The demand for wine in the United States has steadily increased over the past few years, forcing wineries to raise their production. While wineries are capable of making more wine, producing the grapes needed is also a challenging endeavor. If grape costs rise too high, American wine producers could find the already-challenging industry even trickier.
Constellation Brands (NYSE:STZ) is the world's leading premium wine company, with the top market positions in the U.S., Canada, and New Zealand. As such a big company, it has large yearly grape requirements that are satisfied by a series of vineyards in the U.S., Canada, New Zealand, and Italy. If wine demand matches Constellation's expectations then the company will not experience any setbacks. If demand is greater, then the company must source extra requirements from bulk wine markets. If that's not enough, the company could experience product shortages.
Constellation has purchase agreements with most of its grape growers. Prices vary from year to year. If grape prices fluctuate this can cut into the company's margins. In the most recent quarter, the company's gross margin was 40.37% versus 41% the previous year, due to an increase in grape prices.
Wine and spirit producer Brown-Forman (NYSE:BF-B) explained the risks of grape and other agricultural dependency in its most recent 10-K report. Grapes are a challenging fruit to grow, and the yield of a harvest depends on the year's weather. If yield is low, then price will increase. The company might not be able to be able to pass the cost to the consumer, which then cuts into its margins. Weather also influences the quality of the year's grapes, which makes it hard to produce a consistent product every year. This is a major difference between wine and other types of alcohol.
Another of Constellation's close competitors, Diageo (NYSE:DEO), focuses mainly on producing spirits but it also sells smaller amounts of wine. The company's principal wineries are in the United States, Argentina, and Turkey with wines being sold locally and overseas. The company has long term contracts with grape growers to meet demand and mitigate grape expenses. Diageo only has seven wines that account for roughly 4% of the company's net sales. This is much smaller than Constellation wine's 43% of net sales. This means that Diageo will be less affected by fluctuating grape prices in the future.
The three companies' gross margins can be seen below:
While Constellation has the slimmest margins, the 2013 grape harvest was consistent with last year's crop, and price is expected to decrease slightly. This is good news for the company's 2014 financials. It could see a bump in gross margin if sales remain constant.
Selling wine is challenging, and it depends on more externals than beer or spirit production. With wine accounting for 43% of its net sales, Constellation depends heavily on a successful, reasonably priced grape harvest. Having recently acquired Crown Imports, the company that supplies Corona and Modelo to the U.S., Constellation is moving some of its focus to beer. Wine is still the largest part of the company, but now it is diversifying its alcoholic production. This diversification will be good for investors in the long run as Constellation continues to be a major wine producer.
Ben Popkin has no position in any stocks mentioned. The Motley Fool recommends Diageo plc (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.