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The Depth Report - The Wrath of Grapes


Last week Deep Knowledge Investing Food, Restaurant, and Spirits Advisor, Howard Freedland, was asked to speak to The Society of the Four Arts, in Palm Beach, Florida, about the impact of current and projected tariffs on old-world wines. While we normally focus on actionable stock ideas and timely market commentary, Howard is a 20-year veteran of the wine industry, and his observations are fascinating and worth relaying.


Overview:

In October, the World Trade Organization approved US tariffs on $7.5 billion of EU goods in response to subsidies to Airbus. The US responded with 25% tariffs on most wines from France, Spain, Germany, and the UK. The tariffs were announced on October 2nd, and went into effect on October 18th. This created a problem for importers, retailers, and restaurants which stock these wines. The compressed time-frame further compounded the issue. Howard knows people who had wines in transit that upon arrival were 25% more expensive than planned due to the tariffs. Most importers had to absorb the cost as raising prices to their customers during the holiday season wasn’t a good option.


    The situation has become more complicated because in July, France announced a digital services tax which is expected to apply to 30 companies including 17 from the US. The new tax targets companies like Google, Apple, Facebook, and Amazon. In December, the US responded by proposing additional tariffs on EU goods including a 100% tariff on almost all EU wine.


The Impact to the Industry:

    Wine pricing is complicated due to a multi-tier import, distribution, and retail model. While the tariff only applies to the import price, if the US acts on the threats of the new tariffs, then by the time that higher pricing makes its way through the system, prices to end customers will be up around 100%. We’ve seen countless reports predicting Armageddon for the entire wine industry including importers, distributors, retailers, and restaurants. Even the US wine producers are complaining in the press that their business is at risk due to potential retaliatory tariffs from the EU. We acknowledge that there is likely to be substantial disruption in the industry, and that some good businesses may not survive, and that some good people may lose their jobs. We are also skeptical that this is actually Armageddon for an industry that has survived for thousands of years through bad weather, fires, crop disease, and pests. Plus, international trade issues and war are as old as the wine industry itself.


Impact on US Producers:

    Some US producers are claiming that tariffs on old-world wines will hurt their business. They’re claiming that the EU could retaliate and impose tariffs that would reduce US exports. That’s possible, but we’re highly skeptical on this point. That analysis assumes a static wine landscape, and ignores the benefits to US producers of higher prices being imposed on European competitors. A soil scientist attended Howard’s lecture, and he confirmed that while the same grapes could be grown in different places, changes in soil and climate mean that there is no exact substitution for a particular wine. Still, at some price, consumers will switch from French and Italian wines to California and Pacific Northwest wines. Worst case scenario is that American wine lovers start drinking a lot more US (and South American and Australian) wines, and European wine lovers start drinking a lot more European (and South American and Australian) wines. People will continue to enjoy wine, and supply lines will become much shorter as consumers focus more on domestic producers.


    This may not even be the disaster to European producers that is feared. We believe that only 4% of French exports come to the US. Those figures rise to 5% for Spain and 17% for Italy. (Sources here and here.) It might take a little time, but between domestic consumption, and exports to other markets, the big EU producers have other options.


Impact on Importers:

    Whether the US importers survive this challenge probably depends on two things. The first is how nimble and creative they are. Some importers rushed to get wines flown in just ahead of the tariff deadline while others got caught with boats in transit and had to pay the tariff to unload. The second factor is the level of inventory at the end of December. If the 100% tariffs go into effect, it’s going to be expensive for a smaller importer to take the hit to cash flow in order to unload the now-more-expensive product. However, this situation could actually work to the benefit of importers with a full warehouse. They will have inventory stocked at the old pre-tariff price while competitors have to raise prices to account for the tariff. These importers will either take share, or be able to get price increases on existing inventory.


Impact on the Political Situation:

    At Deep Knowledge Investing, we believe in free markets, and prefer that there is as little government friction introduced into commerce as possible. With that said, the EU has been imposing tariffs on US wines for years. While the US has every right to protest the EU subsidizing Airbus, the World Trade Organization has also found the US guilty of subsidizing Boeing. We do believe that President Trump means it when he offers free and fair trade as long as it’s reciprocal. If we were in charge, we’d advise both sides to drop wine tariffs and to stop subsidizing favored industries. Until then, the situation reminds us of the child’s response of “the fight started when he hit me back”.


Advice for Wine Lovers:

Howard notes that the price of “Super-Tuscan” Sassicaia could go from $200 to $400 a bottle, the price of restaurant glass-pour favorite, Chateau Larose Trintaudon, could rise from $20 to $40 a bottle, and 100 points headliner First Growth Bordeaux Lafite Rothschild could go from $900 a bottle to $1,800. If you have a few favorite old-world wines, stock up now. If you have a favorite independent retailer, they’re likely to appreciate a visit from you now more than ever, and can certainly recommend something from the US or South America that fits your preferred profile.


Update:

As we completed this article, news came out that President Macron and President Trump are working on a deal to pair a reduction of the French digital services tax with the reduction or elimination of the proposed increase in US tariffs on EU wine. The proposed tariff and tax increases are being put on hold while the new agreement is being negotiated. As noted above, we’re in favor of lower taxes and reduced government friction in the economy so we greet this news with enthusiasm. 


Second Update:

     Howard has continued to speak with people up and down the wine distribution chain, and he’s hearing continued concern regarding the possibility of 100% tariffs on EU wine. His contacts point out that the World Trade Organization has allowed the US to impose tariffs on $7.5 billion of EU products, and that President Trump could still increase wine tariffs from the current 25% level to 100%.


     We acknowledge that these sources are correct on the facts, but draw a different conclusion. President Trump has tied the 25% tariffs on some EU wine to the Airbus subsidies, and the additional 75% to France’s digital services tax. His deal with President Macron is to delay the increase in the wine tariffs in exchange for a delay in the digital services tax, and the two leaders have agreed that those negotiations will take place throughout 2020. Trump successfully used the threat of increased wine tariffs to get Macron to hold off on the digital services tax. While it’s possible that negotiations could break down during the year, given that the President got what he wanted, we don’t see a motive for him to raise the wine tariff to 100% this year.

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