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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACTS OF 1934
For the quarterly period ended March 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACTS OF 1934
For the transition period from to
Commission file number: 0-13406
THE CHALONE WINE GROUP, LTD.
(Exact Name of Registrant as Specified in Its Charter)
California 94-1696731
(State or Other Jurisdiction of
Incorporation or Organization) (I.R.S. Employer Identification No.)
621 Airpark Road
Napa, California 94558
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: 707-254-4200
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
-------- --------
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes No X
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The number of shares outstanding of Registrant's Common Stock on May 10, 2004
was 12,082,857.
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The Chalone Wine Group, Ltd.
PART I. - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS PAGE
Consolidated Balance Sheets as of March 31, 2004, and December 31, 2003. 3
Consolidated Statements of Income for the three-month periods ended
March 31, 2004 and 2003. 4
Consolidated Statements of Cash Flows for the three-month periods ended
March 31, 2004 and 2003. 5
Notes to Consolidated Financial Statements. 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 12
ITEM 4. CONTROLS AND PROCEDURES 16
PART II. - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
THE CHALONE WINE GROUP, LTD.
CONSOLIDATED BALANCE SHEETS
(All amounts in thousands, except share data)
ASSETS
March 31, December 31,
2004 2003
----------- ------------
(unaudited)
Current assets:
Accounts receivable, net $ 12,935 $ 19,753
Note receivable 221 218
Income tax receivable 232 232
Inventory 82,023 84,840
Prepaid expenses and other current assets 660 405
----------- ------------
Total current assets 96,071 105,448
Investment in Chateau Duhart-Milon 10,938 11,278
Non-current note receivable 154 210
Property, plant and equipment, net 71,350 72,494
Goodwill 8,582 8,582
Trademarks 2,861 2,864
Other assets 1,652 1,719
----------- ------------
Total assets $ 191,608 $ 202,595
=========== ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term obligations $ 7,154 $ 7,154
Current portion of obligations under capital lease 806 791
Revolving bank loan 18,975 13,800
Accounts payable and accrued liabilities 11,435 25,805
----------- ------------
Total current liabilities 38,370 47,550
Long-term obligations, less current maturities 39,041 39,759
Long-term obligations, convertible subordinated debt 11,000 11,000
Obligations under capital lease, less current maturities 652 859
Liability on interest rate swap contract 891 1,084
Deferred income taxes 1,259 1,180
----------- ------------
Total liabilities 91,213 101,432
Minority interest 3,227 3,165
Shareholders' equity:
Common stock - authorized 15,000,000 shares no
par value; issued and outstanding: 12,082,857
and 12,075,503 shares 76,476 76,472
Retained earnings 22,557 23,164
Accumulated other comprehensive loss (1,865) (1,638)
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Total shareholders' equity 97,168 97,998
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Total liabilities and shareholders' equity $ 191,608 $ 202,595
=========== ============
See accompanying notes to consolidated financial statements
3
THE CHALONE WINE GROUP, LTD.
CONSOLIDATED STATEMENTS OF INCOME
(All amounts in thousands, except per share data)
Three months ended
March 31, March 31,
----------------------------------
2004 2003
-------------- -------------
(Unaudited) (Unaudited)
Gross revenues $ 12,715 $ 13,925
Excise taxes (364) (417)
-------------- -------------
Net revenues 12,351 13,508
Cost of wines sold (8,411) (8,913)
-------------- -------------
Gross profit 3,940 4,595
Other operating expense, net 19 (5)
Selling, general and administrative expenses (3,308) (2,939)
-------------- -------------
Operating income 651 1,651
Interest expense, net (1,480) (1,375)
Depreciation and amortization (200) (181)
Other income 62 53
Equity in net income of Chateau Duhart-Milon - -
Minority interests (62) (39)
-------------- -------------
Income before income taxes (1,029) 109
Income taxes 422 (45)
-------------- -------------
Net income $ (607) $ 64
============== =============
Earnings per share - basic and diluted $ (0.05) $ 0.01
Weighted average number of shares outstanding:
Basic 12,083 12,075
Diluted 12,112 12,079
See accompanying notes to consolidated financial statements
4
THE CHALONE WINE GROUP, LTD.
