DUCKHORN PORTFOLIO, INC. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-Q)
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes to those statements included elsewhere in this Quarterly Report on Form 10-Q. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. See "Cautionary note regarding forward-looking statements" included in this Quarterly Report on Form 10-Q. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed in Part I "Item 1A. Risk factors" included in our Annual Report on Form 10-K for Fiscal 2021.
The Duckhorn Portfoliois the premier scaled producer of luxury wines in North America. We have delighted millions of consumers with authentic, high-quality, approachable wines for over four decades. We champion a curated and comprehensive portfolio of highly acclaimed luxury wines across multiple varietals, appellations, brands and price points. Our portfolio is focused exclusively on the desirable luxury segment, which we define as wines sold for $15or higher per 750ml bottle. We sell our wines in all 50 states and over 50 countries at prices ranging from $20to $200per bottle under a world-class luxury portfolio of winery brands, including Duckhorn Vineyards, Decoy, Kosta Browne, Goldeneye, Paraduxx, Calera, Migration, Canvasback, Greenwing and Postmark. Our wines have a strong record of achieving critical acclaim, vintage after vintage. Each winery brand boasts its own winemaking team to create distinct experiences for consumers, to ensure product quality and continuity and to galvanize sustainable farming practices. Beyond our winemaking teams is an organization comprised of passionate, talented employees, including a highly tenured executive team that has approximately 100 years of cumulative experience with Duckhorn. We sell our wines to distributors outside Californiaand directly to retail accounts in California, which together comprise our wholesale channel. We also sell directly to consumers through our DTC channel, which made up approximately 14% of our net sales for the first six months of Fiscal 2022. Our powerful omni-channel sales model drives strong margins by leveraging long-standing relationships developed over the past forty years. We believe our iconic winery brands together with our scaled, quality-focused production, omni-channel distribution and dedicated employees, set the standard for North American luxury wine. Key financial metrics We use net sales, gross profit and adjusted EBITDA to evaluate the performance of our business, identify trends in our business, prepare financial forecasts and make capital allocation decisions. We believe the following metrics are useful in evaluating our performance, but adjusted EBITDA should not be considered in isolation or as a substitute for any other financial information depicting our results prepared in accordance with U.S.GAAP. Certain judgments and estimates are inherent in our processes to calculate these metrics. Three months ended January 31, Six months ended January 31, (in thousands) 2022 2021 2022 2021 Net sales $ 98,736 $ 83,657 $ 202,917 $ 175,295Gross profit $ 49,477 $ 41,757 $ 101,887 $ 86,032Net income attributable to The Duckhorn Portfolio, Inc. $ 17,932 $ 22,003 $ 39,205 $ 39,526Adjusted EBITDA $ 34,310 $ 32,178 $ 72,400 $ 65,90024
The following table represents the reconciliation of adjusted EBITDA and net earnings attributable to
Three months ended January 31, Six months ended January 31, (in thousands) 2022 2021 2022 2021 Net income attributable to The Duckhorn Portfolio, Inc.
$ 17,932 $ 22,003 $ 39,205 $ 39,526Interest expense 1,636 3,612 3,242 7,192 Income tax expense 6,407 7,935 13,784 14,071 Depreciation and amortization expense 6,280 5,765 11,109 10,881 EBITDA 32,255 39,315 67,340 71,670 Purchase accounting adjustments(a) 99 762 292 1,323 Transaction expenses(b) 1,024 - 2,770 - Change in fair value of derivatives(c) (515) (1,279) (957) (2,827) Equity-based compensation(d) 1,416 288 2,875 576 Casualty gain, net(e) - (7,832) - (7,832) Loss on debt extinguishment(f) - - - 272 IPO preparation costs(g) - 210 - 405 Wildfire costs(h) 31 62 80 1,617 COVID-19 costs(i) - 652 - 696 Adjusted EBITDA $ 34,310 $ 32,178 $ 72,400 $ 65,900
(a) Purchase accounting adjustments relate to the impacts of prior business combination accounting for our acquisition by TSG in Fiscal 2017, our subsequent acquisitions of Calera and
Kosta Brownein Fiscal 2018 and Fiscal 2019, respectively, and certain other transactions consummated prior to our acquisition by TSG, which resulted in fair value adjustments to inventory and long-lived assets. (b) Transaction expenses include legal and professional fees and change of control payments incurred in connection with our IPO in March 2021. Also included are expenses incurred for abandoned transactions and the secondary offering completed in October 2021. These expenses were directly related to such transactions and were incremental to our normal operating expenses. (c) See Note 9 (Derivative instruments) to our Condensed Consolidated Financial Statements for additional information. (d) See Note 12 (Equity-based compensation) to our Condensed Consolidated Financial Statements for additional information. (e) Casualty gain, net in adjusted EBITDA pertains to the flood event at one of our wineries in Fiscal 2019, and was primarily comprised of insurance proceeds received pursuant to our claim, offset by flood damage and remediation costs. The proceeds received, offset by costs incurred, are reported on the casualty loss (gain), net line in the Condensed Consolidated Statements of Operations. See Note 13 (Casualty loss) to our Condensed Consolidated Financial Statements for additional information. (f) Loss on debt extinguishment includes charges for unamortized deferred financing fees we recognized in connection with amendments to our Credit Facility. (g) IPO preparation costs include professional fees incurred for outside consultants to advise us on legal, accounting and tax matters related to our preparation for becoming a public company, which were not directly attributable to an offering. (h) Wildfire costs include the cost of unharvested fruit that was damaged and rendered useless, charges we incurred to respond to imminent wildfire threat with fire-fighting crews to protect our assets, clean-up and smoke remediation expenses to restore operations at our tasting rooms after the fires, testing fees to evaluate our fruit for possible smoke damage, and washing or other grape processing costs prior to vinification to reduce the risk of smoke in finished wine.These costs are reported on the casualty loss (gain), net line in the Condensed Consolidated Statements of Operations. See Note 13 (Casualty loss) to our Condensed Consolidated Financial Statements for additional information. While we expect the potential for wildfires to be an ongoing risk to running an agricultural business in California, we believe the wildfires and related costs we experienced are not indicative of our core operating performance. (i) COVID-19 costs include certain incremental expenses incurred during the outbreak of the COVID-19 pandemic and the short-term closure mandates imposed by government officials in the jurisdictions in which we operate. These costs include tasting room expenses incurred during a period of mandatory closure and reduced capacity, salaries and severance expenses for certain employees and other immaterial costs to transfer inventory.
