##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (MARK ONE)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2004ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from            to Commission file number: 0-13406 The Chalone Wine Group, Ltd.  California
    
    94-1696731(State or Other Jurisdiction ofIncorporation or Organization)
    
    (I.R.S. Employer Identification No.)621 Airpark RoadNapa, California
    
    94558(Address of Principal Executive Offices)
    
    (Zip Code)
 Registrants Telephone Number, Including Area Code: 707-254-4200 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes þ       No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes o       No þ The number of shares outstanding of Registrants Common Stock as of November
12, 2004 was 13,479,828.




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PagePART I  FINANCIAL INFORMATIONItem 1.
    
    Financial Statements.Consolidated Balance Sheets as of September 30, 2004, and December 31, 2003.
    
    
    3Consolidated Statements of Income for the three-month and nine-month periods ended September 30, 2004 and 2003.
    
    
    4Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2004 and 2003.
    
    
    5Notes to Consolidated Financial Statements.
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations.
    
    
    9Item 4.
    
    Controls and Procedures.
    
    
    17PART II  OTHER INFORMATIONItem 1.
    
    Legal Proceedings.
    
    
    17Item 5.
    
    Exhibits
    
    
    18EXHIBIT 10.66EXHIBIT 10.67EXHIBIT 10.68EXHIBIT 10.69EXHIBIT 10.70EXHIBIT 10.71EXHIBIT 10.72EXHIBIT 10.73EXHIBIT 10.74EXHIBIT 10.75EXHIBIT 10.76EXHIBIT 10.77EXHIBIT 10.78EXHIBIT 10.79EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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##### Table of Contents



PART I  FINANCIAL INFORMATION 
 Item 1. Financial Statements. 
 THE CHALONE WINE GROUP, LTD.
CONSOLIDATED BALANCE SHEETS
(All amounts in thousands, except share data) ASSETS September 30,
    
    December 31,2004
    
    2003(Unaudited)Current assets:Accounts receivable, net
    
    $
    14,158
    
    
    $
    19,753Note receivable
    
    
    208
    
    
    
    210Income tax receivable
    
    
    
    
    
    
    232Inventory
    
    
    91,098
    
    
    
    84,840Prepaid expenses and other current assets
    
    
    404
    
    
    
    405Total current assets
    
    
    105,868
    
    
    
    105,440Investment in Chateau Duhart-Milon
    
    
    11,316
    
    
    
    11,278Non-current note receivable
    
    
    58
    
    
    
    218Property, plant and equipment, net
    
    
    70,353
    
    
    
    72,494Goodwill and trademarks
    
    
    11,437
    
    
    
    11,446Other assets
    
    
    2,114
    
    
    
    1,719Total assets
    
    $
    201,146
    
    
    $
    202,595LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Current maturities of long-term obligations
    
    $
    4,356
    
    
    $
    7,154Current portion of obligation under capital lease
    
    
    838
    
    
    
    791Revolving bank loan
    
    
    16,600
    
    
    
    13,800Accounts payable and accrued liabilities
    
    
    25,906
    
    
    
    25,805Total current liabilities
    
    
    47,700
    
    
    
    47,550Long-term obligations, less current maturities
    
    
    36,820
    
    
    
    39,759Long-term obligations, convertible subordinated debt
    
    
    
    
    
    
    11,000Obligation under capital lease, less current maturities
    
    
    225
    
    
    
    859Liability on interest rate swap contract
    
    
    500
    
    
    
    1,084Deferred income taxes
    
    
    1,419
    
    
    
    1,180Total liabilities
    
    
    86,664
    
    
    
    101,432Minority interest
    
    
    3,434
    
    
    
    3,165Shareholders equity:Common stock  authorized 25,000,000 shares no par
value; issued and outstanding: 13,478,272 and
12,077,572 shares
    
    
    89,604
    
    
    
    76,472Retained earnings
    
    
    22,950
    
    
    
    23,164Accumulated other comprehensive loss
    
    
    (1,506
    )
    
    
    (1,638
    )Total shareholders equity
    
    
    111,048
    
    
    
