Why We Canceled Our Majestic Wine Issue - For Now

by Quan Hoang

Geoff and I had scheduled Majestic Wine as the May 2015 stock pick for our Singular Diligence newsletter because it looked like an affordable stock with the best competitive position in its small niche (multi-bottle wine purchases in the U.K.). But a transformative acquisition and a change of CEO makes us doubt the board intends to maintain the corporate culture that lead to Majestic’s success. So we’ve scrapped the issue on Majestic for now. We picked a simpler, safer stock for May. Majestic is still an interesting company. And it might be a good stock for some blog readers - just not for Singular Diligence right now. So, here’s my take on the company.

Majestic Wine is the largest specialist retailer of wine in the U.K with 215 stores. Majestic stores are about 3,500 square feet carrying 800-900 types of wines. That’s small compared to U.S. wine stores. In the U.S., an upscale supermarket can carry 2,000 types of wines but having 800 types of wines is a lot to U.K. consumers. Only Waitrose carries a similar range. U.K. retailers offer fewer types of wines perhaps because supermarkets control most of the market share. Supermarkets might want to concentrate purchasing power, and maximize sales per square foot so they don’t carry many types of wines.

Majestic doesn’t try to sell the cheapest wines. They focus on premium wine. Majestic sells on average £7.94 per bottle (or $12), which is 40% higher than the industry average of £5.38 per bottle (or $8.14). The differentiation is the 6 bottle-purchase minimum. Majestic’s average transaction is £129 (or $195) or 16.25 bottles per transaction. The high revenue makes it feasible for great in-store service. Knowledgeable employees can give customers advices about wines. They carry wines to customers’ cars and offer free home delivery. Stores also offer free tasting. Majestic sells good wines and good service at competitive price.


Wine Retailers Enjoy Favorable Product Economics

Unlike in beers or liquors, product economics is better for wine retailers than for brand owners. Brand is less important in wine. Customers choose wine by origin, grape variety, and price range. Selecting wine is like selecting a mutual fund. There are hundreds of choices and each choice tastes different. Price visibility is low. So, customer relationship is better built at store level than at brand level. As a result, retail mark-up on wine can be 30% compared to 10% on beers and spirit.

Wine retailers have strong power over winemakers. Wine retailers are more concentrated than consumers and suppliers. Premium wines are usually made at small scale. Majestic is the #1 or 2 buyer from each producer. My estimate is that Majestic buys about 25% to 50% of each producer’s capacity. As an example of Majestic’s power over suppliers, Majestic asked suppliers to pay 4 pence per bottle between October 2014 and April 2015 when they built a new warehouse.

Favorable product economics, along with efficient operations, allows Majestic to make about 8% EBIT margin. By turning assets 4 to 5 times, Majestic can make 30-40% pre-tax ROIC. From 2000 to 2014, annual sales growth was 9.2% and annual earnings per share growth was 12.3% while Majestic retained only 48% of earnings.

Majestic has 215 stores today. They target to have 330 stores by opening 12-16 stores per year. That would result in high single digit growth for many years while paying about 60% of earnings in dividends. During my research, the share price was around 320 pence per share, which implies 9x EV/Pre-tax Normal Earnings. Majestic pays about a 23% tax rate so that translates into less than 12x After-tax Normal Earnings. Majestic seems like a good “Growth” candidate.

Like I said in the last post, the key to analyzing Growth stocks are durability, moat, and debt. Majestic has almost no debt. Rent is so cheap that EBITR/Rent is about 3.7. The solvency risk is minimal. Durability and moat seem good.

There are two main risks to durability. One, wine brands become more important and the profit pool is shifted from retailers to brand owners. Two, Majestic loses the role of connecting consumers with producers.


Retailers Helps Connect Small Wine Producers with Consumers

There’s little risk that wine brands become more important for some reasons.

First, economies of scale in wine production aren’t significant. 80% of capital investment is highly variable in equipment like refrigeration system, fermentation & storage tanks, or cooperage (barrel, racks, etc.) Some studies show that most of the decline in unit costs are gained when capacity is increased to 10,000 cases (1 cases = 12 bottles of 750ml). Economies of scale become less important for wineries with capacity over 10,000 cases. So, production cost isn’t the problem for small producers. That means there are always many small producers to buy wines from.