Our net sales represent revenue less discounts, promotions and excise taxes.
Gross profit is equal to our net sales less cost of sales. Cost of sales includes all wine production costs, winemaking, bottling, packaging, warehousing and shipping and handling costs. Our gross profit and gross profit margins on net sales are impacted by the mix of winery brands we sell in our portfolio. See "-Components of results of operation and key factors affecting our performance" for additional information. Adjusted EBITDA Adjusted EBITDA is a non-GAAP financial measure that we calculate as net income before interest, taxes, depreciation and amortization, non-cash equity-based compensation expense, purchase accounting adjustments, 25
casualty losses or gains, impairment losses, changes in the fair value of derivatives and certain other items, which are not related to our core operating performance. Adjusted EBITDA is a key metric we use to evaluate business performance in comparison to budgets, forecasts and prior period financial results, providing a measure that Management believes reflects the Company's core operating performance. For comparative periods presented, our primary operational drivers of adjusted EBITDA have been sustained sales growth in our wholesale channel and steady growth in our DTC channel, management of our cost of sales through our diversified supply planning strategy, and discipline over selling, general and administrative expenses relative to our sales growth.
Main operating parameters
We monitor the following key metrics to help us evaluate our business, identify trends affecting our business, measure our performance, formulate business plans and make strategic decisions. We believe the following metrics are useful in evaluating our business but should not be considered in isolation or, solely with respect to price / mix contribution, as a substitute for financial information prepared and presented in accordance with
U.S.GAAP. Certain judgments and estimates are inherent in our processes to calculate these metrics.
Percentage of net sales by channel
We calculate net sales percentage by channel as net sales made through our wholesale channel to distributors, through our wholesale channel directly to retail accounts in
Californiaand through our DTC channel, respectively, as a percentage of our total net sales. We monitor net sales percentage across these three routes to market to understand the effectiveness of our omni-channel distribution model and to ensure we are deploying resources effectively to optimize engagement with our customers across our complementary distribution channels. Three months ended January 31, Six months ended January 31, 2022 2021 2022 2021 Wholesale - distributors 67.2 % 60.2 % 67.9 % 66.9 % Wholesale - California direct to retail 19.8 % 19.6 % 18.1 % 16.9 % DTC 13.0 % 20.2 % 14.0 % 16.2 % The composition of our net sales, expressed in percentages by channel for the three months and six months ended January 31, 2022and 2021, continued to move toward historical trends along with the signs of ongoing recovery from COVID-19 disruption across major markets. While notable gains in on-premise activity continued the shift back toward pre-pandemic levels, off-premise activity remained a key strength in our results as we held onto share gains across our broader wholesale channel. Net sales for the DTC channel were bolstered by higher visitor center sales overall as compared to the prior year period for the three months and six months ended, although comparability to prior year was impacted by earlier member shipment timing pulling a portion of net sales from the second quarter into the first quarter of Fiscal 2022.
We expect the sales channel mix to continue to normalize towards historic levels in correlation with the return of consumer shopping habits and the reopening of on-premises outlets in future periods.
Contribution to net sales growth
Net sales growth is defined as the percentage increase of net sales in the period compared to the prior period. Contribution to net sales growth is calculated based on the portion of changes in net sales for a given period that is driven by two factors: changes in sales volume and changes in sales price and mix. Volume contribution presents the percentage increase in cases sold in the current period compared to the prior period. 26
Price / mix contribution presents net sales growth less volume contribution and reflects that, in addition to changes in sales volume, changes in net sales are primarily attributable to changes in sales price and mix. Three months ended January 31, Six months ended January 31, 2022 2021 2022 2021 Net sales growth 18.0 % 8.7 % 15.8 % 17.1 % Volume contribution 24.8 % 11.4 % 15.3 % 25.4 % Price / mix contribution (6.8) % (2.8) % 0.5 % (8.3) % For the six months ended
January 31, 2022, growth in net sales was mainly attributable to continued strong sales volume growth and a neutral price / mix contribution demonstrating the shift back toward pre-COVID-19 trends with the growth in our on-premise sales. Generally, on-premise growth also drives increased sales in our ultra-luxury brands that sell at higher average sales prices and positively impact price / mix contribution. In the prior year period, we saw immense growth primarily driven by off-premise sales of our luxury winery brands that drove a negative price / mix contribution. Our consistent use of distributor and retail sales discounts and promotions in our wholesale channel to gain market share has historically and may continue to put downward pressure on price / mix contribution given an increase in net sales. For the three months ended January 31, 2022, negative price mix contribution was impacted by the outsized volume growth of the wholesale channel, aided by continued on-premise resurgence and further pressured by DTC shipment timing moving out of the second quarter of Fiscal 2022 into the first quarter of the same fiscal year. We expect price / mix contribution will continue to move toward historical levels as consumer purchasing and consumption habits return to normal following the COVID-19 pandemic. We expect that volume contribution will continue to be the primary driver of changes in our net sales in future periods. To the extent our growth is fueled by sales of lower-priced luxury winery brands, we may see lower or negative price / mix contribution in the future, with potential for favorable impacts to price / mix due to brand velocity at varying price points.
