Marlborough Wine Estates — Update 30 June 2016

MWE owns and operates the Otuwhero Estate, a 157ha vineyard located in the Awatere Valley in the Marlborough wine growing region of the South Island of New Zealand. The 157ha vineyard has a productive capacity of 1,500 tonnes of grapes per year (equivalent to ~1.125m litres of wine)1. In addition to the planted vineyard MWE has a further 179ha of vacant land. Under the Overseas Investment Office (OIO) conditions MWE is required to convert bare land to vineyards. MWE has identified a potential 45 hectares of plantable area. It is implementing irrigation systems, however, further investigation will be required before actual planting starts. The new vineyard will take five years to begin meaningful production. Once the vines have matured, peak yields should be sustained for at least 15 years.

MWE sells the grapes in three product lines:

It has two key brands of bottled wine:

MWE’s pro forma sales profile (exclude other revenues) for FY15 is shown in Exhibit 1 below:

MWE does not own wine processing facilities. Its wines are produced by a contract processor, Spring Creek Vintners, under the direction of MWE’s chief winemaker, Jan Kux, a qualified sommelier with 20 years’ experience in winemaking and vineyard operations.

NZ-bottled wine is sold through supermarket chains and wine distributors, which sell both online and through bricks and mortar stores. Offshore sales are made via non-exclusive distribution agreements with two related party distributors – Great Esprit based in Hong Kong, and New Zenith International Trading (Shanghai) (NZIT).

MWE has contracts in place for the purchase of 1,160 tonnes of bulk grapes from the FY17 vintage. Beyond that, there are no formal agreements in place and formal negotiations for renewing contracts have not begun. Management has stated the two purchasers have indicated they are willing to continue their respective arrangements beyond FY17.

In March 2015 MWE acquired the vineyards known as Otuwhero Estate and Donaldson’s block from its founder and 82.6% shareholder Min (James) Jia, together with inventories and distribution agreements, giving rise to an intangible asset of NZ$5.153m (as at 30 June 2015).2 The purchase was satisfied by the issue of 240m shares, which at the last private issue price of NZ$0.20 per share values the acquisition at NZ$48m.

Min (James) Jia has a background in property development and investment. He formed a relationship with Otuwhero Estate in 2011 when he acquired the rights to produce, market and sell the O:TU brand wines following the 2011 harvest. The vineyard assets were acquired in March 20133 (with foreign investment approval obtained on April 2013), when Min (James) Jia purchased the 256ha Main Block from receivers (Deloitte) and the adjacent 79ha unplanted block known as Donaldson’s. The market value as stated in O:TU Investments’ 2014 audited financial statements for the Main Block, the Donaldson’s block and associated inventories and other assets was NZ$13.1m.4

A new company was incorporated on 18 March 2015 and acts as a holding company for the wholly owned subsidiaries that were previously owned by Min (James) Jia.

In anticipation of its proposed listing on NXT, between November 2015 and June 2016 MWE raised NZ$141,400 (707,000 shares) from investors in NZ and China. In addition, Min (James) Jia sold 47,462,986 shares for total proceeds of NZ$9.5m5 to improve the shareholder spread. With the exception of shares issued to three directors and one senior manager, all sales were made to unrelated parties at NZ$0.20 per share. The company advises that there have been no other capital raises.

MWE owns the land. It uses contractors to manage the vineyard operations and crush grapes, has the wine production process supervised by MWE’s chief winemaker and sells bulk grapes and bulk wines in NZ. Bottled wine sales in NZ are managed by MWE; outside NZ (mostly in the People’s Republic of China) bottled wine sales are made by two related party distributors.

