Naked Wines (WINE.L) - Our first addition to the Partnership Investing portfolio

An exciting Direct-to-Consumer business at a reasonable price waiting to be discovered.

Our first addition to the Partnership Investing portfolio is none other than Naked Wines! To stay updated on our investing decisions and other posts, subscribe to Partnership Investing.

Naked Wines is a British company founded in 2008 by Rowan Gormley. The company is a platform that sells wine from independent winemakers to consumers online and is active in the Direct to Consumer market (DTC). The company was purchased by Majestic Wine in 2015. Majestic Wine operates physical wine stores across the United Kingdom and Australia. Because Naked Wines has grown a lot since this acquisition, the company has chosen to sell the Majestic Wine business in 2019 to focus on developing Naked Wines. Naked Wines currently sells wine through its platform in the United States, the United Kingdom and Australia. The company has a market cap of about 550m GBP.

Business overview

The wine industry has different layers and sales channels. Winemakers are the producers and sell their product through wine distributors, directly to retailers, restaurants or consumers. Smaller winemakers most often choose to sell their wine to distributors, which in turns sells this product through to retailers and restaurants. Wine sales outside of restaurants or different kinds of wine bars are referred to as off-premise sales. Wine has traditionally also been sold through so-called “wine clubs”. These clubs will advise on wine and curate a selection that they expect their members will like. This has been common due to high fragmentation of sorts, brands and origins of wines. Due to the high number of choices, many consumers choose to be members of these wine clubs to narrow down these choices and curate the best wine at a certain price point.

The Naked Wines platform has a different business model than most wine clubs. Naked Wines has a subscription model that is unique. The consumers deposit 40 USD into a “piggy bank” which they can later use to purchase wine at discounted prices. Naked Wines uses the money deposited to provide financial guarantees to independent winemakers who are often short on cash or resources to produce the best wine they could. These guarantees enable the independent winemakers to purchase better grapes, machinery and guarantees the winemaker sales through the Naked Wines platform. Under the traditional model, winemakers would have to spend money on marketing and administrative tasks that would take attention and money away from the product quality, the Naked Wines model eliminates those needs and allows the winemaker to focus on the product.
The subscribers, or Angels, as they are called, keep ownership of the funds in the piggy bank. Angels are also made very aware that these funds help support independent winemakers in their craft, making the Angels feel all the more like they have a vested interest in the wine they buy. This is an interesting psychological trick that breeds loyalty towards the Naked Wines platform. Angels have some sense of ownership towards the success of the winemakers and this makes them more likely to order more wine through Naked Wines than other channels that have more degrees of separation between the winemaker and end consumer. Naked Wines is great at communicating this story to the Angel community and winemakers have the opportunity to interact with consumers by sharing stories in e-mails and responding to reviews. Winemakers also have profiles on the Naked Wines website where Angels can order wine and follow along the story of their favourite craftsmen.
This value proposition for both winemakers and wine drinkers has been the strength of Naked Wines and this is underpinned in stellar customer reviews and reviews from winemakers who have worked with Naked Wines. Naked Wines is hellbent on keeping its customers happy. For example, customers get immediately refunded if they didn’t like the wine they bought.

Naked Wines sells wine that is relatively cheap compared to the average wine that is sold online. Due to the high cost of shipping, it is difficult for many operators to sell wine below 20 USD per bottle online. The fragility and perishability of the product being the main reasons for the large costs of shipping. Naked Wines has entered the market by selling wines between 12 and 20 USD/bottle. This is a price point where the difference in quality can be large due to the wholesalers that usually sit between the winemaker and retailer who sells it. Naked Wines wanted to sell great wine for a cheap price, and this has been a winning combination to gain large volumes of sales, even though the price per bottle is lower than competitors. 

Now that the business model is clear and that we have a picture of the industry, we can explore why Naked Wines has an opportunity to grow significantly in the next few years.

The Growth Opportunity

Naked Wines has seen a lot of growth, first in the United Kingdom and Australia, and now in the United States. The US is the largest wine market in the world, with 20 billion USD being consumed off-premise alone. About 5 billion of that 20 billion is currently being sold Direct-to-Consumer. 