    97,998Total liabilities and shareholders equity
    
    $
    201,146
    
    
    $
    202,595
 See accompanying notes to consolidated financial statements 3




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THE CHALONE WINE GROUP, LTD.
CONSOLIDATED STATEMENTS OF INCOME
(All amounts in thousands, except per share data) Three months ended
    
    Nine months endedSep 30,
    
    Sep 30,
    
    Sep 30,
    
    Sep 30,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Gross revenues
    
    $
    16,481
    
    
    $
    16,878
    
    
    $
    47,951
    
    
    $
    46,792Excise Taxes
    
    
    (463
    )
    
    
    (492
    )
    
    
    (1,360
    )
    
    
    (1,394
    )Net revenues
    
    
    16,018
    
    
    
    16,386
    
    
    
    46,591
    
    
    
    45,398Cost of wines sold
    
    
    (10,741
    )
    
    
    (10,912
    )
    
    
    (31,553
    )
    
    
    (30,303
    )Gross profit
    
    
    5,277
    
    
    
    5,474
    
    
    
    15,038
    
    
    
    15,095Other operating income (expense), net
    
    
    (111
    )
    
    
    3
    
    
    
    (111
    )
    
    
    24Costs associated with proposed acquisition
    
    
    (627
    )
    
    
    
    
    
    
    (939
    )
    
    
    Depreciation and Amortization
    
    
    (200
    )
    
    
    (235
    )
    
    
    (621
    )
    
    
    (683
    )Selling, general and administrative expenses
    
    
    (3,480
    )
    
    
    (3,190
    )
    
    
    (10,192
    )
    
    
    (9,490
    )Operating income
    
    
    859
    
    
    
    2,052
    
    
    
    3,175
    
    
    
    4,946Interest expense, net
    
    
    (1,278
    )
    
    
    (1,371
    )
    
    
    (4,113
    )
    
    
    (3,875
    )Other income
    
    
    87
    
    
    
    62
    
    
    
    289
    
    
    
    160Equity in net income of Chateau Duhart-Milon
    
    
    (64
    )
    
    
    (35
    )
    
    
    530
    
    
    
    418Minority interest
    
    
    (65
    )
    
    
    (65
    )
    
    
    (244
    )
    
    
    (152
    )Income (loss) before income taxes
    
    
    (461
    )
    
    
    643
    
    
    
    (363
    )
    
    
    1,497Income taxes
    
    
    189
    
    
    
    (264
    )
    
    
    149
    
    
    
    (614
    )Net income (loss)
    
    $
    (272
    )
    
    $
    379
    
    
    $
    (214
    )
    
    $
    883Earnings per share  basic
    
    $
    (0.02
    )
    
    $
    0.03
    
    
    $
    (0.02
    )
    
    $
    0.07Earnings per share  diluted
    
    $
    (0.02
    )
    
    $
    0.03
    
    
    $
    (0.02
    )
    
    $
    0.07Weighted average number of shares outstanding:Basic
    
    
    12,284
    
    
    
    12,076
    
    
    
    12,284
    
    
    
    12,075Diluted
    
    
    12,345
    
    
    
    12,078
    
    
    
    12,345
    
    
    
    12,079
 See accompanying notes to consolidated financial statements 4




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THE CHALONE WINE GROUP, LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(All amounts in thousands) Nine months endedSeptember 30,
    
    September 30,2004
    
    2003(Unaudited)
    
    (Unaudited)Cash flows from operating activities:Net income (loss)
    
    $
    (214
    )
    
    $
    883Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation and amortization
    
    
    4,557
    
    
    
    4,432Gain on disposal of property
    
    
    (76
    )
    
    
    (14
    )Equity in net income of Chateau Duhart-Milon
    
    
    (530
    )
    
    
    (418
    )Increase in minority interests
    
    
    244
    
    
    
    152Changes in:Accounts and other receivables
    
    
    5,852
    
    
    
    1,752Inventories
    
    
    (6,258
    )
    
    
    4,409Prepaid expenses and other assets
    
    
    (394
    )
    
    
    254Deferred income taxes
    
    
    
    
    
    
    Accounts payable and accrued liabilities
    
    
    2,081
    
    
    
    (1,858
    )Net cash provided by operating activities
    
    
    5,262
    
    
    
    9,592Cash flows from investing activities:Capital expenditures
    
    
    (2,417
    )
    