Distribution of bottled wine in Asia is conducted by two distributors:

O:TU premium wine also trades on the Shanghai International Wine Exchange (SIWE), an online platform established by the Shanghai government to facilitate the trading of authenticated fine wines and to educate Chinese consumers on the finer points of wine appreciation. In November 2014 MWE listed 27,900 bottles of 2013 premium sauvignon blanc on SIWE at 680 yuan per bottle (US$103)7. Management advises that members (shareholders of MWE under the Joint Ownership scheme) are able to purchase this wine at RMB360 per bottle. Purchases are limited to one per customer. The SIWE only makes agreements with genuine wine producers so the contract, although fulfilled by NZIT, is between MWE and SIWE. The Listing Document (page 44) states that Min (James) Jia has provided MWE with financial and contractual indemnities. In our view, the presence of O:TU wines on SIWE is an important part of establishing the wine as a premium and highly sought-after product in China.

We have looked at the FY15 pro forma revenue, cost and production data to analyse the returns for MWE and the returns for the distributor. The recommended retail price for O:TU wines in NZ is dependent on the variety, the vintage and the distribution outlet. The prices range from NZ$108 per bottle for prestige wines sold at duty free outlets to NZ$21.99 per bottle for sales made in supermarkets. The Music Bay range sells in NZ for between NZ$16.99 and NZ$19.99 per bottle. In China on SIWE the premium O:TU 2013 sauvignon blanc has a list price of 680 yuan (US$103) per bottle. We understand from management that it expects the MWE wines sold in China and elsewhere in Asia to be successfully positioned as a premium product and achieve an average sales price of ~NZ$40 per bottle.

As the owner of the vineyard, MWE is exposed to all risks related to vineyard management and production as well as to wine quality issues through the winemaking process. The financial data in the Listing Document and pro forma financial statements show that MWE made a cash profit in FY15 (see Exhibit 4).

Cost of production is shown in the company’s pro-forma unaudited financial statements for the year ended 30 June 2015 as NZ$1,956,231. MWE has advised that there were non-cash items totalling NZ$841,718 comprising a change in fair value of agricultural produce and inventories of biological assets. This non cash adjustment has reduced cost of production from NZ$1,956,231 to NZ$1,114,513 (see Exhibit 4 above).

Exhibit 5 uses FY15 data to show a cash profit after operating costs of NZ$0.54 per litre compared with a gross profit for the distributor and the retailer of up to NZ$176.23 per litre for any wine sold on SIWE. Management advises that members (shareholders of MWE under the Joint Ownership scheme) can purchase this wine on SIWE for RMB360 per bottle compared with the list price of RMB680 per bottle. The related-party distributors and retailer bear the sales, marketing, promotion, SIWE membership and distribution costs as well as the pricing risk.

FY15 results excluded the sale of bulk wine, which were deferred until 2016 because of weak prices (down 5% on the previous year to a per-litre price of NZ$3.78). At 30 June 2015 bulk wine stocks included in inventory were 853,895 litres at a cost of NZ$3.41 per litre. A small amount of this wine is likely to be retained by MWE to be aged and bottled at a later date. The Listing Document states that for FY16 to date MWE has sold approximately 770,000 litres of bulk wine. However, it is unclear whether all of this relates to bulk wine that would have been sold in FY15 if the price had been acceptable.

We have tested the reasonableness of the gross profit margin available for the distributor and retailer in China by taking published retail prices for a range of NZ and Australian bottled wines sold into China. Where sales data for China were not available, we have used adjusted sales prices from elsewhere in Asia and increased the prices by the ‘China premium’, which is the percentage difference between the sale price for a particular bottled wine in China and that for elsewhere in Asia (such as Hong Kong or Singapore). The gross profit margin for Penfolds Bin 28 Kalimna Shiraz is ~58%. The only cost data available for Oyster Bay is for the Asia/Pacific region, which includes Australia and New Zealand – highly competitive wine markets that are likely to be lower priced. The gross margin for Oyster Bay using the lower cost data is ~73%. For the O:TU brand, the margin available for wines sold for the list price on SIWE is 92% and 85% for wines sold to members at a discount of ~47%. No public data is available on the sale price of O:TU wines in other retail outlets in China, although we understand from management that the O:TU wines are targeted at the premium end of the wine market.