The problem of small winemakers is marketing. Small producers don’t have scale to reach end-consumers in each end-market. Oyster Bay is one big premium brand. Oyster Bay’s gross margin is over 60%. They spend 30% of revenue in marketing. Most wine producers can’t spend that much.

So, for many small wine producers, Majestic is the best route to U.K. consumers. Majestic has store employees to explain new wines to consumers. In fact, one third of Majestic’s wines are replaced each year.


High Barrier to Entry

The risk that Majestic loses the role of connecting consumers with suppliers comes from competition. Majestic competes with supermarkets, high street wine specialist, and distant sellers like mail-order or online retailers. Supermarkets control over 80% of market share but are more focused on cheap wine. High street wine specialists are weak and losing market share. Many wine specialists went out of business during the Great Recession. Online wine retail is a hot area.

Barrier to entry is high in the brick-and-mortar channel. It’s difficult to replicate Majestic’s warehouses. Entry was easiest in early 1980s. After 30 years, it’s difficult to replicate Majestic’s buying power and efficient operations. It’s also difficult to compete with supermarkets. Supermarket market share is concentrated in a few players. Except for growing discounters like Aldi and Lidl, there’s little change in that channel.

Barrier to entry is low online, but it’s very difficult to build a viable online business. Many wine e-retailers come and go quietly. They couldn’t get enough scale to pay for fixed costs. The problem is that pure online retailers don’t have a cost advantage over traditional retailers like Majestic. They’re actually at a cost disadvantage.


Majestic Model

Majestic has an extremely efficient model. Each store has 4 or 5 employees and 1 or 2 vans. Employee’s jobs include lifting lots of boxes of wines, giving customer advices, managing store’s web page, carrying cases to customer cars and delivering wine to customers. Store employees deliver about 40% of sales to customers’ home.

This level of service is possible because each store fulfill an average 30 orders per day. So, stores aren’t busy. Yet, staff and credit card processing expenses are on average only 7.9% of sales. That’s thanks to the high revenue per transaction, which is a natural result of Majestic’s policy to sell by cases.

Majestic stores are usually located away from high street (focal point for shops in U.K. town and city centers.) and between where affluent people work and live. Many are converted garages, pubs, or petrol stations. Average store size is about 3,500 square feet. Each store has free parking for 10-12 cars. Rent expense is just 3.4% of sales.

Big stores allow Majestic to keep inventories at stores instead of distribution centers (DCs). Majestic has only one national warehouse that is in the same building with Majestic’s headquarters where cardboard boxes crowd the reception area. The national warehouse passes through inventories quickly to stores. Each store holds enough inventories for 11 or 12 weeks.

I think Majestic’s model is even more efficient than supermarkets like Tesco. Tesco doesn’t keep a lot of inventories in stores so they have to replenish stores frequently from 28 regionals DCs. Tesco ships a big amount of wine to regional DCs, and then ships a small amount of wine from regional DCs to stores frequently. Meanwhile, Majestic ships a big amount of wines to stores much less frequently. Including store occupancy cost, the cost of getting wines to stores and delivering to customers is just 8.4% of Majestic’s revenue. That’s impressive. Also, inventory cost is financed by suppliers because Majestic gets 75-day credit from suppliers.

Majestic spends about 5.2% of sales in administrative expense. So, total operating expenses is 21.5% of sales. Adjusted gross margin, which considers only cost of wine, duties, and carriage cost in cost of sales, is about 29-30%. So, Majestic can make about 8% EBIT margin.

Online Competitors Don’t Have as Low Costs

Naked Wines is the most successful competitors. Revenue has grown very fast. Revenue was £4 million in 2009, £11 million in 2010, £22 million in 2011, £35 million in 2012, £53 million in 2013, and £74 million in 2014. Naked Wines made £3.3 million EBITDA loss in 2014. However, EBITDA in the U.K. was about £2.1 million, which translates into about 5% EBITDA margin.

In its best year, operating expenses is well over 30% of sales. Naked Wines spends about 16% of sales in selling and distribution expenses, 11% of sales in administrative expenses, and over 6% of sales in customer acquisition.

Selling and distribution expenses are highly variable. Naked Wines’s best chance to reduce cost is to gain operating leverage in administrative expense, and to achieve high customer retention rate (thus reducing customer acquisition cost over customer lifetime value). But it’s perhaps impossible to match Majestic’s efficiency of spending only 21.5% of sales in operating expenses.

That’s understandable because wines are heavy so it’s expensive to ship a few cases from a central warehouse. Also, revenue per transaction is so high that centralizing customer service and order fulfillment doesn’t save that much.

Online competitors are unlikely to have lower cost of wine than Majestic. Majestic has about 4% market share. However, Majestic’s CEO said in an interview in 2011 that 80% of wine sold off-trade in the U.K. was below £5. That means Majestic may have close to 20% market share in premium wines. They have 13% market share of wines from Argentina, 12% market share of wines from Bordeaux, 12% market share of wines from New Zealand, and 10.5% market share of Champagne. So, Majestic has strong buying power.

Majestic is also a tough buyer. Most of business is conducted at trade fairs. Majestic’s wine buyers usually spend 15 minutes talking to a winemaker and taste all of the wines. They don’t socialize or fraternize. They taste and say to winemakers “that wine and that wine I like. Send me a sample and your best price.”

So, I don’t think competitors can have lower cost of sales than Majestic. Some actually said that Naked Wines sell £1 or £2 more than should be. Most critics say that Naked Wines’s wines are bottled very young.

There is evidence that other distant sellers are less efficient than Majestic. For example, Laithwaites is a mail-order wine merchant since 1969. Laithwaites revenue is about £350 million. Laithwaites has over 1 million customers Half to 2/3 of customers are regular customers. Laithwaites sells wine at a higher mark-up than Majestic. One wine critic in the U.K. told me that Laithwaites sells lower quality wines than Majestic. However, Laithwaites EBIT margin is just 2-3%. That suggests high operating expenses, perhaps because of high shipping cost and high customer acquisition cost.

So, it’s easy to establish an online wine retailer but it’s very hard to build a profitable business. It took Naked Wines 4 years to break even. And after 6 years, Naked Wines’s EBITDA in the U.K. is merely £2.1 million. Majestic is in a better position than online competitors because 40% of sales are already delivered by local stores.


Majestic Wine Can Co-Exist with Supermarkets

The biggest competitive risk actually comes from supermarkets. They are trying to sell more online. And they’re trying to sell better wines.

Majestic has some protection. First, Majestic has inherent cost advantage over online retailers as discussed above. Tesco online may have greater scale to match Majestic’s efficiency. Tesco may underprice Majestic by taking lower margins. But that’s all. Online retail of wine isn’t a winner-take-all situation. Different e-retailers don’t carry the same types (or labels) of wines. Price comparison is very difficult. There’s room for several winners. And Majestic has only about 4.2% market share.

Supermarkets can also underprice Majestic in the brick-and-mortar channel. Some Majestic’s employees told us that Waitrose sells similar wines somewhat cheaper than Majestic because they sometimes sell wines as a loss leader.

Pricing competition from supermarkets isn’t a big problem. Majestic has never tried to offer the lowest price. They offer great service at competitive price. The differentiation is 6-bottle purchase minimum. About a half of customers go to Majestic stores once a year to buy wines for events like BBQ, Weddings, Christmas, etc. They buy from supermarkets for the rest of the time. The other half of customers are regular customers. They may visit Majestic stores once every 2 months.

Customers go to Majestic because of product availability and services. Supermarkets don’t normally carry several cases of the same wine. Majestic offers party services like free glass loans or free return of unopened bottles. Supermarkets don’t offer free tasting like Majestic. Supermarkets may try having wine experts in-store but consumers aren’t used to store employees approaching them in supermarkets. Supermarkets definitely don’t help carry wines to customer’s cars.

Price is important but there are always customers willing to pay a bit more for better services. Majestic will be fine as long as they keep prices competitive while maintaining a high level of customer service.


Volatility Creates Opportunities

One more thing I like about Majestic is price volatility. EV/EBIT moved by 5 units in most years since 2001. For example, the lowest EV/EBIT was 8.5 and the highest EV/EBIT was 13.8 in 2012. Recently, the price went from 400 pence per share in early January 2015 to 301 pence per share on March 01, 2015, and to 382 pence per share today. Business fundamentals can’t move that much. Smart investors can make great profit by trading in and out of the stock.


The Inherent Risk in U.K. Stocks

Majestic has one risk that’s typical of U.K. companies. U.K. companies have a tendency to hire external CEOs. But I thought that Majestic had a unique culture. When Tim How, the first CEO, retired in 2008, Majestic didn’t look for external candidates. They had actually appointed Steve Lewis as COO in 2007 to prepare for Tim How’s retirement. Steve Lewis joined Majestic in 1985 as a store employee right after graduating from college. He spent his entire career at Majestic. That’s a strong evidence for the continuity of a culture.

Steve Lewis has done a good job. He took Majestic through the Great Recession unscathed. Majestic’s recent performance isn’t good. They gained market share but expected flat earnings this year. Margins declined because of pricing pressure from supermarkets. I think that’s fine. Majestic is still growing and is now more competitive. Margins declined but are still higher than historical level (and my expected normal margins).

But Steve Lewis was suddenly fired in February 2015. Majestic said they wanted to find a CEO with online expertise. That worried me. It’s true that Majestic is slow in growing the online business but I expect an evolutionary instead of a revolutionary change. An online executive may know nothing about wine warehouse and offline customer service.

Finally, Majestic announced the acquisition of Naked Wines in April 2015. They’ll make Naked Wines CEO Rowan Gormley the new CEO. Majestic will pay £50 million cash, which is financed by debt, and £20 million in shares based on performance over the next 3 years.

I think acquiring Naked Wines make great strategic sense. There’re cost and product synergies between a wine warehouse and a wine club or an online wine store. Last year, Naked Wines made £74 million revenue, £2.1 million EBITDA in the U.K., and -£3.3 million EBITDA overall. If Majestic helps Naked Wine reduce cost of wine, administrative expense, and distribution cost, they can make 8% EBIT margin on Naked Wines’s sales. If that works, the price they paid isn’t high at all. The two companies combined can also offer stronger offerings to consumers.

My concern is that Majestic made Rowan Gormley the new CEO. To me, he’s more of a salesman than a value builder. His experience over the last 15 years has always been with wine e-retailer start-up. He might have spent more time at raising money or PR than creating value. He may not understand what brought Majestic success and may kill Majestic’s culture. I would prefer Steve Lewis to stay as the CEO of the merged company.

This development reminded me of Sequoia’s discussion on Rolls-Royce in the recent letter to shareholder:

Rolls-Royce, our largest UK position, seems willing to destroy shareholder value in the name of diversification. Rolls-Royce has a world class business making engines for wide body jets. These engines are often sold at breakeven prices, or even a loss, but come with long-term Total Care service contracts that are quite profitable. Rolls shares a duopoly with General Electric in wide body engines and the barriers to entry for any newcomer would be formidable. Not only is the business intensely regulated, but a new player selling jet engines without an installed base of profitable service contracts likely would lose billions of dollars to capture market share from GE and Rolls. Not surprisingly, Rolls earns more than a 20% return on invested capital in civil aviation and its installed base of service contracts and strong backlog suggest Rolls should grow profitably for years to come.

And yet Rolls’ board of directors decided that it wanted to diversify deeper into the marine engine and power generation businesses, competitive sectors that are being encroached by low cost Asian players. To pursue this strategy, the board appears to have pushed out a sitting CEO who had crafted the successful Total Care service contract selling model, and replaced him with John Rishton, a board member who, in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated.

Rolls’ stock declined more than 30% in sterling during the year as investors lost confidence in management. We held our shares in the belief that Rolls’ wounds are self-inflicted and reversible. The recent share price does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses. However, management and the board seem stubborn and entrenched, and it may take a tough-minded activist to force strategic change.

A Singular Diligence issue on Majestic was scheduled for May 2015. But there’s a risk that Majestic is changing for the worse like the story Sequoia thinks Rolls-Royce is. So, Geoff and I decided not to publish an issue on Majestic in the near future. There’s too much change and it’s too early to tell. To me, Majestic chairman Phil Wrigley looks like an idiot. But I can be wrong and he may prove a genius. So, I’ll keep watching the developments at Majestic. But for now, we can’t afford any speculation in our newsletter.

This experience also teaches us to be careful of European stocks in general. Independent Chairmen are strong in European countries. European companies tend to hire chairmen and CEOs externally. That results in a risk of change in a company’s culture or direction. It’s perhaps safer to pick good family-controlled companies when investing in European stocks.