    
    (7,920
    )Proceeds from disposal of property, plant and equipment
    
    
    86
    
    
    
    22Net change of note receivable
    
    
    162
    
    
    
    155Distribution from Chateau Duhart-Milon
    
    
    279
    
    
    
    870Net cash used in investing activities:
    
    
    (1,890
    )
    
    
    (6,873
    )Cash flows from financing activitiesBorrowings (payments) on revolving bank loan, net
    
    
    2,800
    
    
    
    (425
    )Distributions to minority partner
    
    
    
    
    
    
    (650
    )Net change in capital lease obligation
    
    
    (587
    )
    
    
    (207
    )Repayment of long-term debt
    
    
    (5,737
    )
    
    
    (1,445
    )Proceeds from issuance of common stock
    
    
    152
    
    
    
    8Net cash (used in) financing activities
    
    
    (3,372
    )
    
    
    (2,719
    )Net increase (decrease) in cash and equivalents
    
    
    
    
    
    
    Cash and equivalents at beginning of year
    
    
    
    
    
    
    Cash and equivalents at end of year
    
    $
    
    
    
    $
    Other cash flow information:Interest paid
    
    $
    3,762
    
    
    $
    3,884Income taxes paid
    
    
    65
    
    
    
    326Non-cash investing and financing activities:Unrealized foreign currency gain
    
    $
    (213
    )
    
    $
    1,003Interest swap fluctuation, net
    
    
    345
    
    
    
    239Subordinated debt converted to common stock
    
    
    12,980
    
    
    
    
 See accompanying notes to consolidated financial statements 5




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Notes to Consolidated Financial Statements NOTE 1  SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The unaudited consolidated financial statements of The Chalone Wine Group,
Ltd. (the Company) are prepared in conformity with accounting principles
generally accepted in the United States of America for reporting interim
financial information and the rules and regulations of the Securities and
Exchange Commission. In the opinion of management, all adjustments necessary
for a fair presentation of the financial position and results of operations for
the periods presented have been included. All such adjustments are of a normal
recurring nature. These unaudited consolidated financial statements should be
read in conjunction with the audited consolidated financial statements included
in the Companys Form 10-K for the year ended December 31, 2003. Results of
operations for the three and nine months ended September 30, 2004 are not
necessarily indicative of the operating results for the full accounting year or
any future period. The consolidated balance sheet at December 31, 2003, presented herein, has
been derived from the audited consolidated financial statements of the Company
for the year then ended, included in the Companys annual report on Form 10-K. Use of Estimates in Preparation of Financial Statements The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported financial
statement amounts and related disclosures at the date of the financial
statements. Actual results could differ from these estimates. Earnings per Share Basic earnings per share (EPS) is computed by dividing net income or
loss available to common stockholders by the weighted average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution
that could occur if securities or other contracts to issue common stock, such
as stock options, were exercised and converted into stock. For all periods
presented, the difference between basic and diluted EPS for the Company
reflects the inclusion of dilutive stock options, the effect of which is
calculated using the treasury stock method. Derivative Financial Instruments The Company uses derivative financial instruments to manage exposures to
interest rate risks in accordance with its risk management policy. The
Companys objective for holding derivative financial instruments is to reduce
or eliminate the Companys exposure to interest rate fluctuations. The
Company formally documents the relationship between hedging instruments and
hedged items as well as its risk management objective and strategy for
undertaking its hedging activities. The Company formally designates derivative
financial instruments as hedging instruments on the date the Company enters
into the derivative contract. The Company assesses, both at inception of the
hedge and on an ongoing basis, whether derivatives used as hedging instruments
are highly effective in offsetting the changes in the fair value or cash flows
of hedged items. If it is determined that a derivative is not highly effective
as a hedge or ceases to be highly effective, the Company discontinues hedge
accounting prospectively. Changes in the fair value of derivative instruments designated as cash
flow hedges, to the extent the hedges are highly effective, are recorded in
other comprehensive income, net of related tax effects. The ineffective
portion of the cash flow hedge, if any, is recognized in current-period
earnings. Other comprehensive income is relieved when current earnings are
affected by the variability of cash flows relating to the derivative instrument
hedged. During the period ended September 30, 2004, the Companys derivative
contracts consisted only of an interest rate swap used by the Company to
convert a portion of its variable rate long-term debt to fixed rate. The Company does not enter into derivative financial instruments for
trading or speculative purposes. The Company records payments or receipts on
interest rate swap agreements in interest expense. Forward exchange contracts
are used to manage exchange rate risks on certain purchase commitments,
generally French oak barrels, denominated in foreign currencies. Gains and
losses relating to firm purchase commitments are deferred and are recognized as
adjustments of carrying amounts of assets acquired or in income when the hedged
transaction occurs. The nominal amounts and related foreign currency
transaction gains and losses, net of the impact of hedging, were not
significant for the nine months ended September 30, 2004 and 2003. 6