Components of operating results and key factors affecting our performance
Our net sales consist primarily of wine sales to distributors and directly to retail accounts in
California, which together comprise our wholesale channel, and directly to individual consumers through our DTC channel. Net sales generally represent wine sales and shipping, when applicable. Sales are generally recorded at the point of shipment and are recorded net of returns, consideration provided to customers through various incentive programs, other promotional discounts and excise taxes. We refer to the volume of wine we sell in terms of cases, each of which represents a standard 12 bottle case of wine (in which each bottle has a volume of 750 milliliters). Cases sold represent wine sales through our wholesale and DTC channels. Depletions, in turn, represent sell-through from our distributors, including our Californiawholesale sales channel, to retail accounts nationally. The following factors and trends in our business have driven net sales growth over the past fiscal years and are expected to be key drivers of our net sales growth for the foreseeable future: •Further leverage brand strength. We believe our comprehensive growth plan will continue to increase brand awareness and grow sales of our winery brands to our existing consumer base and a new generation of consumers. This plan is made possible by our omni-channel platform, which enables us to grow both through increased volume with existing and new customers and accounts as well as through periodic price increases, particularly on our higher end, smaller lot DTC wines. •Insightful and targeted portfolio evolution. Our curated portfolio and historical growth result from long-term dedication to continuous evolution and alignment with the luxury wine consumer. We believe we can drive additional sales through our wholesale and DTC channels. As we continue to scale, we believe our growth mindset, coupled with our differentiated production and distribution platform, will enable us to adapt and remain at the forefront of our industry. •Distribution expansion and acceleration. Purchasing by distributors and loyal accounts that continue to feature our wines are key drivers of net sales. We plan to continue broadening distribution of the wines in 27
our portfolio as well as to increase the volume of wine sold to existing accounts. We believe our long-standing existing commercial relationships coupled with exceptional portfolio strength position us to capture distribution growth opportunities and accelerate sales to existing distributors and retail accounts in
California. •Continued investment in DTC channel. We expect to continue to invest in our DTC channel, leveraging wine clubs and brand-specific tasting rooms to engage with our consumers, create brand evangelists and drive adoption across our portfolio. •Opportunistic evaluation of strategic acquisitions. Our strategic and opportunistic approach to evaluating acquisitions has led to the successful acquisition of two winery brands in the past five years: Kosta Browneand Calera. While our growth and success are not contingent upon future acquisitions, we believe our team has the capabilities and track record both to execute and to integrate meaningful acquisitions when opportunities arise to create stockholder value.
The primary market for our wines is
Our sales and distribution platform is based on long-standing relationships with a highly-developed network of distributor accounts in all
U.S.states (except California, where we sell directly to retail accounts) and in over 50 countries globally. We also have developed strong relationships with consumers whobuy our wines directly from us in the DTC channel. Channel mix can affect our performance and results of operations, particularly gross profit and gross profit margin. •Wholesale channel. Consistent with sales practices in the wine industry, sales to retailers in Californiaand to distributors in other states occur below suggested retail price. We work closely with our distributors to increase the volume of our wines and number of products that are sold by the retail accounts in their respective territories. In California, where we make sales directly to retail accounts, we benefit from greater control over our sales and higher profit margins by selling directly to retailers in the state. Our wholesale channel comprises a greater proportion of our net sales than our DTC channel.
•DTC channel. Wines sold through our DTC channels are generally sold at suggested retail prices. Our DTC channel continues to grow due to a number of factors, including a shift towards increased consumption and home business engagement.
Wholesale channel sales made on credit terms generally require payment within 90 days of delivery, and a substantial majority are collected within 60 days. In periods where the net sales channel mix reflects a greater concentration of wholesale sales (which typically occurs in our first and second fiscal quarters), we typically experience an increase in accounts receivable for the period to reflect the change in sales mix, with payment collections in the subsequent period generally reducing accounts receivable and having a positive impact on cash flows in such subsequent period. While we seek to increase sales in both channels, we expect that our future sales will continue to be substantially comprised of sales in the wholesale channel. We intend to maintain and strengthen our long-standing relationships within our network of distributors, which we believe will be critical to our continued growth and success. In the wholesale channel, we are positioned as a one-stop luxury and ultra-luxury wine shop, offering a diverse mix of high-quality winery brands and varietals at varying luxury and ultra-luxury price points. We believe this strategy will enable us to continue increasing our share of the wholesale luxury and ultra-luxury wine market in the future, as customers will have greater opportunity to engage with and experience wines across our broad portfolio. We continue to innovate with new products at all price points within the portfolio. We strive to enhance customer engagement and increase sales as new customers encounter our wines and existing customers trade up to higher-priced wines. Our sales mix within our wholesale channel has reflected disproportional benefits to off-premise sales in certain periods, while on-premise sales have experienced variability, directly related to the COVID-19 pandemic, which began impacting our sales in
March 2020. Our responses to periods of historical disruption in the wholesale channel have focused on strengthening relationships with our accounts and distributors, introducing new products 28
and maintain and strengthen our wine brand commitment. We believe this approach has allowed us to strengthen our portfolio and increase our market share against our competitors during periods of market disruption.