The company gives a lot of detail on their customer metrics like their retention rates, the profitability of their repeat customers (customers who make purchases after their first purchase). The company also discloses how long it takes to recover the initial marketing costs to acquire a customer and how much they expect it would cost the company to spend on marketing to replenish customers lost to churn. The company has grown at about 15% a year for the last few years but has seen tremendous growth of 80% in the United States during the Covid-19 pandemic. The amount of new customers and customers who stayed on the platform has skyrocketed as people decided to order wine online instead of buying it at the liquor store.
The Majestic Wine sale is also something we find very interesting. From the acquisition until the sale in 2019, the management team was very focused on keeping the traditional Majestic Wine business going. It was not growing slowly and was consuming a lot of resources. Selling this business to focus on the much more promising Naked Wines business seems like a very good decision to us. The sale leaves the remaining Naked Wines business without any debt and about 70 millions GBP in cash on the balance sheet, giving the management the resources necessary to keep growing Naked Wines without any distractions.

Competitive advantages

Scale advantage

The lower price per bottle has allowed Naked Wines to grow volumes that would not have been possible if they started selling more expensive wine. Larger volumes make it possible to lower the costs of shipping per unit due to more favourable terms with couriers and efficiency gains in their distribution. This will help Naked Wines ship more expensive wine at a shipping rate that is far lower than competitors when they introduce these more expensive wines. Naked Wines can also share these economies of scale with its customers. By lowering their cost per bottle, Naked Wines can lower prices to sell more volume without compromising their margins. This reminds us very much of Costco, who fixes their margin at 15% and as they gain scale, lower their prices. This creates a virtuous cyclel where lower prices drive more volume, that further lower costs and the cycle repeats itself.

Networks effects

We believe Naked Wines has network effects working in its favour. As more Angels join the Naked Wines platform, winemakers have more and more reasons to use Naked Wines as a sales channel. The more winemakers are on the platform, the more product and variety Naked Wines can offer customers, the more the customer becomes likely to join and keep using the platform. The business model, where Angels essentially finance the production for the winemakers, also provides more advantages as the platform grows. With a larger Angels “piggy bank”, Naked Wines can finance more production, more winemakers and larger projects. This gives winemakers additional reasons to sell through Naked Wines.

Management and Ownership

Rowan Gormley, the founder of Naked Wines, took over as CEO of Majestic Wine when Majestic bought Naked in 2015. He stayed on as CEO until 2019 when Majestic was sold. Rowan Gormley has gone into retirement and the new CEO is Nick Devlin, Rowan’s protégé. Rowan asked Nick to run the Naked Wines US business in 2017 and because the company entered a new chapter in its history, Rowan felt it was time to pass on the reins to Nick, who is also based in the US to focus on their expansion in that market. The ex-CFO will run the Naked Wines UK business. This underpins the newfound focus on Naked Wines and the US opportunity. Rowan Gormley still owns about 5% of the company and the family who owned Majestic Wines owns about 8% of the company but is slowly liquidating its stake. A member of the aforementioned family also sits on the Board of Directors.

Financials and valuation

The company currently has about 330m GBP in revenues, of which about half is from the United States. The company does not operate at a profit. This may prevent investors from seeing the true economic value Naked Wines has. To grow, Naked Wines primarily invests in marketing to attract new customers. Naked has reinvested every cent of profit to acquire new customers. To understand the opportunity the company has to grow and to become profitable, it is important to have a sense of the profitability of Naked if it would not try to grow its customer base. This means we have to look at how profitable the current customers are, how much customers Naked WInes would lose every year and what it would cost to replace that lost customer. Fortunately, the company discloses more Key Performance Indicators (KPIs) than most companies we have researched. These KPIs make it very easy for  investors to have a sense of the true profitability of Naked Wines.

(Source: Company info)

(Source: Company info)

These illustrations show the data on customer cohorts and show the retention, profitability and the payback on investments in marketing. The lockdowns during 2020 have had a big impact on Naked Wines performance. Existing customers ordered more wine more frequently and new customers also ordered more, shortening the payback period on marketing investments.

Naked Wines also has Standstill EBIT KPI (Key Performance Indicator). This figure is meant to give an impression of the profitability of the current customer base and disregards investments in growth. The Standstill EBIT would represent the profit before tax of Naked Wines, excluding marketing investments to grow its customer base. The main inputs for the Standstill EBIT calculation is the customer retention rate, the year 1 payback percentage (how much of the marketing spend has been recovered in the first year) and the contribution margin (profit margin from sales to existing customers). By using these KPIs, we can calculate the amount of sales lost due to customer churn and how much Naked would need to spend to replenish the lost sales.