CONSOLIDATED STATEMENTS OF CASHFLOWS
(All amounts in thousands)
Three months ended
March 31, March 31,
---------------------------
2004 2003
------------- ------------
Cash flows from operating activities: (Unaudited) (Unaudited)
Net income $ (607) $ 64
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization 1,524 1,492
Equity in net income of Chateau Duhart-Milon - -
Increase in minority interests 63 39
Deferred income taxes - 54
Other - -
Changes in:
Accounts and other receivables 6,818 3,927
Inventories 2,817 4,028
Prepaid expenses and other assets (188) 95
Accounts payable and accrued liabilities (14,371) (10,490)
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Net cash used in operating activities (3,944) (791)
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Cash flows from investing activities:
Capital expenditures (377) (977)
Proceeds from disposal of property and equipment - -
Net changes of notes receivable 53 52
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Net cash used in investing activities (324) (925)
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Cash flows from financing activities:
Borrowings on revolving bank loan-net 5,175 2,574
Distributions to minority partner - (650)
Net change in capital lease obligation (193) (195)
Repayment of long-term debt (718) (15)
Proceeds (re-purchase of) from issuance of common stock 4 2
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Net cash provided by financing activities 4,268 1,716
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Net increase (decrease) in cash and equivalents - -
Cash and equivalents at beginning of period - -
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Cash and equivalents at end of period $ - $ -
============= ============
Other cash flow information:
Interest paid $ 1,438 $ 1,311
Income taxes paid - 62
Non-cash investing & financing activities:
Unrealized foreign currency gain (loss) $ (340) $ 304
Interest swap fluctuation, net 114 78
See accompanying notes to consolidated financial statements
5
THE CHALONE WINE GROUP, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The unaudited consolidated financial statements of the Chalone Wine Group,
Ltd. ("the Company") are prepared in conformity with accounting principles
generally accepted in the United States of America for reporting interim
financial information, and the rules and regulations of the Securities and
Exchange Commission. In the opinion of management, all adjustments necessary for
a fair presentation of the financial position and results of operations for the
periods presented have been included. All such adjustments are of a normal
recurring nature. These unaudited consolidated financial statements should be
read in conjunction with the audited consolidated financial statements included
in the Company's Form 10-K for the year ended December 31, 2003. Results of
operations are not necessarily indicative of the results that may be expected
for future interim periods or for the full year.
The consolidated balance sheet at December 31, 2003, presented herein, has
been derived from the audited consolidated financial statements of the Company
for the year then ended, included in the Company's annual report on Form 10-K.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported financial
statement amounts and related disclosures at the date of the financial
statements. Actual results could differ from these estimates.
EARNINGS PER SHARE
Basic earnings per share ("EPS") excludes dilution and is computed by
dividing net income available to common stockholders by the weighted average
number of common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock (e.g. stock options) were exercised and converted into stock. For
all periods presented, the difference between basic and diluted EPS for the
Company reflects the inclusion of dilutive stock options, the effect of which is
calculated using the treasury stock method.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses derivative instruments to manage exposures to interest
rate risks in accordance with its risk management policy. The Company's
objectives for holding derivatives are to minimize the risks using the most
effective methods to eliminate or reduce the exposure to interest rate
fluctuations. The Company formally documents the relationship between hedging
instruments and hedged items as well as its risk management objective and
strategy for undertaking its hedging activities. The Company formally designates
derivatives as hedging instruments on the date the derivative contract is
entered into. The Company assesses, both at inception of the hedge and on an
ongoing basis, whether derivatives used as hedging instruments are highly
effective in offsetting the changes in the fair value or cash flows of hedged
items. If it is determined that a derivative is not highly effective as a hedge
or ceases to be highly effective, the Company discontinues hedge accounting
prospectively.
Changes in the fair value of derivative instruments designated as cash flow
hedges, to the extent the hedges are highly effective, are recorded in other
comprehensive income, net of related tax effects. The ineffective portion of the
cash flow hedge, if any, is recognized in current-period earnings. Other
comprehensive income is relieved when current earnings are affected by the
variability of cash flows relating to the derivative hedged. During the quarter
ended March 31, 2004, the Company's derivative contracts consisted only of an
interest rate swap used by the Company to convert a portion of its variable rate
6
THE CHALONE WINE GROUP, LTD.
long-term debt to fixed rate.
The Company does not enter into financial instruments for trading or
speculative purposes. Payments or receipts on interest rate swap agreements are
recorded in interest expense. Forward exchange contracts are used to manage
exchange rate risks on certain purchase commitments, generally French oak
barrels, denominated in foreign currencies. Gains and losses relating to firm
purchase commitments are deferred and are recognized as adjustments of carrying
amounts of assets acquired or in income when the hedged transaction occurs. The
nominal amounts and related foreign currency transaction gains and losses, net
of the impact of hedging, were not significant for the three months ended March
31, 2004 and 2003.
STOCK BASED COMPENSATION
The Company accounts for stock-based awards to employees using the
intrinsic value based method in accordance with APB No. 25, ACCOUNTING FOR STOCK
ISSUED TO EMPLOYEES and provides the pro forma disclosures required by SFAS No.
123, ACCOUNTING FOR STOCK-BASED COMPENSATION. No compensation expense has been
recognized in the financial statements for employee stock arrangements.
As of January 1, 2003 the Company adopted the disclosure requirements of
SFAS 148, ACCOUNTING FOR STOCK BASED COMPENSATION, which amends Accounting
Principals Board ("APB") No. 28 by adding to the list of disclosures to be made
for interim reporting periods.
