Taking Advantage of the Alcohol Distribution System

 
Back in April, my wife and I spent a few days in Napa Valley, California, doing what comes natural ... eating and drinking and enjoying the company of good friends.  It's hard not to have a good time in Napa.

One highlight of the trip was a visit to Truchard Vineyards in the Carneros region.  A Boston wine distributor had arranged a private tour with owner Jo Ann Truchard, who after 30 years in the business with her husband, is a fountain of knowledge on the subject of winemaking.

Jo Ann took us on a tour of the cellars—which had been bored into the hill and lined with gunite—telling tales about the evolution of Truchard.  She shared stories about buying neighboring vineyards back in the days was prices were far lower, told us how they acquired goats to prune the overgrown vineyards, and discussed the challenges of marketing fine wine in a system dominated by bigger producers.

But best of all she poured us some delicious wines.  Now, I don't typically drink wine before noon; mornings are my most productive time.  But I wasn't in Napa to be productive.  And I wasn't driving (we had a designated driver).  So we enjoyed the wine and when the tasting was done we ordered a case of Cabernet Franc to be shipped home to Massachusetts.  That's when we learned the one thing Jo Ann didn't know about the wine business ... how to run the computer and process my credit card.  But she called Anna, an employee who was nearby, and in no time, Anna had completed the transaction and we were on our way.

Shipping Discrepancies

We had another great tasting the following day at Prager Winery and Port Works in St. Helena, a place that had been recommended to me four months earlier by a young woman dressed in a Santa Claus suit at a party in Boston (that's another story).  To reach the Prager winery, we first had to walk through a flower garden that was so beautiful that we had to stop and take a few pictures.  When we entered the tasting room, we were astounded to see that every surface of the walls and ceiling in the room had been covered with dollar bills.  On closer examination, we found some that were foreign currency, and some dollars—in large denominations—that bore the pictures of Ronald Reagan and Bill Clinton on the front.  Our host, Peter Prager, explained that after one early customer stapled a dollar on the wall, the trend simply continued.

The room's only window was clouded by 30 years of spider webs (you can see it on the winery's Web site).  And the port, patiently poured and explained by Peter, was delicious.  In the end, we bought six bottles of Aria White Port, named after the founding Pragers' first granddaughter, and asked Peter to ship it home to us.  But after consulting a chart inside a cabinet, he told us that he couldn't ship to Massachusetts.  Fortunately, we had a back-up plan, in the form of a brother-in-law in Maine, so Peter shipped the port there.

In the back of my mind, however, a small voice was saying, "It looks like one of these wine-growers is wrong about shipping to Massachusetts."  Sure enough, a few days later, a woman from Truchard called to say they couldn't ship to Massachusetts, so I gave her the Maine address, too.

The port from Prager arrived in Maine a week or so later, and my brother-in-law delivered it to us soon after; it's only a two-hour drive from his house to mine.

But there was no word on the wine from Truchard.  Still, I'm a patient man, and life is busy, so I waited.  And then this week I called Truchard and talked to a woman named Linda.  When I informed her that my wine hadn't arrived, she said, "Oh, dear," and promised to have the matter resolved.

In my mind, of course, were visions of a case that "fell off the truck," or was mistakenly delivered to MN (Minnesota) instead of ME (Maine).  But in the end, the explanation was simple.  Truchard had been confused by the change of shipping addresses and had done nothing; the case was still waiting shipment.

But here comes the strangest part.  Anna said that as of Monday, Massachusetts was back on their list of legal shipping destinations!  She promised to ship it on Thursday, and I expect the wine sometime next week.

Why the confusion?  For the answer, we plunge with curiosity and trepidation into the murky waters of interstate alcohol shipping.

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Prohibition and the System

The trouble dates back to the days of Prohibition, when the 18th Amendment to the Constitution enabled organized crime to assume responsibility for fulfilling Americans' demand for alcohol.  That experiment lasted nearly 14 years, and when the 21st Amendment ended that colorful chapter in our history, control of alcohol trafficking was given to the individual states.

That put the criminals out of business, and it created a system that persists to this day, which is dominated by distributors, who in many cases provide the only legal route by which a producer can send alcohol to a customer in another state.

The other big factor in control is the states, who think first of tax revenues and second about the wants of their citizens.  The result is that every one of the 50 states in the U.S. has different regulations about shipping alcohol!

Rules Vary From State to State

For example:

Alaska does not limit or tax wine shipments into the state. It does, however, permit its communities to restrict sales/shipments of alcohol by way of local election and it is illegal to ship to those communities.

Alabama prohibits direct-to-consumer shipments, but there is a special order provision that allows for an individual consumer to obtain prior written approval from the Alabama Beverage Control Board before the merchandise is brought into the state.

Arizona allows limited direct shipments of two cases annually to consumers, as long as the consumer has physically visited the winery at anytime during the calendar year prior to placing the order.

And those are just the first three!  Massachusetts, for the record, amended its laws in 2006. The new law has a limit on how much wine an individual consumer can receive from an aggregate of wineries every year, but because no one is tracking all the shipments an individual receives, no winery can be assured that it won't be penalized for being the one that goes over the annual limit!  Most importantly, FedEx and UPS do not ship wine into Massachusetts.