Historically, Naked has retained about 83% of its sales. This was higher in 2020, but we could expect normalization in 2021 and 2022 as lockdowns ease and the Covid crises ends. The payback percentage has been more volatile. It has hovered between 70 and 80% the last few years. Our model assumes that this figure starts at 75% but declines to 67%, which was the payback percentage for the 2019 cohort. These assumptions, along with the 15% growth assumption and no contribution margin expansion, would yield a Standstill EBIT of 35m GBP. By adapting some inputs to a more optimistic view, the 40m number appears very achievable for 2021.

(Source: Own estimates, with help from @inpractise_ on Twitter)

This 35-40m is currently being reinvested to acquire new customers, and as long as those customers deliver the expected returns, this should be accretive to the total enterprise value. We have forecasted relatively modest growth for the next few years, especially considering the COVID-19 boost of 2020. By our estimations, Naked Wines could do about 530m GBP in sales and have 60m in profit before tax in 2026. This is quite conservative compared to most estimates we have seen and this does not give the company much credit for their increased focus and the more efficient marketing methods they might develop. For these estimates, we have assumed 15% revenue growth, slowing to 10% in 2026. We have assumed 30% contribution margins, historical retention and payback numbers. Excluding cash on the balance sheet, investors can currently buy shares in Naked Wines for ~15-17x the profit before tax without any growth in 2021 (600m GBP / 35-40m GBP). This, in our opinion, is an opportunity to buy a good company and get its growth practically for free. At a 17x Standstill EBIT multiple, Naked Wines could be worth 1 billion GBP (60m Standstill EBIT x 17). This would mean Naked Wines could be worth ~1350 pence (13.50 GBP) per share in 2026, excluding any excess cash on the balance sheet. The 1200 pence price in 2026 would return ~11.5% a year from today’s price of 789 pence. We honestly believe that these estimates are somewhat conservative and Naked Wines could grow faster and that the exit multiple of 17x EBIT for a growing, quality business could be higher once the market, especially US investors, discover this business. A higher Standstill EBIT multiple, faster growth or better margins than our conservative assumptions easily take the potential return above our 12% return hurdle. 

To put it simply, if you believe the current customer base is worth 15-17x the Standstill EBIT, and Naked Wines invests these cash flows in new customer acquisition at an attractive rate of return (their history indicates that they can, we hope our analysis has convinced you they will likely keep doing so), you are essentially getting the growth for free at today’s prices.

Conclusion

We believe Naked Wines can execute on their goal to become the largest DTC player in the wine market in the US. They got rid of the distraction of Majestic Wine, they have the largest scale in the market and have a management we feel is competent and passionate. The business has lots of interesting psychological aspects that make the customers and winemakers loyal. The more customers join the platform, the more winemakers join and this cycle reinforces itself. The company still has a lot of things they can do better when it comes to marketing and acquiring customers and, if they execute on that, they could blow through our current expectations. However, there is a risk that the niche Naked Wines is not large enough to grow the 10-15% a year we expect them to grow at for the next few years. The 20B USD off-premise wine market in the United States gives me confidence that as customers buy more online, the market for Naked Wines should grow as well. It is also very possible that, as customers get more expensive to acquire, our current projections of profitability will not materialize. Naked Wines currently has 757.000 Angels who are regular customers. Only about half of them are in the United States. Naked Wines still has a long runway to acquire new Angels and grow this number. Another risk is that the growth experienced in 2020 brought in a lot of customers who will immediately leave the platform when everything opens up. Although we have considered normalization in our forecast, a material let down could change our valuation of the business. It will be key to keep an eye on the KPIs to anticipate any trouble on the horizon.

The current share price gives investors who believe in Naked Wines story an ability to execute a great entry price. If Naked Wines executes on their ambitions, like we believe they can, the share price could compound at a 12-15% rate for the foreseeable future.

Resources you can use to learn about the company:

InPractise (Paid Research service)

Good Investing Talks - Interview with Rowan Gormley

Good Investing Talks - Interview with Nick Devlin


Disclaimer: Always do your own research. This is not investment advice and for informational purposes only. Partnership Investing is not a registered investment adviser and may or may not hold securities discussed on this blog.