SFAS 123, Accounting for Stock-Based Compensation, requires the disclosure
of pro forma net income and earnings per share had the Company adopted the fair
value method as of the beginning of fiscal year 1995. Under SFAS 123, the fair
value of stock-based awards to employees is calculated through the use of option
pricing models, even though such models were developed to estimate the fair
value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock
volatility and expected time to exercise, which greatly affect the calculated
values. The Company's calculations were made using the Black-Scholes option
pricing model with the following weighted average assumptions: expected life,
117 months following vesting; stock volatility of 34.7% for the three months
ended March 31, 2004 and 32.7% for the three months end March 31, 2003,
risk-free interest rates of 4.27% for the three months ended March 31, 2004 and
3.83% for the three months ended March 31, 2003, and no dividends during the
expected term. The Company's calculations are based on a multiple option
valuation approach and forfeitures are recognized as they occur.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized over the options' vesting period. Had the Company's stock
option and stock purchase plan been accounted for under SFAS No. 123, net income
and earnings per share would have been reduced to the following pro forma
amounts (IN THOUSANDS, EXCEPT PER SHARE DATA).
Three months ended
--------------------------------
Net income (loss): March 31, 2004 March 31, 2003
-------------- --------------
As reported $ (607) $ 64
Compensation Expense,
net of tax $ (30) $ (23)
-------------- --------------
Pro forma $ (637) $ 41
Earnings (loss) per share:
Basic $ (0.05) $ 0.01
Diluted $ (0.05) $ 0.01
Pro forma basic $ - $ -
Pro forma diluted $ - $ -
7
THE CHALONE WINE GROUP, LTD.
NOTE 2 - COMPREHENSIVE INCOME
Comprehensive income includes unrealized foreign currency gains and losses
related to the Company's investment in Chateau Duhart-Milon and gains or losses
relating to derivative instruments. The following is a reconciliation of net
income and comprehensive income (IN THOUSANDS):
Three months ended
March 31,
---------------------------
2004 2003
-------------- ------------
(Unaudited) (Unaudited)
Net income (loss) $ (607) $ 64
Changes in fair value of derivatives; net of tax
effect 22 28
Reclassification adjustment; net of tax effect 92 50
Foreign currency translation gain (loss) (340) 304
-------------- ------------
Comprehensive income (loss) $ (833) $ 446
============== ============
NOTE 3 - INVENTORIES
Inventories are stated at lower of cost (first-in, first-out) or market and
consist of the following (IN THOUSANDS):
March 31, December 31,
----------------------------------
2004 2003
---------------- -----------------
(Unaudited)
Bulk wine $ 49,401 $ 50,502
Bottled wine 32,235 33,955
Wine packaging supplies 165 165
Other 222 218
---------------- -----------------
Total $ 82,023 $ 84,840
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NOTE 4 - COMMITMENTS AND CONTINGENCIES
Future minimum lease payments (excluding the effect of future increases in
payments based on indices which cannot be estimated at the present time)
required under non-cancelable operating leases with terms in excess of one year
are as follows: (IN THOUSANDS)
Calendar year:
(nine months remaining)
2004 $ 758
2005 999
2006 1,026
2007 958
2008 731
Thereafter 3,150
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Total $ 7,622
=============
The Company contracts with various growers and certain wineries to supply
a large portion of its future grape requirements and a smaller portion of its
future bulk wine requirements. The Company estimates that it has contracted to
purchase approximately 9,000 to 13,000 tons of grapes per year over the next ten
years. While most of these contracts stipulate that prices will be determined by
current market conditions at the time of purchase, several long-term contracts
provide for minimum grape or bulk wine prices. Purchases under these contracts
were $18,994,000 for the year ended December 31, 2003.
8
THE CHALONE WINE GROUP, LTD.
NOTE 7-SUBSEQUENT EVENTS
In May 2004, the Company successfully completed the renewal of its
revolving bank loans with Rabobank and a group of syndicated lenders to provide
for an additional three years. In addition, the Company amended the loan
documents on its revolving bank loan and senior notes to modify the financial
covenants. Management expects that these covenant modifications provide
reasonable business measurements which correspond to current economic trends as
well as to provide for our anticipated liquidity requirements.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
In the ordinary course of business, the Company has made a number of
estimates and assumptions relating to the reporting of results of operations and
financial condition in the preparation of its financial statements in conformity
with accounting principles generally accepted in the United States of America.
Actual results could differ significantly from those estimates under different
assumptions and conditions. The Company believes that the following discussion
addresses the Company's most critical accounting policies, which are those that
are most important to the portrayal of the Company's financial condition and
results. The Company constantly re-evaluates these significant factors and makes
adjustments where facts and circumstances dictate. Historically, actual results
have not significantly deviated from those determined using the necessary
estimates inherent in the preparation of financial statements. Estimates and
assumptions include, but are not limited to, customer receivables, inventories,
assets held for sale, fixed asset lives, contingencies and litigation. The
Company has also chosen certain accounting policies when options were available,
including:
o The first-in, first-out (FIFO) method to value a majority of our
inventories;
o The intrinsic value method, or APB Opinion No. 25, to account for
our common stock incentive awards; and
o We record an allowance for credit losses based on estimates of
customers' ability to pay. If the financial condition of our
customers were to deteriorate, additional allowances may be
required.
