (different) upper/mid-tier Napa operation using very similar grapes to Frederick’s pays closer to $6,500 per by this point, for example. Therefore, I think the default option of bulk sales is understated in its attractiveness. 

The Great French Wine Blight

Grape Phylloxera. What the heck is that? We keep talking about it as if it is a commonly known event/disease/thing that I don't even know enough to classify. I certainly didn't know what it was and I have been faking it the last few weeks, acting like I did. Even worse, I cannot pronounce it! So I decided to do some basic Wikipedia-ing to find out! Here is what I learned:

The "disease" was brought across the Atlantic from the States to Europe in the late 1850s and it was first recorded in France in 1863 in Languedoc. The aphid (insect) that caused the damage, however, was known to the French much earlier and was first discovered by the French themselves in their plantations in Florida in the 16th century. as they tried to plant grape vines there, but failed quickly. The Phylloxera is a pest that injects a venom that is very deadly to the European variety of grape vine. The toxin the bug releases targets the root structure of the vine and quickly corrodes it, allowing the bug to insert its feeding tube and extract the sap. The insect then moves on as soon as it has had its fill, making it hard for the vintners to discover the cause at first. But how did it finally cross the Atlantic? It is believed that the invention of the steam ship allowed quicker transport of American vines to Europe, which the Europeans had been experimenting with for years. The quicker journey gave the aphids better chances of surviving and led to their arrival in the mid 19th century. After trying many solutions, including positioning toads and fowl near the vines to get them to eat the insects, ultimately Americans and French together discovered that by grafting the European vines to the to the aphid-resistant American rootstock, they could save the European vine stock. The process / event of saving the European vines became known as the "reconstitution" by the European grape growers. In modern day, there is no known cure for the blight, and the only way to prevent it is to use grafted vines. The only exception is a vine that grows in Santorini, however, people believe it has more to do with the volcanic ash in which the vines are planted, and not the roots themselves. While most European vines are now grafted, some still remain ungrafted and untouched by the blight, sparking a debate as to which produces better wines. Bollinger is one such vineyard that uses ungrafted vines. I say, let's test them all and find out!

Canned Wine

After finding myself once again coming to the defense of canned wine this past weekend, I felt compelled to bring myself up to speed on the new phenomenon (as my friends can confirm, lack of knowledge rarely discourages me from picking sides). While still striking many as a novelty (Neilsen estimates canned packaging to only comprise ~0.2% of the US off-prem sales), the canned market has actually been booming over the past couple years (+59.5% YoY in 2017). [1]

I was first introduced to canned wine about 12 months back in my local San Francisco grocery store, and was immediately struck by its convenience: its portion size was perfect for a Saturday afternoon at Fort Mason (admittedly, the back of the can says 2-2.5 servings), and it was easy to carry / dispose of without the added headache of a glass bottle.

While beer and other beverages have been retailed in cans for some time now, canning still wine has required a recent step-forward in material science. In addition to a specially designed resin liner on the inside of the can (you never want the wine to touch the aluminum can), canned beverages need to be manufactured in a sturdy way. While beers and soda have the benefit of carbon dioxide (which creates a high pressure level inside a sealed can), wine requires liquid nitrogen (harmless to the health of the wine and consumers) to re-create equivalent pressure levels inside the can. Recent advances in cost-effective manufacturing techniques for both the resin liner and use of liquid nitrogen have allowed quality canned wine to become reality. [2]

In fact, there may also be quality and environmental benefits as well. As the packaging's (non-aesthetic) goal is to prevent the air and light from contaminating the wine, aluminum cans' UV resistant exterior and air-tight design are actually a cost-effective option for producers (particularly those small scale wineries looking to minimize packaging costs). Additionally, as canned wines reduce total weight on a volumetric basis, this also results in fuel cost savings for wineries (cans are also much easier to stack, which could drive additional transportation / handling cost savings through the logistics chain). [3]

If you're convinced, here's a list of top canned wine options: https://vinepair.com/buy-this-booze/10-best-canned-wines-2018/. In addition, I'm partial to West + Wilder as it's what I started off with (available at K&L in Redwood City).

Sources:
[1] https://www.nielsen.com/us/en/insights/news/2018/heard-it-through-the-grapevine-wine-trends-to-watch-for-in-2018.html
[2] http://palatepress.com/2015/12/wine/the-some-science-behind-canned-wine/
[3] https://www.chowhound.com/food-news/216899/is-canned-wine-the-new-boxed-wine/