(Furthermore, the law excludes any winery that produces more than 30,000 gallons annually, and that has had a distributor in Massachusetts during the previous six months, from shipping directly to consumers in the state.)

Pennsylvania prohibits direct shipments, but says one gallon may be brought in tax-free if purchased while abroad; state markup and taxes apply to foreign purchases in excess of one gallon.  (Peripherally, it's worth noting that a person buying a bottle of wine at a Pennsylvania shop pays an 18% tax known as the "Johnstown Flood Tax" on top of Pennsylvania's 6% sales tax and the 30% Liquor Control Board markup.)

New York allows direct shipments, but requires the winery to obtain three types of permits (a sales tax permit, a direct shipper's permit and a "distributors" permit to allow excise tax payments).  The winery must also file three types of returns (a semi-annual manufacturer's report of shipments to the State Liquor Authority, a quarterly sales tax return, and a monthly excise tax payment).  Can you imagine being a small-time winemaker in California and making monthly tax payments to New York?!

In short, while the Internet has revolutionized commerce in most industries, the alcohol industry remains hobbled by a Constitutional Amendment enacted in 1933, and defended by its chief beneficiaries ... the distributors and the states.

Changes in the Works

Nevertheless, some progress has been made.  In 2005, the U.S. Supreme Court ruled that all states must treat out-of-state wineries the same way they treat in-state wineries ... but I don't see any change.  And a few states have made reciprocity agreements, allowing wine shipments to go unimpeded either way.  As a result of that, wineries in Wisconsin can ship to customers in Iowa and vice versa ... but I don't imagine there are many wineries or consumers helped by that arrangement.  For the most part, the obstacles remain.

Legally, the argument involves balancing rights granted by the 21st Amendment, the Interstate Commerce Clause, the Federal Sherman Antitrust Act and perhaps even the First Amendment.

Proponents of free trade claim that lowering state barriers-cutting out the middleman—would increase choice and lower prices, and I have no doubt they're right.

Detractors say underage drinking would increase.

Proponents say asking for an adult signature upon delivery solves that, and note there's no proven link between mail order booze and underage drinking.

Detractors claim opening the gates will result in "import alcohol anarchy," but it's clear their main interest is the protection of their livelihood ... to the detriment of the consumer.

So it goes.

If you have expert knowledge or an intelligent opinion, I'd love to hear it.

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Profiting From the System

On the investment front, my advice today is to put your money into one of the distributors.  After all, they've got the power, and while you may not like it as a consumer, you can still benefit from it as an investor.  But the distributor I like is not in the U.S.; it's in Poland and Russia!

The company is Central European Distribution (CEDC).  It's not a hot stock, but it's a dependable stock, and it's benefiting from the economic growth of Central Europe (and its neighbors) as well as a well-managed program of acquisition.  It's possible that a paucity of restrictive laws where it operates are a good thing for its growth, too.

Here's what Michael Cintolo wrote last September, when the stock appeared in Cabot Top Ten Report.

"Central European Distribution is the major distributor of alcoholic beverages in Poland, with an unblemished 10-year record of growth since it came public in 1998.  It's the country's main importer of Remy Martin, Jim Beam, Metaxa, Sauza Tequila, Grant's, Corona, Foster's and Guiness.  But this year the company completed the acquisition of Poland's largest distillery, Polmos Bialystock, and it's this move into the high-margin production business that has lit a fire under the stock.  Also attractive is the company's move into Hungary last year, and its anticipated move into the Czech Republic and Russia.  Here the big story is vodka; 75% of the company's revenues come from selling vodka, and only Russia exceeds Poland in per capita consumption.  Also, the company's premium brand, Zubrowka, will soon be launched in the U.S.—Zubrowka means Bison Grass Vodka, and each bottle contains a blade of grass from the Bialowieza forest.  In sum, the future for Central European—which is helmed by a 42-year-old former Floridian, William Carey—is bright."

Back when that was written, the stock was trading at 45.  Yesterday it closed at 70.  But I don't believe the growth is over.  Looking at the numbers, I see that Central European now boasts accelerating growth of both revenues (up 37% in the first quarter) and earnings (up 55%), as well as growing institutional sponsorship.

Looking deeper, I see that in May the company completed its acquisition of a 75% economic interest in Whitehall Group, a leading importer of spirits and wines in Russia.  In the same month, it also signed a binding commitment for strategic investment in the Russia Alcohol Group, the leading producer of vodka in Russia.

With a market capitalization of less than $3 billion, Central European is a third the size of Brown Forman (BFB), a third the size of MolsonCoors (TAP), and one-seventh the size of Anheuser Busch (BUD).  It's less well known than all these, and has greater growth opportunities, and I think you can buy some here.

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Editor's Note: Central European Distribution is no longer followed by Cabot Top Ten Report, it doesn't have the patience, and got shaken out at the March market low with a profit of 26%.  But you can find similar up-and-coming stocks in every issue of Cabot Top Ten Report.  It's your ticket to the hottest stocks in the market, perhaps the next Crocs, Dryships or Illumina.  To get started with a no-risk trial subscription, simply click the link below.

http://www.cabot.net/info/ctt/cttid00.aspx?source=wc01

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Publisher
Cabot Wealth Advisory

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Timothy Lutts can be found on Google Plus.

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