These accounting policies are applied consistently for all periods
presented. Our operating results would be affected if other alternatives were
used.
FORWARD LOOKING STATEMENTS
From time to time, information provided by the Company, statements made by
its employees, or information included in its filings with the Securities and
Exchange Commission (including this Form 10-Q) may contain statements which are
not historical facts, so called "forward looking statements" that involve risks
and uncertainties. Forward-looking statements are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. When
used in this Form 10-Q, the terms "anticipates," "expects," "estimates,"
"intends," "believes," and other similar terms as they relate to the Company or
its management are intended to identify such forward looking statements. The
Company's actual future results may differ significantly from those stated in
any forward-looking statements. Factors that may cause such differences include,
but are not limited to (i) reduced consumer spending or a change in consumer
preferences, which could reduce demand for the Company's wines; (ii) competition
from numerous domestic and foreign wine producers which could affect the
Company's ability to sustain volume and revenue growth; (iii) interest rates and
other business and economic conditions which could increase significantly the
cost and risks of borrowings associated with present and projected capital
projects; (iv) the price and availability in the marketplace of grapes meeting
the Company's quality standards and other requirements; (v) the effect of
weather, agricultural pests and disease and other natural forces on growing
conditions and, in turn, the quality and quantity of grapes produced by the
9
THE CHALONE WINE GROUP
Company; and (vi) regulatory changes which might restrict or hinder the sale
and/or distribution of alcoholic beverages. Each of these factors, and other
risks pertaining to the Company, the premium wine industry and general business
and economic conditions, are more fully discussed herein and from time to time
in other filings with the Securities and Exchange Commission, including the
Company's annual report on Form 10-K for the year ended December 31, 2003.
DESCRIPTION OF THE BUSINESS
The Company produces, markets and sells super premium, ultra premium, and
luxury-priced white and red varietal table wines, primarily Pinot Noir, Cabernet
Sauvignon, Merlot, Syrah, Chardonnay and Sauvignon Blanc. The Company owns and
operates wineries in various counties of California and Washington State. The
Company's wines are made primarily from grapes grown at Chalone Vineyard, Edna
Valley Vineyard, Moon Mountain Vineyard, Company-owned vineyards adjacent to the
Acacia(TM) Winery and Hewitt Vineyard in California and the Canoe Ridge Vineyard
in Washington State, as well as from purchased grapes.
The wines are primarily sold under the labels "Acacia(TM)," "Canoe
Ridge(R) Vineyard," "Chalone Vineyards(R)," "Dynamite Vineyards(R),"
"Echelon(TM)," "Edna Valley Vineyard(R)," "Jade Mountain(R)," "Moon Mountain
Vineyards(R)," "Provenance Vineyards(TM)," and "Sagelands Vineyard(R)."
In France, the Company owns a minority interest in fourth-growth Bordeaux
estate Chateau Duhart-Milon ("Duhart-Milon") in partnership with Les Domaines
Barons de Rothschild (Lafite) ("DBR"). The vineyards of Duhart-Milon are located
adjacent to the world-renowned Chateau Lafite-Rothschild in the town of
Pauillac.
The Chalone Wine Group, Ltd. was incorporated under the laws of the State
of California on June 27, 1969. The Company became a publicly held reporting
company as the result of an initial public offering of common stock in 1984.
RESULTS OF OPERATIONS - FIRST QUARTER OF 2004 COMPARED TO FIRST QUARTER 2003
The following table represents financial data as a percentage of net revenues
for the indicated periods:
Three months ended Percent change
March 31, March 31, Increase/(decrease)
------------------------------- -------------------
2004 2003 2004 vs 2003
--------------- -------------- -------------------
Net revenues 100.0% 100.0% 0.0%
--------------- --------------
Cost of wines sold (68.1)% (66.0)% 3.2%
Gross profit 31.9% 34.0% (6.2)%
Other operating expense, net 0.2% 0.0 0.0%
Selling, general and administrative expenses (26.8)% (21.8)% 22.9%
--------------- --------------
Operating income 5.3% 12.2% (56.6)%
Interest expense, net (12.0)% (10.2)% 17.6%
Depreciation and amortization expense (1.6)% (1.3)% 23.1%
Other income 0.5% 0.4% 25.0%
Minority interests (0.5)% (0.3)% 66.7%
--------------- --------------
Income (loss) before income taxes -8.3% 0.8% (1,137.5)%
Income taxes 0.0 (0.3)% (1,233.3)%
--------------- --------------
Net income (loss) -4.9% 0.5% (1,080.0)%
=============== ==============
10
THE CHALONE WINE GROUP, LTD.