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Stock Based Compensation The Company accounts for stock-based awards to employees using the
intrinsic value based method in accordance with APB No. 25, Accounting for
Stock Issued to Employees,and provides the pro forma disclosures required by
SFAS No. 123, Accounting for Stock-based Compensation. No compensation expense
has been recognized in the financial statements for employee stock
arrangements. SFAS 123 requires the disclosure of pro forma net income and earnings per
share had the Company adopted the fair value method as of the beginning of
fiscal year 1995. Under SFAS 123, the fair value of stock-based awards to
employees is calculated through the use of option pricing models, even though
such models were developed to estimate the fair value of freely tradable, fully
transferable options without vesting restrictions, which significantly differ
from the Companys stock option awards. These models also require subjective
assumptions, including future stock volatility and expected time to exercise,
which greatly affect the calculated values. The Companys calculations were
made using the Black-Scholes option pricing model with the following weighted
average assumptions: expected life, 116 months following vesting; stock
volatility of 34.7% to 35.9% for the nine months ended September 30, 2004 and
32.7% to 33.9% for the nine months end September 30, 2003, risk-free interest
rates of 4.27% to 4.62% for the nine months ended September 30, 2004 and 3.43%
to 4.04% for the nine months ended September 30, 2003, and no dividends during
the expected term. The Companys calculations are based on a multiple option
valuation approach and forfeitures are recognized as they occur. As of January 1, 2003, the Company adopted the disclosure requirements of
SFAS 148, Accounting for Stock Based Compensation, which amends Accounting
Principals Board (APB) No. 28 by adding to the list of disclosures to be made
for interim reporting periods. For purposes of pro forma disclosures, the estimated fair value of the
options is amortized over the options vesting period. Had the Companys stock
option and stock purchase plan been accounted for under SFAS No. 123, net
income (loss) and earnings (loss) per share would have been reduced to the
following pro forma amounts (In thousands, except per share data). Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss):As reported
    
    $
    (272
    )
    
    $
    379
    
    
    $
    (214
    )
    
    $
    883Compensation Expense,
net of tax
    
    $
    (38
    )
    
    $
    (26
    )
    
    $
    (491
    )
    
    $
    (216
    )Pro forma
    
    $
    (310
    )
    
    $
    353
    
    
    $
    (705)
    
    
    $
    667Earnings (loss) per share:Basic
    
    $
    (0.02
    )
    
    $
    0.03
    
    
    $
    (0.02
    )
    
    $
    0.07Diluted
    
    $
    (0.02
    )
    
    $
    0.03
    
    
    $
    (0.02
    )
    
    $
    0.07Pro forma basic
    
    $
    (0.02
    )
    
    $
    0.03
    
    
    $
    (0.06
    )
    
    $
    0.06Pro forma diluted
    
    $
    (0.02
    )
    
    $
    0.03
    
    
    $
    (0.06
    )
    
    $
    0.06
 NOTE 2  COMPREHENSIVE INCOME Comprehensive income includes unrealized foreign currency gains and losses
related to the Companys investment in Château Duhart-Milon and gains or losses
relating to derivative financial instruments. The following is a
reconciliation of net income and comprehensive income (In thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    (272
    )
    
    $
    379
    
    
    $
    (214
    )
    
    $
    883Changes in fair value of derivatives, net of tax effect
    
    
    (45
    )
    
    
    20
    
    
    
    84
    
    
    
    (158
    )Reclassification adjustment, net of tax effect
    
    
    78
    
    
    
    102
    
    
    
    261
    
    
    