We routinely offer sales discounts and promotions through various programs to distributors around the country and to retail accounts in
California. These programs, where permissible, include volume-based discounts on sales orders, depletion-based incentives we pay distributors and certain other promotional activities. The expense associated with these discounts and promotions is estimated and recorded as a reduction of total sales in order to arrive at reported net sales. While our promotional activities may result in some variance in total net sales from quarter to quarter, historically, the total impact of such activities on annual net sales has been generally stable, and we expect this trend to continue in the future. In the DTC channel, our holistic approach to consumer engagement both online and offline is supported by an integrated e-commerce platform and portfolio wine shop, seven distinctive tasting room experiences located throughout Northern Californiaand Washington, and several award-winning wine clubs, all of which enable us to cross-sell wines within our portfolio. These strategies are designed to maximize each winery brand and property while driving awareness for the Company's other world-class wines and properties, resulting in more and deeper customer connections. We strive to evolve our offerings, experiences and communication to match the generational shifts in wine engagement preferences and related purchasing decisions. In addition, we anticipate that our holistic consumer engagement approach will help our DTC sales remain strong through the near-term impact of the COVID-19 pandemic on consumer purchasing behaviors. Increasing customer engagement is a key driver of our business and results of operations. We continue to invest in our DTC channel and in performance marketing to drive customer engagement. In addition to developing new offerings and cross-selling wines in our portfolio of winery brands, we focus on increasing customer conversion and customer retention. As we continue to invest in enhancing our DTC channel, we expect to continue to increase customer engagement, which we believe will result in greater customer satisfaction and retention. Seasonality Our net sales are typically highest in the first half of our fiscal year, mostly due to increased consumer demand around major holidays. Net sales seasonality differs for wholesale and DTC channels, resulting in quarterly seasonality in our net sales that depends on the channel mix for that period. We typically experience a higher concentration of sales through our wholesale channel during our first and second fiscal quarters due to increased purchasing by distributors in anticipation of higher consumer demand during the holiday season, which has the effect of lowering average selling prices as a result of the use of distributor and retail sales discounts and promotions in our wholesale channel. See "-Key operating metrics." In Fiscal 2021, our net sales in the first, second, third and fourth fiscal quarters represented approximately 27%, 25%, 27% and 21%, respectively, of our total net sales for the year.
Gross profit is equal to our net sales, minus our cost of sales. Cost of sales includes grape and bulk wine purchase costs. For grapes we grow, cost of sales includes amounts incurred to develop and farm the vineyards we own and lease. Cost of sales also includes all winemaking and processing charges, bottling, packaging, warehousing and shipping and handling. Costs associated with storing and maintaining wines that age longer than one year prior to sale continue to be capitalized until the wine is bottled and available for sale. As we continue to grow our business in the future, we expect gross profit to increase as our sales grow and as we effectively manage our cost of sales, subject to any future unexpected volatility in the grape and bulk wine markets, increased seasonal labor costs and, to a lesser extent inflationary impact from commodity costs such as dry goods. Additionally, we expect gross profit as a percentage of net sales to remain consistent with historical levels or to improve to the extent we observe a return toward normalized consumer spending behavior across the industry and within our business, particularly with respect to on-premise sales in the wholesale channel, which would favorably influence our gross profit margins on net sales. 29
We have developed a diversified sourcing and production model, supported by our eight wineries and world-class, strategically located Estate vineyards and strong relationships with quality-oriented growers. In addition, our sourcing model includes the purchase of high-quality bulk wine from established suppliers to add a highly flexible element of diversity to our supply model. Generally, over 85% of our total production is sourced from third-party growers and, to a significantly lesser extent, the bulk wine market. Our ability to adjust the composition of a particular vintage among our grape and bulk wine sourcing supply channels allows us to tailor inputs based on varying market or seasonal factors, which we believe enables us to produce the highest possible quality wine while optimizing gross profit. Consistent with other agriculture enterprises, the cost of our wine fluctuates due to annual harvest yields, which vary due to weather and other events. In addition to agricultural factors, price volatility in the grape and bulk wine markets, competition for supply and seasonal labor costs also impact our cost of sales. We may continue to experience fluctuations in the costs of producing wine, which could impact our gross profit.
Selling, general and administrative expenses
Selling, general and administrative expenses consist of selling expenses, marketing expenses and general and administrative expenses. Selling expenses consist primarily of direct selling expenses in our wholesale and DTC channels, including payroll and related costs, product samples and tasting room operating costs, including processing fees and outside services. Marketing expenses consist primarily of advertising costs to promote winery brand awareness, customer retention costs, payroll and related costs. General and administrative expenses consist primarily of payroll and related costs, administrative expenses to support corporate functions, legal and professional fees, depreciation, accounting and information technology, tenancy expenses and other costs related to management. Although we expect selling, general and administrative expenses to increase as sales and related support needs expand, we expect our sales growth rate to outpace the rate of increased selling, general and administrative expenses as we achieve further efficiencies of scale. We also expect to incur greater selling, general and administrative expenses as a result of operating as a publicly traded company. Other expenses
Other expenses consist primarily of interest expense we incur on outstanding balances under our credit facility and unrealized gains or losses on our derivative instruments.
income tax expense
Income tax expense consists of federal and state taxes payable to various federal, state and local taxing authorities.
Viticulture on our estate vines
Although generally over 85% of our wine is typically derived from grapes grown by third party growers and, to a significantly lesser extent, bulk wine we purchase, the remainder is sourced from our Estate vineyards that we own or lease. Once a vineyard reaches consistent yield levels, approximately three to five years after planting, it will generally produce a relatively consistent amount of fruit for approximately 15 to 25 years, at which time blocks of the vineyard will gradually be replanted in stages after a period of lying fallow. The length of time between initial investment and ultimate sale of our Estate wines, coupled with the ongoing investment required to produce quality wine, is not typical of most agricultural industries. Over the long-term as our business grows, we expect Estate vineyards to represent a smaller relative share of our overall sourcing model. Harvest-to-release Of the total case volume we produce and sell, the majority is comprised of red wines from grape varietals such as Cabernet Sauvignon, Pinot Noir and Merlot, which can have production lifecycles spanning months and years from harvest until the time the wine is released, depending on the aging requirements prescribed by the winemakers responsible for each of our winery brands. Our red wines generally have a harvest-to-release inventory lifecycle that can range from 15 to 48 months. Our white, rosé and sparkling wines generally have a 30
inventory life cycle, from harvest to release, which can range from five to 35 months. During aging and storage, we continue to capitalize overhead costs into the book value of the wine.
Given the long-term nature of our investment, grape purchasing and bulk wine purchasing decisions, our production planning processes are designed to mitigate the risk of over-supply by sourcing a portion of our production needs in the spot markets to the degree appropriate based on winery brand and vintage. This opportunistic approach to grape purchases also helps reduce our exposure to future grape price volatility.