NET REVENUES
Net revenues for the three months ended March 31, 2004, decreased
$1,157,000 or 8.6%, reflecting a 12.7% decrease in case sales offset by a 4.9%
increase in revenue per case when compared to the same period in the prior year.
The decrease in case sales is primarily due to our sales division's conversion
to a fiscal year commencing in April. This conversion combined with strong
shipments in the fourth quarter of 2003 resulted in less cases than the same
time period in the prior year. We anticipate we will see variations in our
historical seasonality as we convert our distributors back to a fiscal year
ending March 31. For financial reporting purposes the Company remains on a
calendar year.
The increase in revenue per case is due to new luxury wine releases and
continued growth of our Provenance brand.
GROSS PROFIT
Gross profit margin for the three months ended March 31, 2004, decreased
by $655,000 or 14% when compared to the same period in the prior year. The gross
profit percentage decreased 2.1 percent when compared to the same period in the
prior year. The decrease is due to continued discount pressure experienced in
the marketplace combined with the growth of wines with both higher net revenue
and cost per case.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the three months ended
March 31, 2004, increased approximately $371,000 or 12.6% over the comparable
period in the prior year. The increase was due to the certain sales and
marketing programs related to new releases. Additionally, rising worker
compensation and health care costs contributed to the increase in selling,
general and administration.
OPERATING INCOME
Operating income for the three months ended March 31, 2004, decreased
$1,002,000 or 61% from $1,653,000 for the three months ended March 31, 2003. The
decrease occurred due to the decrease in case shipments, increase in program
allowances and in selling and administrative expenses.
INTEREST EXPENSE
Interest expense for the three months ended March 31, 2004, increased
$105,000 or 7.6% over the comparable period in the prior year. The increase
occurred as a result in the reduction of capitalized interest. Currently, the
company has minimal vineyards in development which, in the prior year, generated
capitalized interest.
EQUITY IN NET INCOME OF DUHART-MILON
The Company monitors its investment in Duhart-Milon primarily through its
on-going communication with DBR. Such communication is facilitated by the
presence of the Company's chairman on DBR's Board of Directors, and DBR's
representation on the Company's Board of Directors. Additionally, various key
employees of the Company make periodic visits to Duhart-Milon's offices and
production facilities.
Since the investment in Duhart-Milon is a long-term investment denominated
in a foreign currency, the Company records the gain or loss for currency
translation in other comprehensive income or loss, which is part of
shareholders' equity.
MINORITY INTEREST
The financial statements of Edna Valley Vineyard ("EVV") are consolidated
with the Company's financial statements. The interest in EVV attributable to
parties other than the Company is accounted for as a "minority interest". The
minority interest in the net income of EVV for the three months ended March 31,
2004, was approximately $62,000. The increase in minority interest was
approximately $23,000 when compared to the same period last year. The increase
was due to strong outside processing revenues as compared to the same period in
the prior year.
11
THE CHALONE WINE GROUP, LTD.
NET INCOME(LOSS) AND EARNINGS PER SHARE
As a result of the factors discussed above, the Company reported net loss
amounted to $607,000, or ($.05) per diluted share, compared to a reported net
income of $64,000, or $.01 per diluted share for the same period a year ago.
LIQUIDITY AND CAPITAL RESOURCES
Net working capital remained essentially unchanged for the three months
ended March 31, 2004. The Company has historically financed its growth through
increases in borrowings and cash flow from operations. Management expects that
the Company's working capital needs will grow significantly to support expected
future growth in sales volume. Due to the lengthy aging and processing cycles
involved in premium wine production, expenditures for inventory and fixed assets
need to be made one to three years or more in advance of anticipated sales.
The Company expects to finance these future capital needs through
operations, securities offerings and additional borrowings. There can be no
assurance that the Company will be able to obtain this financing on terms
acceptable to the Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following disclosures should be read in conjunction with Management's
Discussion and Analysis of Financial Condition and Results of Operations. These
disclosures are intended to discuss certain material risks of the Company's
business as they appear to management at this time. However, this list is not
exhaustive. Other risks may, and likely will, arise from time to time.
OUR REVENUES AND OPERATING RESULTS FLUCTUATE SIGNIFICANTLY FROM QUARTER TO
QUARTER
We believe period-to-period comparisons of our operating results are not
necessarily meaningful, and cannot be relied upon as indicators of future
performance. In addition, there can be no assurance that our revenues will grow
or be sustained in future periods or that we will maintain profitability in the
future. Significant factors in these quarterly fluctuations, none of which are
within our control, are changes in consumer demand for our wines, the affect of
weather and other natural forces on growing conditions and, in turn, the quality
and quantity of grapes produced by us, interest rates, inventory levels and the
timing of releases for certain wines, among other factors. Consequently, we have
experienced, and expect to continue to experience, seasonal fluctuations in
revenues and operating results.
Large portions of our expenses are fixed and difficult to reduce in a
short period of time. In quarters when revenues do not meet our expectations,
our level of fixed expenses tends to exacerbate the adverse effect on net
income. In quarters when our operating results are below the expectations of
public market analysts or investors, the price of our common stock may be
adversely affected.
REDUCED CONSUMER SPENDING COULD LESSEN DEMAND FOR OUR WINES AND HARM OUR
BUSINESS
Consumer spending trends and changes in consumer tastes has a substantial
impact on the wine industry and our business. To the extent that wine purchases
are negatively impacted by economic and other factors, or wine consumers reduce
consumption of wine in favor of other beverages, demand for our wines could
decrease.
OUR BUSINESS IS SEASONAL, WHICH COULD CAUSE OUR MARKET PRICE TO FLUCTUATE
Our business is subject to seasonal as well as quarterly fluctuations in
revenues and operating results. Our sales volume tends to increase during the
summer months and the holiday season and decrease after the holiday season. As a
result, our sales and earnings are typically highest during the fourth calendar
quarter and lowest in the first calendar quarter. Seasonal factors also affect
our level of borrowing. For example, our borrowing levels typically are highest
during winter when we have to pay growers for grapes harvested and make payments
related to the grape harvest. These and other factors may cause fluctuations in
the market price of our common stock.
12
THE CHALONE WINE GROUP, LTD.
WE WILL NEED MORE WORKING CAPITAL TO GROW
The premium wine industry is a capital-intensive business, which requires
substantial capital expenditures to develop and acquire vineyards and to improve
or expand wine production. Further, the farming of vineyards and acquisition of
grapes and bulk wine require substantial amounts of working capital. We project
the need for significant capital spending and increased working capital
requirements over the next several years, which must be financed by cash from
operations and, by additional borrowings or additional equity.
OUR ACQUISITIONS AND POTENTIAL FUTURE ACQUISITIONS INVOLVE A NUMBER OF
RISKS
Our acquisition of Provenance Vineyards, Hewitt Ranch, Staton Hills Winery
(renamed Sagelands Vineyard), the Jade Mountain brand, enlarging Canoe Ridge
Vineyard and buying out our partners, and expansion to the recently acquired
winery for the Provenance Vineyards (and potential future acquisitions) involve
risks associated with assimilating these operations into our Company;
integrating, retaining and motivating key personnel; integrating and managing
geographically-dispersed operations; integrating the technology and
infrastructures of disparate entities; risks inherent in the production and
marketing of wine and replanting of existing vineyards from white wine grapes to
red wine grapes.
We relied on debt financing to purchase Hewitt Ranch, Staton Hills Winery,
the Jade Mountain brand, enlarging Canoe Ridge Vineyard and buying out our
partners and other vineyard land and related assets in prior periods.
Consequently our debt-to-equity ratio is high in relation to our historical
standards, even after the successful completion of our rights offering in
November 2001. The interest costs associated with this debt will increase our
operating expenses and the risk of negative cash flow.
OUR PROFITS DEPEND LARGELY ON SALES IN CERTAIN STATES AND ON SALES OF
CERTAIN VARIETALS
In the three months ended March 31, 2004, approximately 90% of our wine
sales were concentrated in 19 states. Changes in national consumer spending or
consumer spending in these states and other regions of the country could affect
both the quantity and price level of wines that customers are willing to
purchase which could harm our business.
Approximately 90% of our consolidated net revenues in the three months
ended March 31, 2004 were concentrated in our four top selling varietal wines.
Specifically, sales of Chardonnay, Cabernet Sauvignon, Pinot Noir, and Merlot
accounted for 41%, 18%, 16% and 16% of our net revenues, respectively. Changes
in consumer preferences with respect to these varietal wines could adversely
affect our business.
COMPETITION MAY HARM OUR BUSINESS
The premium table wine industry is intensely competitive and highly
fragmented. Our wines compete in all of the premium wine market segments with
many other premium domestic and foreign wines, with imported wines coming
primarily from the Burgundy and Bordeaux regions of France and, to a lesser
extent, Italy, Chile, Argentina, South Africa and Australia. Our wines also
compete with popular-priced generic wines and with other alcoholic and, to a
lesser degree, non-alcoholic beverages, for shelf space in retail stores and for
marketing focus by our independent distributors, many of which carry extensive
brand portfolios.
The wine industry has experienced significant consolidation. Many of our
competitors have greater financial, technical, marketing and public relations
resources than we do. Our sales may be harmed to the extent we are not able to
compete successfully against such wine or alternative beverage producers.
13
OUR BUSINESS IS SUBJECT TO A VARIETY OF AGRICULTURAL RISKS
Winemaking and grape growing are subject to a variety of agricultural
risks. Various diseases, pests, fungi, viruses, drought, frosts and certain
other weather conditions can affect the quality and quantity of grapes available
to us, decreasing the supply of our products and negatively impacting
profitability.
Many California vineyards have been infested in recent years with
phylloxera. Our vineyard properties are primarily planted to rootstocks believed
to be resistant to phylloxera. However, there can be no assurance that our
existing vineyards, or the rootstocks we are now using in our planting programs,
will not become susceptible to current or new strains of phylloxera.
