📍 TL;DR

• Vintage Wine Estates has accounting problems, plunging margins, and an ugly balance sheet. Fundamental analysis suggests the stock is a screaming sell.

• But the company and the stock have one enormously valuable attribute: time.

• Turnaround potential is real, and valuation is reasonable if the business improves only modestly.

• VWE looks like a “zero or triple” situation.

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We’ve talked a couple of times this year, most recently on Friday, about the opportunities created by a market driven by fund positioning. That positioning can create dislocations that should be attractive to fundamentally-minded investors with a longer time horizon.

Vintage Wine Estates VWE 0.00 unequivocally is not that kind of opportunity. The stock is, to use industry jargon, an absolute mess. The company, which went public via the de-SPAC route in 2021

Meanwhile, VWE was leveraged ~5x on a net basis based on that guidance that has been withdrawn. Add it all up, and this stock absolutely can be a zero. We’ve been comfortable (and remain comfortable) taking risk in this market, but even by that standard this is a high-risk idea.

Indeed, VWE has probably the most potential for downside of any stock we’ve recommended to this point. But, underneath the mess, there’s a potentially high-quality business here. If new management can find a way to fix current problems and rediscover that business, VWE has probably the highest potential rewards of any stock we’ve recommended as well.

Introducing Vintage Wine Estates

Vintage Wine Estates traces back to the 2000 acquisition of Girard, a high-end winery, by a group led by Patrick Roney. Later that decade, VWE began what essentially has been a mini-roll-up. The company has executed roughly 25 acquisitions, building out a portfolio of over 60 brands driving annual case volume of ~2.5 million and calendar 2022 revenue of ~$312 million.

VWE’s products span price points from $10 — served by Layer Cake, one of its larger and better-known brands — to $150-plus (Swanson Vineyards, Girard, and recently-acquired Kunde, among others). But the company’s core focus is on the $10-$20 range, which accounts for ~80% of its case volume.

Both the capital allocation and go-to-market strategies seem to have an attractive underlying logic. The $10-plus price point represents a “sweet spot” (no pun intended) between cheaper and higher-end markets, which have limitations. In addition, VWE’s core categories grew nicely during the pandemic:

source: VWE/BCAC S-4, May 2021

The wine industry itself seems to have potential for growth. Per capita consumption in the U.S. is still well below that of Europe — in the range of half, depending on the country chosen. And the importance of scale to distribution and profit margins makes a roll-up strategy potentially lucrative. Roney has said that his company generally pays 8x-11x EBITDA for acquisitions — but thanks to synergies (including back-office and sales consolidation), is actually acquiring at multiples closer to 4x-6x. There’s room to expand beyond wine as well: VWE acquired ACE Cider in November 2021 and has floated the idea of cannabis-infused beverages if and when federal legalization arrives.

VWE management describes its business as a “three-legged stool”. It has a direct-to-consumer business (31% of FY22 sales) which sells through on-site tasting rooms, e-commerce, and even U.S. home shopping network QVC (which sells the brand of “Shark Tank” personality Kevin O’Leary, admittedly a strike against the bull case). The wholesale business (29% of revenue) sells to distributors who in turn serve end customers such as grocery stores, liquor stores, and restaurants. The B2B segment (39% of the total; another ~1% comes from ‘other’ revenue) includes private-label offerings from a number of key customers, including Target TGT 0.00, Costco Wholesale COST 0.00, and Albertsons ACI 0.00, as well as outsourced production.

As noted, VWE went public via a merger with a SPAC (special purpose acquisition company). That tie-up seems to help the case for the company’s acquisition potential. The acquirer was Bespoke Capital Acquisition, led by former Diageo DEO 0.00 chief executive officer Paul Walsh. Walsh had an enormously successful tenure at the spirits giant, one defined by a number of successful acquisitions (Seagrams) and divestitures (Pillsbury). With tons of room for further acquisitions — there are roughly 10,000 wineries in the U.S. — the experience and expertise of Roney and Walsh would seem to be valuable assets.

VWE Stock Tanks

For a while, that’s largely how the market saw it. The merger was announced in February 2021, and closed four months later. While many de-SPACs started to tank in the second half of that year, VWE held up. As recently as late June, shares still traded around $9.

Since then, the bottom has absolutely fallen out:

source: finviz.com

The core problem — at least until last week — is that results disappointed. Fiscal 2022 (ending June) was solid, with revenue up 33% (~19% organic). Adjusted EBITDA margins did see some pressure, but given pressure on freight and other factors that wasn’t a huge concern; the figure still increased 21% year-over-year.