Other factors affecting the comparability of our results of operations
Impacts of COVID-19
March 2020, the World Health Organizationdeclared a global pandemic due to the spread of COVID-19, the disease caused by a novel strain of coronavirus. As governmental authorities implemented various measures limiting the activities of businesses and individuals to reduce the spread of COVID-19, wine producers in the United Stateswere generally classified as essential businesses, which enabled us to continue producing and selling our wine. For the safety of our employees and the individuals with whom we work, we adapted our policies and protocols to meet applicable federal, state and local requirements, and we continue to monitor and revise our policies as appropriate. The comparability of our results of operations have been significantly impacted by the effects of the COVID-19 pandemic on our business, industry, customer behavior, key markets where we operate and as a result of macroeconomic factors. Accordingly, certain period-over-period comparisons have been and may continue to be influenced by disruption due to the COVID-19 pandemic. At the outset of the COVID-19 pandemic in the third quarter of Fiscal 2020, we experienced a significant decrease in sales of ultra-luxury wines sold through our on-premise wholesale sales channel and a significant increase of sales of ultra-luxury and luxury wines sold at off-premise retailers. Historically, our ultra-luxury winery brands have delivered higher gross profit margins, and generally sell in larger volumes on-premise than our luxury winery brands, which typically see higher sales volumes off-premise. This shift in sales channel mix continued through the majority of Fiscal 2021. As we observe continued signs of reopening across the domestic consumer product markets and reversion toward consumer consumption and purchasing habits which we believe to be more in line with trends observable before the COVID-19 pandemic, we expect on-premise sales to continue to increase from their pandemic lows, resulting in higher sales of our ultra-luxury winery brands. At the same time, the significant growth in off-premise sales that we have experienced during the pandemic may be tempered, and the rate of growth may marginally slow at off-premise retailers. Although we have observed strong customer demand during periods impacted by pervasive stay-at-home restrictions, and cannot predict the future impact on consumer spending as these restrictions continue to lessen, we believe that the diverse offerings of The Duckhorn Portfolio, which include a broad spectrum of price points, mitigates some of the risk to our future operations in periods in which the on- and off-premise relative mix fluctuates. During the pandemic, our tasting rooms have also experienced lower tasting fee revenue due to reduced capacities or mandatory closure in order to comply with applicable regulations despite sustained operating levels of expenses, primarily comprised of tasting room operating expenses during periods of capacity restrictions or mandatory closure. Conversely, e-commerce sales increased substantially in response to lockdowns as customers sought to purchase our wines in a manner that reduced human contact. We believe that our tasting rooms will continue to see significant increases in tasting fee revenue as the pandemic wanes, tourism increases and regulations limiting occupancy are eased. At the same time, we believe that customers whoused e-commerce platforms to purchase our wines will continue to enjoy the convenience of those platforms to purchase wines from The Duckhorn Portfolio, Inc.
Impact of forest fires
During the first quarter of Fiscal 2021, several wildfires occurred in
Northern California. These fires have adversely affected industry grape supplies, though the full extent is not yet known. Other than smoke exposure to grapes that had not been harvested, our own vineyards did not sustain damage during the fires. However, smoke and fire damage to vineyards in the primary regions and markets where we source fruit rendered some of the available grapes unacceptable for the Company's production needs. In response, we took steps to obtain alternative sources of supply that we believe substantially mitigates the impact of the fires on our supply. Based 31
on our internal analysis of the impacts of the wildfires, we believe the potential future impact on our operational results to be immaterial. We intend to continue monitoring the ongoing effects on our business for any material changes to that conclusion. Wildfires and smoke damage to grape yields have resulted in disruption and could continue to disrupt the overall grape supply market, introduce changes to our production plan, impact the quantity or release timing of expected case sales in our sales forecast, or result in changes to future gross profit margins as compared to prior periods.
We continue to improve our wildfire response plan and mitigate the supply risk associated with fires by:
•our diversified sourcing strategy, with a mix of our owned or leased Estate properties and high-quality grower contracts, covers a wide geographic footprint across
Californiaand Washington; and •we have assembled a team of winemakers and operational leadership with deep industry experience, enabling us to respond effectively to supply disruption in our active grape sourcing markets or to expand into new sourcing markets if needed.
Impacts of accounting for purchases due to prior acquisitions
We were acquired by TSG in Fiscal 2017, and subsequently completed acquisitions of Calera and
Kosta Brownein Fiscal 2018 and Fiscal 2019, respectively. In applying business combination accounting pursuant to U.S.GAAP authoritative literature in connection with each of these transactions, we recorded acquired assets and liabilities at their fair values. The impacts of these purchase accounting adjustments primarily resulted in reductions to deferred revenue, increases to inventory, increases to long-lived assets and recognition of indefinite-lived intangible assets and definite-lived intangible assets, which amortize over their assigned useful lives ranging from 9 to 14 years. See Note 6 (Other intangible assets) to our Condensed Consolidated Financial Statements for additional information. The effects of purchase accounting adjustments on our operational performance caused our pre-tax income from operations to be lower in certain periods than we would otherwise have recognized due to reduced revenue for the fair value adjustment to deferred revenue, increased cost of sales due to step-up on inventory and increased operating expenses due to step-up depreciation on property and equipment and amortization of definite-lived intangible assets. The table below reflects the line items of our Condensed Consolidated Statements of Operations impacted by these purchase accounting adjustments: Three months ended January 31, Six months ended January 31, (in thousands) 2022 2021 2022 2021 Purchase accounting adjustments to cost of sales $ 99 $ 762 $ 292 $ 1,323Impact of purchase accounting on gross profit (99) (762) (292) (1,323) Amortization of customer relationships and other intangible assets 1,921 1,921 3,842 3,842 Impact of purchase accounting on selling, general and administrative expenses 1,921 1,921 3,842 3,842 Impacts of purchase accounting on income before income taxes $ (2,020) $ (2,683) $ (4,134) $ (5,165)Results of operations
The following table sets forth our results of operations for the periods presented and expresses the relationship of each line item presented as a percentage of net sales for the periods indicated. The table below should be read in conjunction with the corresponding discussion and our annual audited consolidated financial statements.