A key element of the marketing strategy is to involve MWE’s sales and distribution partners in China in the ownership of MWE by offering them modest parcels of shares that will be sold at the current price (for now the issue price is NZ$0.20 but in future the price will be the current NXT market price). We understand from management that small parcels of shares of about 100 shares per customer have been issued to around 400 customers in China.

MWE’s management believes that an important part of any sales proposition in China is to establish credibility and that a listing on NXT is part of establishing a long-term customer relationship. This relationship can be further cemented by aligning the interests of the distributors with the interests of MWE shareholders. At this stage we understand that no shares have been issued to MWE’s distributors or associates in China.

MWE’s growth strategy includes:

According to Wine Institute, Global vineyard plantings in 2014 were 17,960 thousand acres (7,268 thousand hectares).8 NZ plantings were 88,000 acres (35,612 hectares)9 or 0.5% of global vineyard area. In 2014 the top five countries measured by vineyard area were Spain (13.0%), China (11.0%), France (10.4%), Italy (9.5%) and Turkey (9.9%). NZ was ranked No 32 on the World Vineyard Acreage table.10 USA is the largest consumer of wine (13.03% of world consumption in 2014)11 followed by France (11.29%), Italy (8.26%), Germany (8.18%) and China 6.4%.

The chart below shows global vineyard plantings, wine production and consumption:

Global wine consumption per capita is forecast to grow the most in emerging wine consuming regions such as China. Euromonitor International’s forecasts for CAGR in wine consumption per capita over the five years from 2013 to 2018 are shown in Exhibit 8.

The chart below contrasts the change in per capita in wine consumption in the US with the change in wine consumption in China. From 2007 to 2013 the CAGR in per capita wine consumption in the US was 3.14% compared with China where the CAGR in per capita wine consumption was 19.48%. In 2014 wine consumption in China fell from 1.28 litres per capita to 1.16 litres per capita mainly due to the economic slowdown in China.

In China the fastest-growing bottled wine categories are the cheapest and the most expensive, which supports MWE’s strategy to position its wines at the premium end of the market. This is illustrated with data on Australian bottled wine exports.

With plantings in 2014 of 35,859 hectares, the NZ wine industry is only 0.5% of global production. The MWE 157ha planted vineyard represents 0.4% of the total NZ vineyard plantations. NZ has established an export industry that has almost tripled in value in the 10 years since 2006.

The Marlborough wine district of New Zealand accounts for 75% of the country’s total wine production12 and 79% of its wine exports. The region is renowned for producing sauvignon blanc wines, which account for some 86% of total wine production. The MWE FY17 forecast harvest of 1,544 tonnes (as per the FY17 KOM) is 0.5% of the last available data (2014) for total Marlborough wine production. Details of plantings are set out below:

Wines produced in the Marlborough region in 2014 show the sauvignon blanc variety is dominant:

The MWE vineyards are in the Awatere Valley, which has been categorised as the coldest and driest part of the Marlborough district. Climatic classifications of the sub regions of Marlborough are set out below:

The Awatere Valley has a more extreme climate than the other regions with strong winds, variable soils and temperatures and a later ripening season. One of the issues is the scarceness of irrigation water, which in a drier than normal season can limit vine growth. Berry sizes tend to be smaller with a more intense flavour, which gives the Awatere Valley wines their unique character.

MWE has set four key metrics by which investors should be able to assess performance:

MWE has an experienced board and senior management team with knowledge and understanding of vineyard operations and Asian markets, particularly the China market.

Executive chairman Min (James) Jia is the founder holds 82.6% of the issued shares. James is an experienced property developer and has held real estate, vineyard and forestry assets in NZ and China. He is active in property development in Auckland, NZ. Min (James) Jia purchased the Otuwhero Estate and Donaldson’s Block and associated vineyard assets in April 2013 for NZ$13.1m. These assets together with the distribution agreements were sold to MWE for 240m shares, which at a value of NZ$0.20 per share valued his interests at NZ$48m. James sold 47.7m shares into the float (at NZ$0.20 per share) to assist with achieving a greater shareholder spread. He is paid NZ$120,000 pa for his role as executive chairman. James has a Bachelor’s degree in engineering and a Master’s in business administration.