But guidance for FY23 disappointed. A couple of quarters after promising ~20% revenue growth (split roughly equally between organic increases and acquisitions), VWE’s outlook implied organic growth of just ~2% to ~6%. Shares tanked 40%. With Q1 results in November, VWE cut its Adjusted EBITDA outlook to just $50 million to $60 million, against ~$47 million the year before. Shares actually rallied, albeit off an all-time low, as investors likely focused on a strong quarter for organic growth (roughly 13%).

Last week, however, Vintage Wine Estates wiped out what little confidence there was left. The company said it would restate financial results for the first quarter, increasing revenue by $0.7 million but decreasing net income by a nearly equal amount. VWE also disclosed preliminary revenue for Q2 of about $81 million, down 3%-4% year-over-year, with organic sales down in the range of 10%. Adjusted EBITDA is expected to be $3.5 million against a record $20.2 million the year before.

Full-year guidance was withdrawn, and Roney is moving from CEO to Chairman. Walsh is stepping down as chair, and becoming lead independent director. Shares fell 28% on Thursday and another 5% on Friday.

Run As Fast As You Can

There’s an argument that the response from the market could have been, and maybe should have been worse.

Quantitatively, Q2 clearly is a disaster. Negative organic growth is one thing; the sheer collapse in EBITDA margins is another. In Q2 FY22, EBITDA margins were 24%; they should be roughly 4% a year later. First-half margins are 5.3%; at the low end of revenue guidance (which, again, has been withdrawn), VWE is tracking toward ~$16 million in FY23 Adjusted EBITDA. At that level, the stock is trading at 25x Adjusted EBITDA, and, even worse, has a net leverage ratio of 17x.

But the VWE story is taking a qualitative hit as well. The preliminary Q2 results are essentially the market’s worst fears come to life. Investors were worried about inflationary pressures on consumer demand. But Roney said after Q1 that the company had benefited from consumers trading down during the financial crisis, and predicted that they would do so again this time around. Q2 results suggest that is not the case.

On the same call, Cowen analyst Vivian Azer asked about SG&A spending, which (excluding amortization) had cleared $30 million for two straight quarters, yet was guided below that run rate for the full year. Chief financial officer Kristina Johnston cited “some atypical expense” for the Q1 figure; SG&A now is guided to ~$33 million, again excluding amortization but including ~$2 million in spend on an acquisition that wasn’t consummated.

Even that latter spend isn’t comforting, given worrisome leverage coming out of Q1 and Roney’s insistence that any deal would be “right down the middle of the fairway.” Clearly, that wasn’t the case here, given that the deal didn’t make it over the finish line (and was large enough to cost $2 million).

VWE has been dealing with accounting issues since going public; Roney promised after Q4 they were close to being fixed (Johnston’s hiring ten months ago appears part of the hoped-for solution) but clearly they are not. And one of the post-SPAC pillars for VWE was that both Roney and Walsh were proven M&A operators; both are now gone from day-to-day operations.

So much here screams for investors to turn and run in the other direction. The roll-up strategy in general seems close to binary, and when they fail, they fail big. The balance sheet is in tatters. Revenue is declining even with substantial spending on acquisitions, and there’s little sign (yet) of inflationary pressures abating. Management is overpromising and (to put it mildly) underdelivering.

The case for shorting VWE seems reasonable. Indeed, it seems like even the analysts who follow the stock have turned, with both Telsey and Cannacord moving their price targets below Friday’s close ($1.50 and $1, respectively).

And Yet…

As bad as things look right now, there are some reasons for optimism.

Quantitatively, there is room for the results to get better. Along with announcing management changes, VWE said it would cut costs and take pricing, which it projected would have an annual benefit of roughly $10 million. Investors would be forgiven for some skepticism toward that target being hit, given recent failures, but that aside there’s some hope for Layer Cake.

Again, Layer Cake is the lowest-priced brand, and presumably the one that should benefit the most from trading down by inflation-pressured customers. The problem is that Layer Cake has been struggling for several quarters: Roney admitted back in September that the company was working to fix the brand. The then-CEO projected improvements would not arrive until March or April. Some success there can provide a bit of a floor under revenue, if not necessarily margins.

VWE has also struggled with overhead absorption. Last year, the company spent big — capex was nearly $40 million, ~14% of sales — to expand bottling and warehouse capacity. There’s room for improvement there in terms of cost of goods, even if the option is as unpalatable as reducing some of that capacity and hunkering down.

The company plans to take more pricing in 2023, after having some success on that front in the first part of last year. There will be real urgency toward the $30 million SG&A target; particularly with a new CEO, Johnston will not be able to get up on a fourth conference call and explain how an opex reduction is coming next quarter. All told, there are levers to pull here that can improve profitability in the mid-term, and given current margins in the 4-5% range, those choices can be material to the overall bottom line. (Cutting $3 million in quarterly opex alone is almost 400 bps in margin improvement on the current revenue base.)