financial statements, our unaudited condensed consolidated financial statements and related footnotes included elsewhere in this Quarterly Report on Form 10-Q:
Three months ended January 31, Six months ended January 31, (in thousands, except percentages) 2022 2021 2022 2021 Net sales
$ 98,736100.0 % $ 83,657100.0 % $ 202,917100.0 % $ 175,295100.0 % Cost of sales 49,259 49.9 41,900 50.1 101,030 49.8 89,263 50.9 Gross profit 49,477 50.1 41,757 49.9 101,887 50.2 86,032 49.1 Selling, general, and administrative expenses 23,814 24.1 17,471 20.9 46,972 23.1 34,276 19.6 Casualty loss (gain), net 31 - (7,770) (9.3) 80 - (6,215) (3.5) Income from operations 25,632 26.0 32,056 38.3 54,835 27.0 57,971 33.1 Interest expense 1,636 1.7 3,612 4.3 3,242 1.6 7,192 4.1 Other income, net (338) (0.3) (1,491) (1.8) (1,431) (0.7) (2,814) (1.6) Total other expenses 1,298 1.3 2,121 2.5 1,811 0.9 4,378 2.5 Income before income taxes 24,334 24.6 29,935 35.8 53,024 26.1 53,593 30.6 Income tax expense 6,407 6.5 7,935 9.5 13,784 6.8 14,071 8.0 Net income 17,927 18.2 22,000 26.3 39,240 19.3 39,522 22.5 Less: Net loss (income) attributable to non-controlling interest 5 - 3 - (35) - 4 - Net income attributable to The Duckhorn Portfolio, Inc. $ 17,93218.2 % $ 22,00326.3 % $ 39,20519.3 % $ 39,52622.5 %
Comparison of three and six months ended
Net sales Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ % Net sales
$ 98,736 $ 83,657 $ 15,079
15.8 % Net sales for the three months ended
January 31, 2022increased $15.1 million, or 18.0%, to $98.7 millioncompared to $83.7 millionfor the three months ended January 31, 2021. The increase in net sales for the three months ended January 31, 2022is driven by increased volume growth and partially offset by a negative price/mix contribution due to channel mix. Additionally, we saw a significant increase in our Wholesale to Distributor channel. Net sales for the six months ended January 31, 2022increased $27.6 million, or 15.8%, to $202.9 millioncompared to $175.3 millionfor the six months ended January 31, 2021. The increase in net sales for the six months ended January 31, 2022is primarily driven by volume growth and a neutral price/mix contribution, driven by both volume and mix improvements in the wholesale channel as well as growth in the DTC channel from higher tasting room sales. There were no material pricing changes for the periods presented. Cost of sales Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ % Cost of sales $ 49,259 $ 41,900 $ 7,35917.6 % $ 101,030 $ 89,263 $ 11,76713.2 % Cost of sales increased by $7.4 million, or 17.6%, to $49.3 millionfor the three months ended January 31, 2022compared to $41.9 millionfor the three months ended January 31, 2021. Cost of sales increased by $11.8 million, or 13.2%, to $101.0 millionfor the six months ended January 31, 2022compared to $89.3 millionfor the six months ended January 31, 2021.The increases in both periods were mainly driven by higher sales, partially offset by diminishing impacts of step-up cost of wine due to purchase accounting adjustments from prior acquisitions. For additional information see "-Other factors impacting the comparability of our results of operations". 33
Table of Contents Gross profit Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ % Gross profit
$ 49,477 $ 41,757 $ 7,72018.5 % $ 101,887 $ 86,032 $ 15,85518.4 % Gross profit increased $7.7 million, or 18.5%, to $49.5 millionfor the three months ended January 31, 2022compared to $41.8 millionfor the three months ended January 31, 2021. Gross profit increased $15.9 million, or 18.4%, to $101.9 millionfor the six months ended January 31, 2022compared to $86.0 millionfor the six months ended January 31, 2021. The changes in gross profit were primarily the result of: •higher sales volume;
• changes in the mix of brands and net channels favorable to the gross margin; and
• a reduction in the progressive cost of wine sold for the half-year ended
Gross profit margin was 50.1% for the three months ended
January 31, 2022compared to 49.9% for the three months ended January 31, 2021. Gross profit margin was 50.2% for the six months ended January 31, 2022compared to 49.1% for the six months ended January 31, 2021. The increases in both periods depict the shift in sales mix in favor of luxury wines sold in the Wholesale to Distributor channel in the current periods, with additional margin lift due to lower step-up from purchase accounting impacting cost of sales than in previous periods. The gross profit margin increases, primarily due to movement towards historical trends in consumer spending patterns with the continued recovery of on-premise sales locations, also depict a shift in sales mix slightly in favor of ultra-luxury wines sold through all sales channels. These shifts are especially prevalent in our Wholesale California and DTC channels in the current period. As our luxury winery brands contribute to outsized volume growth in the future, we may expect downward pressure on gross profit margins in future periods, with brand mix potentially introducing favorable gross profit margin impacts based on brand velocity at different price points. Operating expenses Selling, general and administrative expenses Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ % Selling expenses $ 10,971 $ 8,403 $ 2,56830.6 % $ 21,369 $ 16,727 $ 4,64227.8 % Marketing expenses 2,887 2,178 709 32.6 5,059 3,925 1,134 28.9 General and administrative expenses 9,956 6,890 3,066 44.5 20,544 13,624 6,920
Total selling, general and administrative expenses
$ 23,814 $ 17,471 $ 6,343
Selling, general and administrative expenses increased
$6.3 million, or 36.3%, to $23.8 millionfor the three months ended January 31, 2022, compared to $17.5 millionfor the three months ended January 31, 2021. Selling, general and administrative expenses increased $12.7 million, or 37.0%, to $47.0 millionfor the six months ended January 31, 2022compared to $34.3 millionfor the six months ended January 31, 2021. The increase for both the three months and six months ended January 31, 2022was largely attributable to compensation costs due to our expanded workforce, higher equity-based compensation as a public company as compared to the prior year period, transaction expenses incurred for the secondary offering (see Note 1 (Description of business) for additional information related to the offering), higher general and administrative costs related to being a public company and higher selling expenses in support of revenue-generating activities as travel restrictions lessened versus the comparative prior year period. General and administrative expenses were higher for the three months and six months ended January 31, 2022compared to the respective prior year periods, primarily due to equity-based compensation costs and public company costs that we had not incurred in the prior year period shown. Selling expenses were higher for the three months and six months ended January 31, 2022due to equity-based and other compensation costs along with the impacts of increased sales activities to support sales growth, including higher levels of business travel than in 34
prior periods constrained due to COVID-19 restrictions in key markets where we operate. Marketing expenses increased by
$0.7 millionand $1.1 millionfor the three months and six months ended January 31, 2022, respectively, versus the comparative period due primarily to increases in equity-based compensation and other compensation costs, further increased due to the prior year period showing reductions in marketing and promotional events as a result of the ongoing pandemic.