Ly (Lily) Lee is married to Min (James) Jia. She is an experienced property developer both in NZ and China and in the 1990s established a large travel agency in Germany. She is the general manager of Shanghai Aufun Investment Consultancy, which helps Chinese investors invest offshore. Lily holds a bachelor’s degree in language and is paid an annual director’s fee of NZ$40,000.

Jack Zhong Yin holds a bachelor’s degree in business studies and a master’s in taxation studies. He is a member of the NZ Institute of Directors and is a registered financial services provider (FSP). Jack is the head of Asian Development for DFK Griffiths Carlton, an Auckland-based accountancy firm, and has extensive management and investment advice experience. He is an executive director and is paid an annual directors fee of NZ$50,000.

Danny Chan is an independent director and holds a bachelor’s degree in commerce and administration. He holds directorships in Academic Colleges Group, Abano Healthcare, Farmers’ Mutual Group, Flowerzone International and Auckland Tourism Events and Economic Development. He is also a member of the Department of the Prime Minister and Cabinet’s China Project Advisory Group, the NZ/China Advisory Council and NZ Markets Disciplinary Tribunal.

Songyuan (Benny) Huang is an independent director and heads up global margin lending business KVB Kunlun NZ. He holds a bachelor’s degree in accounting, a master’s degree in international business and is a chartered financial analyst. He is also a member of the NZ Institute of Directors and is paid an annual directors fee of NZ$30,000.

Senior staff include Catherine Ma (bachelor’s degree in commerce) as group CEO, Eric Li (bachelor’s degree in commerce) as financial controller and Jan Kux, a winemaker with 20 years’ experience in Europe and NZ. Jan is a member of the GESCO Society for the Sciences and Development of Viticulture and is an active member in the German Sommelier Association.

MWE is exposed to primary production risk, which includes climatic conditions and the impact of disease and pests. It is also exposed to the global supply/demand dynamics.

Distribution agreements with related parties – management advises that the terms of the agreement with related party GEL and Min (James) Jia-owned NZIT have been negotiated on an arm’s length basis. The sale of O:TU premium wines to these two distributors has been set at a premium to the average NZ white wine FY15 export price of NZ$11.86 per litre. The Listing Document (page 8) states that the premium is “dependent on MWE brand and varietal but that most of range is priced at a premium of 30% or more”. The GEL agreement can be terminated on 90 days’ written notice by either party. The loss of this agreement could place MWE at a disadvantage in the China market, however, management believes that acceptable alternative distribution agreements could be put in place with little or no impact on MWE’s market position in China.

Grape supply – all grapes are sourced from MWE’s vineyards. A reduction in the supply of high-quality grapes could limit MWE’s wine and bulk grape revenues.

Viticulture management – MWE engages experienced viticulturists and has put in place strategies to mitigate against the effects of frost, diseases, pests and birds. It has also developed dams to provide a water supply during the dry summer months.

Quality issues – it is possible that the wine harvesting and winemaking processes result in a reduction in quality of the finished product thus affecting product reputation, costs and future sales. The current dispute with the Ministry for Primary Industries (MPI) is an example of a dispute arising from the production process that could lead to a significant liability. See below for additional information on this dispute.

Size and market position – MWE is a relatively small boutique producer of premium NZ white wines and is in competition with much larger producers of white wine from the Marlborough region and other regions of NZ as well as producers from Australia, France, Italy, Spain, Chile and other large wine-producing countries. To provide some perspective, NZ-based listed wine company Delegat sold 2.2m cases of wine in FY15 and MWE sold 6,587 cases.