Qualitatively, it’s difficult to argue at this point that management changes are bad news. Whether or not Roney and Walsh are M&A experts simply doesn’t matter anymore — because from this point forward acquisitions are 100% irrelevant to the investment case. The only way Vintage does another deal is if the business gets substantially fixed from here (or if the equity gets zeroed out and the company has repaired its balance sheet in a restructuring).

What Roney and Walsh have not been in recent years is good operators. A new CEO (interim CEO Jon Maramarco at least has ~40 years’ experience in the industry) will have fresh eyes and, no doubt, license from the board and major shareholders to make significant changes. It’s also noteworthy that Roney agreed to leave; he controls the board slate and probably could have held his spot if he wanted to. With more related-party activity than seems prudent, new management seems like a plus for the mid-term investment case, rather than a minus.

Admittedly, there’s a lot of speculation here. There may be more that we don’t know. A new CEO isn’t guaranteed to be an improvement, and investors might wonder who would want the job at this point. But one hugely important point in favor of taking the VWE plunge is that the company has plenty of time. In December, Vintage refinanced its debt, extending maturities to 2027. Interest rates on the debt are 80% hedged through 2025.

A 17x net leverage ratio (and, remember, that’s just an estimate; it may be worse based on FY23 actuals) suggests a stock headed to zero in a hurry. But VWE almost can’t go to zero in a hurry.

What VWE Needs

The SPAC merger valued VWE at about 12.5x FY22E Adjusted EBITDA. Many SPACs have seen multiples compress sharply based on peer comparisons, but that’s not necessarily the case here.

In 2021, Altria MO 0.00 sold its Ste. Michelle wine business for (based on Altria financial statements) about 12x EBITDA. Ste. Michelle had been in a multi-year decline in terms of volumes, though it did see a pickup in business (perhaps with some help from the pandemic environment) before the deal was struck.

Larger U.S. peer Duckhorn Portfolio NAPA 0.00 trades at about 14x EBITDA. Crimson Wine Group (traded OTC under ticker 'CWGL') is at 16x, and Australian giant Treasury Wine Estates (TWE.ASX) in the middle.

To merit a multiple in line with peers, Vintage would need EBITDA of ~$30 million or so (against a fully-diluted enterprise value of ~$410 million, which includes a modest amount of contingent consideration). That’s an EBITDA margin of 10% — barely half recent levels and a figure that is likely doable at some point before the balance sheet becomes an existential threat.

Perhaps more importantly, that $30 million figure is about equal to what the business generated all the way back in 2018. Public company costs (and inflation) might need to be deducted from those results, but Vintage has also made ~$140 million in acquisitions since then. That past performance in a solid, if not quite spectacular, economy, suggests that even moderately improved results can (at least) support the current share price.

There are other ways to argue that current valuation is not as bad as it looks. Valuation per case, for instance, is moderately below that implied by the Ste. Michelle deal (again, a declining business sold by a motivated seller to a successful private equity firm in Sycamore Partners) and less than half that assigned to Treasury Wine Estates. VWE even trades at a discount to tangible book (~0.9x), while inventories alone now are equal to ~half of enterprise value.

In fact, VWE properties have been appraised at $246 million, while inventories are almost $200 million. The sum of those two valuations suggests a nearly 10% premium to the current enterprise value. That alone doesn’t suggest a floor on the share price, but there is room for Vintage to improve the balance sheet before the operating business inflects higher. (Indeed, the company already has monetized some non-core assets, and had nearly $7 million in such assets held for sale as of the end of fiscal Q1.)

Meanwhile, the upside here is tremendous, even ignoring prior long-term targets (for instance, Vintage has said it believes it can get EBITDA margins to 25%). A 12x multiple (accounting for the weaker balance sheet) on FY22 EBITDA of $47 million gets the stock to $4.50, 135% upside. Add in some debt reduction and a triple is in sight — simply from a reversion to results from a year when sales likely had a tailwind but margins (owing to freight and other factors) did not.

To be sure, getting back to FY22 results is not a simple matter. A man falls off a horse much quicker than he gets back on. But this is a business that grew both organically and inorganically for two decades, and was doing well enough to hold up even when last year’s bear market began in earnest. There have clearly been self-inflicted wounds of late, but these few quarters don’t entirely negate 20 years of success and value creation.

There’s a lot of work to do, but that’s not necessarily a bad thing. New management is coming in, and the new CEO (and whoever else he or she brings along) will have time to make improvements.

That time has value in terms of allowing changes to take hold and improve the P&L. But it has value from the perspective of VWE stock as well. All equity is optionality on the value not claimed by creditors — and the longer-dated an option, the greater its value. Few situations offer this kind of optionality (the equity slice is ~30% of enterprise value) for this long. If this gets better at all, at some point investors willing to take the plunge are likely to come out ahead.

As of this writing, Vince Martin has no positions in any securities mentioned.

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