Loss (gain), net
Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ %
Loss (gain), net
Casualty loss (gain), net increased by
$7.8 million, or 100.4%, for the three months ended January 31, 2022compared to the three months ended January 31, 2021. Casualty loss (gain), net increased by $6.3 million, or 101.3%, for the six months ended January 31, 2022compared to the six months ended January 31, 2021. The change between the current and prior year is primarily due to insurance proceeds received in Fiscal 2021 related to a flood at one of our wineries in a previous fiscal year that did not reoccur in the current fiscal year. See Note 13 (Casualty loss) to our Condensed Consolidated Financial Statements for further information. Other expenses Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ % Interest expense 1,636 3,612 $ (1,976)(54.7) % $ 3,242 $ 7,192 $ (3,950)(54.9) % Other income, net (338) (1,491) 1,153 (77.3) % (1,431) (2,814) 1,383 (49.1) % Total other expenses $ 1,298 $ 2,121 $ (823)
Other expenses decreased by
$0.8 million, or 38.8%, to $1.3 millionfor the three months ended January 31, 2022compared to $2.1 millionfor the three months ended January 31, 2021. Other expenses decreased by $2.6 million, or 58.6%, to $1.8 millionfor the six months ended January 31, 2022compared to $4.4 millionfor the six months ended January 31, 2021. Our interest expense was reduced year over year due to lower debt balances outstanding for the period, in conjunction with lower average interest rates on our variable-rate debt. The change in our other income, net was primarily driven by downward pressure on LIBOR and a lower overall swap notional balance. Both of these factors contributed to a net gain for the three months and six months ended January 31, 2022and a change in overall position to an asset on our Condensed Consolidated Statements of Financial Position. In addition, see "-Liquidity and capital resources" for discussion of our Credit Facility. Income tax expense Three months ended January 31, Change Six months ended January 31, Change (in thousands, except percentages) 2022 2021 $ % 2022 2021 $ % Income tax expense $ 6,407 $ 7,935 $ (1,528)(19.3) % $ 13,784 $ 14,071 $ (287)(2.0) % Income tax expense decreased $1.5 million, or 19.3%, to $6.4 millionfor the three months ended January 31, 2022compared to $7.9 millionfor the three months ended January 31, 2021. Income tax expense decreased $0.3 million, or 2.0%, to $13.8 millionfor the six months ended January 31, 2022compared to $14.1 millionfor the six months ended January 31, 2021. The change in our income tax expense was primarily due to decreased pre-tax income in the current period, as the effective tax rate remained largely consistent year over year.
Cash and capital resources
Sources of liquidity
Our primary cash needs are for working capital purposes, such as producing or purchasing inventory and funding operating and capital expenditures. We fund our operational cash requirements with cash flows from operating activities and borrowings under our Credit Facility. As of
January 31, 2022, we had $4.8 millionin cash and $290.0 millionavailable in undrawn capacity on our revolving line of credit, subject to the terms of our Credit Facility. 35
In response to the COVID-19 pandemic, we assessed the risks related to our inventory and cash management, which we determined to be sufficiently mitigated, subject to reassessment in the future in response to impacts related to the pandemic as they occur. The full impact of COVID-19 on our future operations remains uncertain and will be determined by the duration and severity of pandemic-related disruptions. Accordingly, unforeseen future events could adversely affect our business, results of operations, cash flow and liquidity.
Due to the seasonal nature of our operations, our cash needs are generally greatest during harvest, a period which can span from August to November based on agricultural conditions and other factors outside our control. We believe that our expected operating cash flows, cash on hand and borrowing capacity on our revolving line of credit, will be adequate to meet our cash needs for the next 12 months. However, changes in our business growth plan, planned capital expenditures or responses to the impacts of the global pandemic or to an ever-changing and highly competitive industry landscape may result in changes to our cash requirements. If our cash needs change in the future, we may seek alternative or incremental funding sources to respond to changes in our business. To the extent required, we may seek to fund additional liquidity through debt or equity financing, although we can provide no assurance that such forms of capital will be available when needed, if at all, or available on terms that are acceptable.
The following table presents the main components of free cash flow.
Six months ended
January 31, (in thousands) 2022
Cash flows provided by (used in): Operating activities
$ 18,828 $ 26,141Investing activities (23,336) (9,748) Financing activities 5,034 (13,371) Net increase in cash $ 526 $ 3,022Operating activities Our cash flows from operating activities consist primarily of net income adjusted for certain non-cash transactions, including depreciation and amortization, amortization of debt issuance costs, changes in the fair values of derivatives, equity-based compensation and deferred income taxes. Operating cash flows also reflect the periodic changes in working capital, primarily inventory, accounts receivable, prepaid expenses, accounts payable and accrued expenses. For the six months ended January 31, 2022, net cash provided by operating activities was $18.8 millioncompared to $26.1 millionfor the six months ended January 31, 2021, a decrease of $7.3 million. The decrease in cash provided by operating activities was driven by the following factors:
•Net income after adjusting for non-monetary items increased operating cash flow by
•Increases in prepaid expenses for the six months ended
January 31, 2022that were less than the higher prepaid expenses in the prior year period due to increased professional fees and insurance, partially offset by timing impacts in bulk and bottled wine supply management to support increases in demand, in aggregate resulted in an increase to operating cash flow of $4.0 million; •Our wholesale sales channel, generally subject to credit terms, saw an increase in net sales, which drove a corresponding increase in accounts receivable and resulted in a $6.5 milliondecrease in operating cash flow;
• Changes in accounts payable and accrued liabilities increased cash flow from operations
• Decrease in accumulated compensation of
• Deferred revenue decreased operating cash flow by
For the six months ended
January 31, 2022, net cash used in investing activities was $23.3 millioncompared to $9.7 millionfor the six months ended January 31, 2021, an increase of $13.6 million, primarily due to vineyard acquisitions completed during the current fiscal quarter, see Note 5 (Property and equipment). Capital expenditures were $23.4 millionfor the six months ended January 31, 2022and $9.8 millionfor six months ended January 31, 2021. From time to time, we evaluate wineries, vineyards and production facilities for potential opportunities to make strategic acquisitions to support our growth. Any such transactions may require us to make additional investments and capital expenditures in the future. Financing activities For the six months ended January 31, 2022, net cash provided by financing activities was $5.0 millionas compared to net cash used in financing activities of $13.4 millionfor the six months ended January 31, 2021, an increase of $18.4 millionof net cash provided by financing activities. The increase in cash provided by financing activities was primarily the result of an increase in net borrowings on our revolving line of credit totaling $11.0 millionfor the six months ended January 31, 2022in comparison to $6.0 millionin net revolving line of credit paydowns for the six months ended January 31, 2021. Additionally, payments made on long-term debt decreased by $1.5 million, thereby increasing cash provided by financing activities.
October 14, 2016, we entered into the Credit Facility with a syndicated group of lenders. The Credit Facility provides a combination of term and revolving line of credit features. The term and revolving line of credit borrowings have variable interest rates, based primarily on LIBOR plus an applicable margin as defined in the First Lien Loan Agreement. Interest is paid monthly or quarterly based on loan type. Our debt is collateralized by substantially all of our cash, trade accounts receivable, real and personal property. Pursuant to the terms and conditions of the First Lien Loan Agreement, we have issued the instruments discussed below. As of January 31, 2022, outstanding principal balances on the debt instruments were $135.0 millionfor the revolving line of credit, $6.9 millionfor the capital expenditure loan, $100.1 millionfor the term loan (tranche one) and $13.8 millionfor term loan (tranche two).
The Senior Loan Agreement contains customary positive covenants, including the delivery of audited financial statements and customary negative covenants which, among other things, limit our ability to incur additional indebtedness or grant certain privileges. From
Revolving line of credit The revolving line of credit allows us to borrow up to a principal amount of
$425.0 million(including a letter of credit sub-facility of the revolving loan facility in the aggregate of $15.0 millionand a swingline sub-facility of the revolving loan facility in the aggregate of $15.0 million), with an incremental seasonal borrowing amount for harvest costs increasing the total amount to a maximum of $455.0 million. The revolving line of credit matures on August 1, 2023. The interest rate ranges from LIBOR plus 125 basis points to LIBOR plus 175 basis points depending on the average availability of the revolving line of credit. Capital expenditure loan The capital expenditure loan has a maximum, non-revolving draw-down limit of $25.0 millionwith quarterly principal payments and the remaining unpaid principal and interest due upon maturity on August 1, 2023. As of January 31, 2022, the $25.0 millionlimit was fully drawn. This instrument has an interest rate of LIBOR plus 190 basis points.
The first tranche of term loans was issued in 2016 for a principal balance of
$135.0 millionwith quarterly principal payments and the remaining unpaid principal and interest due upon maturity on August 1, 2023. This tranche of the term loans has an interest rate of LIBOR plus 190 basis points. 37
The second tranche of term loans, issued in
August 2018, allowed for a principal balance up to $25.0 millionwith quarterly principal payments and the remaining unpaid principal and interest due upon maturity on August 1, 2023. We drew $16.4 millionof the second tranche of the term loan in November 2018. This tranche of the term loans has an interest rate of LIBOR plus 163 basis points.
Off-balance sheet arrangements
January 31, 2022, we did not have any off-balance sheet arrangements that had, or are reasonably likely to have in the future, a material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
Significant Accounting Policies and Estimates
Our management's discussion and analysis of our financial condition and results of operations are based on our Condensed Consolidated Financial Statements, which are prepared in accordance with
U.S.GAAP. The preparation of these Condensed Consolidated Financial Statements requires the application of appropriate technical accounting rules and guidance, as well as the use of estimates. The application of these policies requires judgments regarding future events. These estimates and judgments could materially impact the Condensed Consolidated Financial Statements and disclosures based on varying assumptions, as future events rarely develop exactly as forecasted, and even the best estimates routinely require adjustment. There have been no material changes in our critical accounting policies during the six months ended January 31, 2022, as compared to those disclosed in the "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies" in our Annual Report on Form 10-K for Fiscal 2021.
Recent accounting statements
See Note 2 (Basis of presentation and significant accounting policies) to our Condensed Consolidated Financial Statements included in Part I, Item 1 of this Report for additional information regarding recent accounting pronouncements.
Emerging Growth Business Status
We are an emerging growth company, as defined in the JOBS Act. Section 107 of the JOBS Act provides that an "emerging growth company" can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an "emerging growth company" can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. Section 107 of the JOBS Act provides that any decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies. As a result, our financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. Based on the Company's aggregate worldwide market value of voting and non-voting common equity held by non-affiliates as of
January 31, 2022, the Company will become a "large accelerated filer" and lose emerging growth company status beginning with its Annual Report on Form 10-K for the year ending July 31, 2022.
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