Key man risk – Min (James) Jia is the executive chairman, founder and owner of the Otuwhero Estate vineyard assets from April 2013. He is also the key to distributing bottled wines in China through related party distributors GEL and NZIT.

Premium white wine market in China – this is not as well established as the premium red wine market and there is a risk the market may not develop as quickly or extensively as MWE anticipates, which could affect sales revenues. However, in FY16 and FY17 the minimum purchase requirements under the related-party distribution agreements underpin between 87.5% and 93.8% of expected international bottled wine sales in FY16 and FY17.

Bulk grape purchase agreements – the current agreements expire after the FY17 harvest. New agreements need to be put in place and there is a risk they could be struck on less favourable terms than the existing agreements.

Processing agreement – MWE is reliant on a third-party processor for producing bulk and bottled wine. Any change to or termination of this agreement could have an adverse effect on the quantity and quality of wine available for sale.

Shanghai International Wine Exchange (SIWE) – only wine producers can make sales on the SIWE. NZIT (owned by Min (James) Jia) supplies wine to SIWE but the contract risk lies with MWE as the producer, which means MWE has provided a NZ$4.4m performance bond. MWE has an obligation to redeem wine not sold by SIWE at 102.5% of the original price. The current offering of O:TU wines on SIWE is 27,900 bottles of 2013 sauvignon blanc with a selling price of 680 yuan per bottle (NZ$143.72/US$103). Management advises that members (shareholders of MWE under the Joint Ownership scheme) receive a discount on wine purchased on SIWE and are able to purchase the wine at RMB360 per bottle. An NZ company owned by Min (James) Jia has novated the liability that MWE has to ICBC and has also provided an indemnity to MWE, which extinguishes all other liabilities that MWE may have under its contractual relationships with SIWE.

Dependence on the China market – MWE intends to develop markets outside China, in the US, Japan, South Korea, Australia and Europe. For FY15 (pro-forma) management advises that 76% of MWE’s exports were to China and Hong Kong.13

Currency – sales to China and other international markets expose MWE to currency risks. MWE does not have a hedging policy in place.

There is a dispute between the Ministry for Primary Industries (MPI) and MWE’s former contracted wine processor. MWE is not a party to the ongoing dispute involving the origins of NZ$1.2m of bottled wine that the MPI alleges it cannot trace. If the MPI’s position is upheld, the wine will be destroyed. MWE is in discussions with its insurer, however, there is no guarantee that its insurance policy will cover this potential loss. MWE may have a claim against the processor. A worst case outcome is that MPI’s position is upheld, the wine is destroyed, there is no cover under MWE’s insurance policy and a claim cannot be made against the processor. The result would reduce bottled wine inventories by NZ$1.2m, which would see inventories as at 30 June 2015 restated at NZ$5.0m and an impairment charge against profits of NZ$1.2m. The directors have not made an impairment charge; the outcome is expected within six months.

O:TU Investments (OIL) obtained consent from the Overseas Investment Office (OIO) to acquire the Otuwhero vineyard, Donaldson’s Block and associated assets in April 2013. However, the restructure undertaken in preparation for a NXT listing inadvertently breached the consent because it increased Min (James) Jia’s interest by 3%. MWE became aware of this breach and in December 2015 lodged a retrospective consent application. The OIO remedies available are a fine (up to NZ$100,000), a penalty (up to NZ$300,000) and, in the worst case, selling down or disposing of some of the land.

MWE was incorporated on 18 March 2015 and audited financial statements are available for the period from incorporation to 30 June 2015. MWE has also prepared pro forma accounts for the 12 months ended 30 June 2015 to include the restructure as if it had taken place on 1 July 2014. These financial statements have not been audited.

Because of a decline in the price of bulk wine, in 2015 MWE decided to hold bulk wine stocks until prices increased. This meant that sales of bulk wine that would normally have been made in FY15 were made in FY16. Management advises that at the date of the Listing Document in FY16 it had sold 770,000 litres of bulk wine. No details were provided of the price received. Under normal pricing conditions, it would be reasonable to expect that bulk wine would be sold in the year of production.

