As I mentioned in my previous article, The Duckhorn Portfolio, Inc. (NYSE: NYSE: NAPA) (the “Company”) is a producer of luxury wines, or wines priced at $15 or more per 750ml bottle, in North America.
Especially these days, supply chain analysis is very important and for this reason I have tried to understand the potential issues that the company may face in the future along its supply chain. ‘supply. Below, from left to right, you can see a representation of the typical wine supply chain.
- Winemaker: in the short term, this step is not a problem for two reasons: first, because most of the grapes are purchased from third-party winemakers (more than 322 counterparties worldwide); second, because of the oversupply of grapes (and therefore I don’t expect any short-term pressure on margins). If we think long term, however, we can identify a clear challenge that the industry could face, water scarcity. Water shortage, combined with other unfavorable weather conditions, can have a negative impact on the supply of grapes and therefore on the price of this product. As the Company is not engaged in commodity hedging, this could adversely impact its margins.
- wine producer: this is the step in charge of the Company.
- Bulk Wine Dispenser: this stage may represent a future challenge for the Company due to the consolidation of the sector, through M&A, which gives bulk wine distributors strong contractual power.
- Filler/Packer: this stage is not a major issue for the Company due to strong diversification of suppliers and the purchase of these inputs through relatively long-term contracts that cap the increase in these elements. Indeed, the glass bottles come from Mexico and China (even if the objective of the Company is to have glass bottles coming 100% from the United States), the cork comes from Portugal and the metal components of packaging comes from USA and EU.
I think the company is currently in between the “high growth” and “mature growth” phases, with the latter being the most likely. It does not belong to a fast growing industry. In fact, the global wine market is expected to grow at a CAGR of 5.52% in the next 10 years, while the United States grows at a CAGR of 6.80%but I see enough room to grow within this slow growing industry.
Indeed, thanks to premiumization (or switch to more expensive wines), customers become more aware of wine quality health benefitsefficient marketing to appeal to younger generations as well as its continued expansion into the United States (the largest consumer of wine in the world) and Canada (the two markets I believe the company should primarily target) will allow the company to grow in this industry low growth by taking control of the market share of competitors.
Additionally, total wine per capita in the United States continues to grow at a steady rate.
Analysis of financial statements
Below is a summary of key statement data.
As you can see from the numbers, the company has positive free cash flow, which is good, but not as good as it could be if the company were able to unleash its full potential. In fact, by analyzing the cash conversion cycle, we can identify some of the issues that cannot be assessed by just looking at the free cash flow count.
As you can see, net working capital is positive, which is good in theory, since our current assets are growing at a faster rate than our current liabilities, however, it’s not so good from a cash flow since more cash is tied to operations. So I asked myself a question: “Is there a way for the company to improve its free cash flow by effectively managing its net working capital? the answer is Yes..but with a caveat. Indeed, by increasing the number of days it takes on average to pay its suppliers (the “easy” part) and by reducing the time it takes on average to collect credit from its customers (the “difficult” part ) it can improve its free cash flow structure. The latter, however, is the most difficult part due to the company’s customer concentration risk which leaves the company without selling power/bargaining leverage. In fact, as you can see below, the top 5 customers account for over 45% of the company’s total revenue.
For the rest of the analysis, I attempted to assess the financial health of the company. Overall, the Company is in very good health with a a solid balance sheet and solid figures for turnover and net income. The the interest-bearing debt component is very low and the ROE is currently 7.5% against a cost of equity of 8.45%.
How much do we expect to earn?
In order to answer the question above, I performed a discounted cash flow analysis under 3 different scenarios and at the end I calculated the probability weighted target price. The target price is $27.50/share.
The three scenarios with their respective probabilities are:
- Downside scenario (15% probability) – $17.59/share: In this scenario, the Company’s current valuation does not reflect any upside. This scenario assumes a positive price/mix ratio with on-site converging towards its historical norms but remaining below them. The impact of inflation is much higher than initially expected, resulting in a compression of the profit margin. Finally, I also assume that customers retain purchasing power due to the Company’s inability to diversify its customer base.
- Base case (55% probability) – $25.51/share: This is where the consensus lies. This scenario assumes a slightly positive price/mix, strong growth in offsite volumes, offsite to onsite returning to its historical 80-20 norm, and a take-off of the e-commerce segment. The impact of inflation is in line with current expectations and is effectively managed by raising prices which does not affect aggregate demand.
- Bull-Case Scenario (30% probability) – $36.09/share: This is where the real opportunity lies. This scenario assumes a negative price/mix demonstrating that increased sales volumes continue to be the primary revenue driver. In fact, the pace of offsite volume growth is strong, and onsite continues to grow at a steady state. The impact of inflation is effectively mitigated and the Company is able to effectively reduce its customer concentration risk and increase the value of its free cash flow. Finally, an effective marketing campaign attracts new young customers.
Finally, below you can see the numbers obtained in my base scenario.
The competition is represented by established and well-known companies, many of which are private. In particular, in the United States, wine sales are relatively concentrated on a limited number of large suppliers such as E&J Gallo, Constellation (STZ), Trinchero, Jackson Family Wines, Ste. Michelle and the wine group.
Inflation risk (short term): if not effectively managed, inflation can be a strong headwind and lead to margin compression. According to the latest updates provided by management, so far inflation has not been a big headwind, with the company seeing its effect through relatively higher prices for glass, higher costs for new equipment (this is why management has provided an updated CapEx number which is driven by higher cost of new equipment), higher travel costs (for vendors).
Recession Risk (short term): I put it in the risk category even though I don’t see it as a real headwind for the Company. Historically, the wine sector has performed very well despite the period of recession. Additionally, the Company’s focus on high-end customers should provide better protection against an industry’s declining demand. Below, you can see the sales growth rate of premium wineries since 2000.
Customer concentration risk (short to long term): In my opinion, this is the biggest headwind I see for the company since without customer diversification, it cannot create “selling power” and this can negatively affect the dollar value per sale.
Access to water (long term): this is a very big challenge as the water supply becomes less secure and can turn into severe shortages. Water shortages could lead to higher grape prices and thus adversely affect the Company’s overall profitability.
On-site / e-commerce: Currently, we are well below the historical off-site to on-site norm, however, it continues to return to pre-COVID levels. Recalling that on-premises/e-commerce has a higher dollar value per sale and higher margins, if the business is able to grow its on-premises and online commerce effectively, it will be a big tailwind for its turnover and results.
Premiumization: Over the past decade, wine drinkers have spent more money on bottles of wine. This trend can be interpreted as an entire generation becoming wealthier and older (and therefore willing to buy high quality wine), as a new generation willing to pay more for items perceived as superior, or as a mixture of both. I believe it’s a mix of the two and if the company is able to effectively attract a younger clientele, it will allow them to gain significant market share.
Market expansions: As of December 31, 2021, Canada represents only 1.59% of the Company’s total revenues. If the Society is able to effectively replicate the work it is doing in the United States, Canada will be an important long-term catalyst.
I keep it Rating “BUY” on the stock with a fair value of $27.50/share, implying a 26.6% off against the current price of $20.17.
What do I personally do? With the release of the third quarter results, I reduced my overall position, motivated by the belief that I would see additional downward pressure on the entire stock market, and therefore on the company as well. Since then, I have not increased my stake in the Company. My plan is to increase my participation, if it is affordable and not too expensive at that time, thanks to LEAPS call options.