Pierce's Disease is a vine bacterial disease that has been in California
for more than 100 years. It kills grapevines and there is no known cure. Small
insects called sharpshooters spread this disease. A new strain of the
sharpshooter, the glassy winged, was discovered in Southern California and is
believed to be migrating north. We are actively supporting the efforts of the
agricultural industry to control this pest and are making every reasonable
effort to prevent an infestation in our own vineyards. We cannot, however,
guarantee that we will succeed in preventing contamination in our vineyards.
Future government restrictions regarding the use of certain materials used
in grape growing may increase vineyard costs and/or reduce production.
Grape growing requires adequate water supplies. We generally supply our
vineyards' water needs through wells and reservoirs located on our properties.
We believe that we either have, or are currently planning to insure, adequate
water supplies to meet the needs of all of our vineyards. However, a substantial
reduction in water supplies could result in material losses of grape crops and
vines.
WE MAY NOT BE ABLE TO GROW OR ACQUIRE ENOUGH QUALITY GRAPES FOR OUR WINES
The adequacy of our grape supply is influenced by consumer demand for wine
in relation to industry-wide production levels. While we believe that we can
secure sufficient supplies of grapes from a combination of our own production
and from grape supply contracts with independent growers, we cannot be certain
that grape supply shortages will not occur. A shortage in the supply of wine
grapes could result in an increase in the price of some or all grape varieties
and a corresponding increase in our wine production costs.
AN OVERSUPPLY OF GRAPES MAY ALSO HARM OUR BUSINESS
Current trends in the domestic and foreign wine industry point to rapid
plantings of new vineyards and replanting of old vineyards to greater densities,
with the expected result of significantly increasing the worldwide supply of
premium wine grapes and the amount of wine which will be produced in the future.
This expected increase in grape production has resulted in an excess of supply
over demand and forces us to reduce, or not increase, our prices.
WE DEPEND ON THIRD PARTIES TO SELL OUR WINE
We sell our products primarily through independent distributors and
brokers for resale to retail outlets, restaurants, hotels and private clubs
across the United States and in some overseas markets. To a lesser degree, we
rely on direct sales from our wineries, our wine library and direct mail. Sales
to our largest distributor and to our ten largest distributors combined
represented approximately 28% and 58% of our net revenues for the three months
ended March 31, 2004. Sales to our ten largest distributors are expected to
continue to represent a substantial portion of our net revenues in the future.
The laws and regulations of several states prohibit changes of distributors,
except under certain limited circumstances, making it difficult to terminate a
distributor for poor performance without reasonable cause, as defined by
applicable statutes. Any difficulty or inability to replace distributors, poor
performance of our major distributors or our inability to collect accounts
receivable from our major distributors could harm our business.
14
THE CHALONE WINE GROUP, LTD.
NEW REGULATIONS OR INCREASED REGULATORY COSTS COULD HARM OUR BUSINESS
The wine industry is subject to extensive regulation by the Federal Bureau
of Alcohol, Tobacco and Firearms and various foreign agencies, state liquor
authorities and local authorities. These regulations and laws dictate such
matters as licensing requirements, trade and pricing practices, permitted
distribution channels, permitted and required labeling, advertising and
relations with wholesalers and retailers. Any expansion of our existing
facilities or development of new vineyards or wineries may be limited by present
and future zoning ordinances, environmental restrictions and other legal
requirements. In addition, new regulations or requirements or increases in
excise taxes, income taxes, property and sales taxes or international tariffs,
could reduce our profits. Future legal or regulatory challenges to the industry,
either individually or in the aggregate, could harm our business.
ADVERSE PUBLIC OPINION ABOUT ALCOHOL MAY HARM OUR BUSINESS
A number of research studies suggest that various health benefits may
result from the moderate consumption of alcohol, but other studies suggest that
alcohol consumption does not have any health benefits and may in fact increase
the risk of stroke, cancer and other illnesses. If an unfavorable report on
alcohol consumption gains general support, it could harm the wine industry and
our business.
WE USE PESTICIDES AND OTHER HAZARDOUS SUBSTANCES IN THE OPERATION OF OUR
BUSINESS
We use pesticides and other hazardous substances in the operation of our
business. If hazardous substances are discovered on, or emanate from, any of our
properties, and their release presents a threat of harm to public health or the
environment, we may be held strictly liable for the cost of remediation. Payment
of such costs could have a material adverse effect on our business, financial
condition and results of operations. We maintain insurance against these kinds
of risks, and others, under various insurance policies. However, our insurance
may not be adequate or may not continue to be available at a price or on terms
that are satisfactory to us.
CONTAMINATION OF OUR WINES WOULD HARM OUR BUSINESS
We are subject to certain hazards and product liability risks, such as
potential contamination, through tampering or otherwise, of ingredients or
products. Contamination of any of our wines could result in the need for a
product recall, which could significantly damage our reputation for product
quality, which we believe is one of our principal competitive advantages. We
maintain insurance against these kinds of risks, and others, under various
general liability and product liability insurance policies. However, our
insurance may not be adequate or may not continue to be available at a price or
on terms that are satisfactory to us.