The income statement for 2015 does not include amortisation of intangibles. Future years’ profits will be reduced by an amortisation charge of NZ$515,315, which is based on the provisional useful life of the distribution rights of 10 years.

NZ IFRS require certain assets to be stated at fair value rather than at historic cost. All movements in these fair values are reflected in and impact the Statement of Financial Performance. The assets affected are:

In 2015 the fair value adjustments resulted in additional gain of NZ$1.054m. According to management, this is offset by an increase in cost of goods sold of NZ$1,054m less biological asset adjustment of NZ$0.213m. According to the Listing Document (page 33), MWE has incurred an EBIT profit of NZ$0.6m or net profit after tax of NZ$0.2m for the year to 30 June 2015 (pro forma).

Interest-bearing liabilities of NZ$6.1m are shown as current at 30 June 2015 because, as stated in the audited financial statements, the loan with ICBC was due to mature on 17 December 2015 and the intention was to apply for the loan to be refinanced for a two-year period. Management advises that this loan has been extended to 22 September 2016 and a new facility will be renegotiated after the NXT listing is complete.

Cash flow from operations is negative, mainly because FY15 did not include sales of bulk wines that were deferred until FY16 due to weak market pricing.

There have been no dividends paid and the board has not yet set a dividend policy.

MWE is a young company that reported a NPAT of NZ$0.59m for the period from 18 March 2015 to 30 June 2015. The unaudited pro forma NPAT for the 12 months ended 30 June 2015 was NZ$0.170m. Management expects that as production volumes ramp up and sales of bottled wines increase from NZ$0.78m in FY15 to the company’s KOM estimate of NZ$3.4m in FY17 that profitability will increase significantly. MWE has not provided any forecast material other than the KOMs.

We have undertaken a sensitivity analysis using the company’s KOMs and a set of our assumptions to illustrate in Exhibit 21 the improved margin that could be achieved by selling increased quantities of higher margin bottled wine and reducing the amount of lower value bulk wine sales. For the purpose of this sensitivity, we have excluded other revenue and fair market value adjustments. This sensitivity analysis is not meant to be a forecast and has been provided to illustrate the impact of increasing production and changing product mix. Our sensitivity analysis shows cash-based gross margin could increase from 53.8% in FY15 to 58.0% in FY17 if all KOMs and our pricing and cost assumptions are met.

In our sensitivity analysis, we have assumed an increased cash cost of goods sold (per litre produced) because of increased volumes of bottled wines, which will include not only the crushing costs but the costs associated with winemaking and bottling. Details of assumptions and their sources are included in the table below.

Where there is sufficient information available, fundamental valuations are undertaken using discounted cash flow analysis or other methods such as the dividend discount model or the Gordon’s growth model. To provide a valuation reference for MWE we have looked at how the market is pricing comparable companies.

There are two listed peers in the NZ/Australian market. Both companies are well established and are substantially larger than MWE and are therefore of limited relevance. Treasury Wine Estates is not considered to be a relevant peer because of its diversified product range, its global spread and its size which is 123x the market capitalisation of MWE.

Due to lack of meaningful profit forecasts, we have also looked at EV/sales ratios, have included Foley Family Wines and used historic multiples as a reference point. If we assume that the Delegat and Foley Family Wines multiples (see Exhibit 23) are the most appropriate then MWE sales would need to increase from current levels of NZ$2.4m to between ~NZ$16m and ~NZ$21m (assuming EV/sales multiples of between 3.0x and 4.0x). The EV used for MWE is NZ$64m. comprising the implied market capitalisation of NZ$58.7m plus net debt of NZ$5.1m as of June 2015.

MWE’s share register is tightly held, with 82.6% held by executive chairman and founder Min (James) Jia. A further 7.8% is held by Li Zhong Wang, taking total holdings by substantial shareholders to 90.5%. The escrow arrangements entered into by Min (James) Jia, and associated entities are as follows: