WHEN RICHARD GRAFF KNOCKS ON wood, as he is wont to do, he tends to rap on whichever of the roughly 5,000 oak barrels at Chalone Inc. happens to be nearest him. The sound is reassuring, and -- who knows? -- it may bring him good luck, too. He certainly needs it these days.
Graff is chairman and chief operating officer of a small wine-making company whose fate depends on sum and rain, among other factors beyond his control. But weather isn't the biggest risk; competition is. The number of California wineries has doubled to more than 500 in the past decade, and 90% of the new ones are challenging Chalone in the premium end of the business, in which bottles retail for $7 or more.
There isn't much reason for Graff to worry about the hobbyists who have entered the business. Many are content to produce a few bottles and rhapsodize about the dew shining on the grape leaves at dawn.But the Ernest and Julio Gallo winery is another story. The biggest wine maker in the world, it already owns one of the largest shares of the premium-wine market, despite its jugwine image. And other major companies, including Nestle, United States Tobacco, Moet-Hennessy, and Suntory, have been buying premium wineries as well.
Big is a word that is anathema to Chalone. Unlike almost every other small California premium producer, Chalone won't build volume at one location. Instead, it operates wineries at four different locations. Graff, who is 49, and his partner, Philip Woodward, 47, are betting that small production units are the key to competing in the top end of the wine-making business.
Their success to date -- sales are approaching $8 million, having doubled every year since 1980 -- tends to feed the conventional wisdom about the advantages of managing small operating units. But look at Chalone again. The financial strain of duplicating assets is beginning to show at exactly the time when Chalone faces much stiffer competition in its market.
"The strategy I had from the beginning," explains Woodward, who is Chalone's president and chief executive officer, "was to grow by staying small, to keep the production facilities separate and limited, and to build a different winery in each of the four premium wine-growing areas of California." This year, Chalone's total production will amount of about 120,000 cases or about one-quarter what the Beaulieu Vineyard, to take one exmple, produces at its single winery in Napa Valley. Chalone, Woodward says, is modeled after the French negociant, or broker-dealer, who typically represents many small wine makers. But Chalone has added the twist of producing the wine itself.
Dear to Chalone is the notion that keeping quality high means keeping its wineries small. Chalone wineries use modern crushing, fermenting, and bottling equipment, but age wine in hand-split oak barrels in the traditional French manner. Graff oversees the four wineries, but leaves day-to-day operations to a chief wine maker at each location, who hires and fires workers as well as oversees production. These managers are denim-clad men in their thirties who have enology degrees from the University of California. "There's got to be one person in charge of each winery," Graff says. "That one person has got to be able to go through all of the barrels within a week to smell, taste, and examine the wine."
By Graff's reckoning, a winery's standards start to slip when it handles more than 50,000 cases a year, which just happens to match the planned output at Chalone's largest winery, in San Luis Obispo, once an expansion is completed there sometime this year. The logic of the 50,000-case limit is lost on many competitors. "We used to say that ourselves when we were smaller, but it didn't have a whole lot of merit," says Legh Knowles, chairman of Beaulieu Vineyard.
Whether limited production is crucial to making fine wine, it certainly helps sell it. Chalone's marketing strategy is built on snob appeal. "The reality is that you're selling magic as much as taste," says Harvey Steiman, managing editor of The Wine Spectator, a San Francisco-based newspaper for wine drinkers. "Once you get up there [in price], you're paying for more than the liquid in the bottle." Adds Woodward, "There's a lot of image in this thing. If you're known as a grocery-store wine or an airplane wine, you're not going to get $20 in a store of $40 in a restaurant." About 60% of Chalone's wine is sold in restaurants, 15% in mail-order sales, and 25% in retail stores at prices as high as $28 for a bottle of Chalone Vineyard Reserve Pinot Noir, though most are in the $10-to-$20 range.
Having four wineries, each in a distinct grape-growing region under a separate label, adds variety to Chalone's product line. This aids Chalone's network of independent distributors in 40 states and six foreign countries, particularly in selling to restaurants where diversity on a wine menu is a plus. "If Chalone had funneled all its products into one label, it would not have met with the success it has," says Gerald Hirsch, president of Custom House Wine Merchants and Chalone's Chicago distributor since 1976.
Those marketing advantages come at a high price, though. Running four wineries requires expensive duplication of resources. Each outfit has its own crushing, pressing, and bottling equipment, such as $50,000 "bladder crushers," which extract juice from grapes, as well as a $25,000 testing laboratory. There are other extraordinary expenses as well. Just stringing a seven-mile power line to the Chalone mountaintop vineyard in Monterey County cost the company $250,000. Woodward estimates that Chalone's operating costs run about 25% higher than they would producing the same amount of wine at one winery. (Chalone owns three of its wineries and leases some of the assets of the fourth, the Edna Valley Vineyard, in San Luis Obispo, from a joint-venture partner.)
Building its new Carmenet winery in Sonoma County was a real lesson in the costs of staying small. The price tag was $3.1 million, $1.6 million higher than planned. "I think we'd all do that differently if we had it to do over," admits William Hamilton, Chalone's chief financial officer. No wonder. Interest expenses boubled due to borrowings to cover costs at Carmenet. To pay off the debt, the company went public in May 1984 and followed with two other offerings (no other premium winery is publicly held). The moves eased debt service, but reduced Graff's and Woodward's ownership of the company from 28% to 19%.
Nonetheless, debt remains high. The costs of building the Carmenet plant, plus the $8.5-million acquisition last summer of the Acacia winery in Napa Valley, have helped raise Chalone's long-term debt as a percentage of equity from 28% to 48%. "I wouldn't want to load it up any higher than that," Hamilton says. Meanwhile, the Carmenet facility isn't producing the kind of revenues the company wanted. More than half of its output is a sauvignon blanc that has been on the market since 1983 and is not yet well established. Its anticipated retail price had been $11 a bottle, but competitive pressures have forced it below $9. Woodward sometimes twists his distributors' arms to move the wine. "I think Carmenet is going to be difficult," Chalone's London distributor, Geoffrey Roberts, observed during a buying trip last year to San Francisco, before he agreed to order 25 cases. Chalone's profits last year dipped 12%, and at one time, its stock price slid almost 50% from its 1984 high of $8 a share. As of October 31, 1986, the stock was selling for 5 3/4 a share.
What makes Chalone's problems all the more serious is timing. Everyone wants a piece of the premium-wine market. Despite declining sales of table wines in general, sales in the premium class have been rising at a compounded annual rate of 22% since 1979, according to Jon Fredrikson, publisher of The Gomberg-Fredrikson Report, which covers the wine-marketing industry. Some of those expanding most ambitiously have the capital and marketing clout to compete aggressively with such small wineries as Chalone. According to a recent Fortune magazine article, Gallo, for instance, has more than 300 distributors and awesome marketing power; it quickly climbed to dominance in the wine-cooler -- juice splashed with wine -- market through a remarkable ad campaign featuring two downhome farmer characters, Frank Bartles and Ed Jaymes.
Can Chalone and its small-plant strategy thrive against the big guys?Running four plants gives it four chances to stumble on construction costs and other problems. That reality is coming home to Graff and Woodward, who have relinquished control of part of their company to keep costs under control.