THE LOSS OF KEY EMPLOYEES WOULD DAMAGE OUR REPUTATION AND BUSINESS
Our success depends to some degree upon the continued services of a number
of key employees. Although some key employees are under employment contracts
with us for specific terms, the loss of the services of one or more of our key
employees could harm our business and our reputation, particularly if one or
more of our key employees resigns to join a competitor or to form a competing
company. In such an event, despite provisions in our employment contracts, which
are designed to prevent the unauthorized disclosure or use of our trade secrets,
practices or procedures by such personnel under these circumstances, we cannot
be certain that we would be able to enforce these provisions or prevent such
disclosures.
SHIFTS IN FOREIGN EXCHANGE RATES OR THE IMPOSITION OF ADVERSE TRADE
REGULATIONS COULD HARM OUR BUSINESS
We conduct some of our import and export activity for wine and packaging
supplies in foreign currencies. We purchase foreign currency on the spot market
on an as-needed basis and engage in limited financial hedging activities to
offset the risk of exchange rate fluctuations. There is a risk that a shift in
certain foreign exchange rates or the imposition of unforeseen and adverse trade
regulations could adversely impact the costs of these items and have an adverse
impact on our operating results.
In addition, the imposition of unforeseen and adverse trade regulations
could have an adverse effect on our imported wine operations. Export sales
accounted for approximately 2.5% of total consolidated revenue for the three
months ended March 31, 2004. We expect the volume of international transactions
to increase, which may increase our exposure to future exchange rate
fluctuations.
15
THE CHALONE WINE GROUP, LTD.
INFRINGEMENT OF OUR TRADEMARKS MAY DAMAGE OUR BRAND NAMES OR OUR BUSINESS
Our wines are branded consumer products, and we distinguish our wines from
our competitors' by enforcement of our trademarks. There can be no assurance
that competitors will refrain from infringing our marks or using trademarks,
tradenames or trade dress which dilute our intellectual property rights, and any
such actions may require us to become involved in litigation to protect these
rights. Litigation of this nature can be very expensive and tends to divert
management's time and attention.
THE MARKET PRICE OF OUR COMMON STOCK FLUCTUATES
All of the foregoing risks, among others not known or mentioned in this
report, may have a significant effect on the market price of our shares. The
stock markets have experienced extreme price and volume trading volatility in
recent months and years. This volatility has had a substantial effect on the
market prices of securities of many companies for reasons frequently unrelated
or disproportionate to the specific company's operating performance and could
similarly affect our market price.
DECREASED CASH FLOW COULD LIMIT OUR ABILITY TO SERVICE OUR DEBT
As a result of incurring debt, we are subject to the risks normally
associated with debt financing, including the risk that cash flow from
operations will be insufficient to meet required payments of principal and
interest. Our ability to satisfy our obligations to pay interest and to repay
debt is dependent on our future performance. Our performance depends, in part,
on prevailing economic conditions and financial, business and other factor,
including factors beyond our control.
OUR DEBT FINANCING AGREEMENTS CONTAIN RESTRICTIVE COVENANTS WITH WHICH WE
MAY NOT BE ABLE TO COMPLY
Our existing line of credit and long-term debt financing agreements
contain restrictive financial covenants. These covenants require us, among other
things, to maintain specified levels of net income, working capital, tangible
net worth and financial ratios. Our ability to comply with restrictive financial
covenants depends upon our future operating performance. Our future operating
performance depends, in part, on general industry conditions and other factors
beyond our control.
ITEM 4. CONTROLS AND PROCEDURES
Within the 90-day period prior to the date of this report, the Company
carried out an evaluation, under the supervision and with the participation of
the Company's management, including its Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures. Based on that evaluation, the
Chief Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures are effective in a timely manner to alert
them to material information relating to the Company, which is required to be
disclosed by the Company in the reports that it files or submits under the
Securities Exchange Act of 1934. There have been no significant changes in our
internal or other factors that could significantly affect these controls
subsequent to the evaluation date, including any corrective actions with regard
to significant deficiencies and material weaknesses.
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PART II. - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
31.1 Certification of Chief Financial Officer.
31.2 Certification of Chief Executive Officer.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K.
On March, 5 2004 the Company filed a Form 8-K to provide its press
release announcing its year end 2003 financial results.
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Dated: May 14, 2004 THE CHALONE WINE GROUP, LTD.
-------------------- ----------------------------
(Registrant)
/s/ THOMAS B. SELFRIDGE
--------------------------------------------
Thomas B. Selfridge
President and Chief Executive Officer
Dated: May 14, 2004 /s/ SHAWN M. CONROY BLOM
-------------------- --------------------------------------------
Shawn M. Conroy Blom
Vice President and Chief Financial Officer
17