    301Foreign currency translation gain (loss)
    
    
    215
    
    
    
    137
    
    
    
    (213
    )
    
    
    1003Comprehensive income (loss)
    
    $
    (24
    )
    
    $
    638
    
    
    $
    (82
    )
    
    $
    2,029
 7




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NOTE 3  INVENTORIES Inventories are stated at lower of cost (first-in, first-out) or market and
consist of the following (In thousands): September 30,
    
    December 31,2004
    
    2003(Unaudited)Bulk wine
    
    $
    42,158
    
    
    $
    50,502Bottled wine
    
    
    48,536
    
    
    
    33,955Wine packaging supplies
    
    
    166
    
    
    
    165Other
    
    
    238
    
    
    
    218Total
    
    $
    91,098
    
    
    $
    84,840
 NOTE 4  COMMITMENTS AND CONTINGENCIES Future minimum lease payments (excluding the effect of future increases in
payments based on indices which cannot be estimated at the present time)
required under non-cancelable operating leases with terms in excess of one year
are as follows (In thousands): Calendar year:2004 (three months remaining)
    
    $
    2552005
    
    
    9992006
    
    
    1,0262007
    
    
    9582008
    
    
    731Thereafter
    
    
    3,150Total
    
    $
    7,119
 The Company contracts with various growers and certain wineries to supply
a large portion of its future grape requirements and a smaller portion of its
future bulk wine requirements. The Company estimates that it has contracted to
purchase approximately 9,000 to 13,000 tons of grapes per year over the next
ten years. While most of these contracts stipulate that prices will be
determined by current market conditions at the time of purchase, several
long-term contracts provide for minimum grape or bulk wine prices. Purchases
under these contracts were $18,994,000 for the year ended December 31, 2003. NOTE 5  COSTS ASSOCIATED WITH THE PROPOSED ACQUISITION The Chalone Wine Groups board of directors has formed a special
committee, consisting solely of independent directors, to review and evaluate a
proposed acquisition of all of Chalones outstanding publicly held shares of
common stock at $9.25 per share in cash by an affiliate of Domaines Barons de
Rothschild (Lafite) SCA (DBR). DBR currently owns approximately 49% of
Chalones outstanding common stock. The costs associated with the proposed
acquisition represent the legal and financial advisory fees incurred by the
committee to review and evaluate the DBR proposal. In the event a successful
acquisition occurs, the Company would be liable for an additional financial
advisory fee of 1.0 million dollars to be paid at the time of closing. NOTE 6  SUBORDINATED DEBT CONVERTED TO COMMON STOCK The Company issued two convertible subordinated promissory notes in
exchange for $11 million in cash on August 23 , 2002 (the 2002 Notes). The
2002 Notes were issued to DBR, in the amount of $8.25 million, and to SFI
Intermediate Limited or its affiliates (SFI), in the amount of $2.75 million.
The 2002 Notes accrued interest on the principal sum at a rate of 9% per
annum. The principal sum and all accrued interest were due and payable in
full, two years from the date of the 2002 Notes (the Maturity Date). At the
Maturity Date, the Company could elect to pay all of the outstanding principal
and accrued interest in cash or to repay all or part of these amounts through
conversion into shares of Company common stock at the conversion price of
$9.4207 per share (the Conversion Price). 8




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On August 23, 2004, the Company elected to repay the 2002 Notes in full
through conversion into shares of its common stock at the Conversion Price.
Consequently, the following additional shares were issued as of August 23,
2004: SharesDBR
    
    
    1,033,363SFI
    
    
    344,454TOTAL
    
    
    1,377,817
 NOTE 7  SUBSEQUENT EVENTS On October 30, 2004, the Company entered into a merger agreement with DBR
and Triple Wines, Inc., a wholly owned subsidiary of DBR. Under the terms of
the merger agreement, at the effective time of the merger, each outstanding
share of the Companys common stock (other than those shares held by DBR) will
be converted into the right to receive $11.75 in cash. Following consummation
of the merger, the Company will be a wholly owned subsidiary of DBR. DBR
currently owns approximately 49% of the Companys outstanding stock. The merger agreement provides, among other things, that the Company may
continue to solicit acquisition proposals from third parties at a higher price
than $11.75 per share. In the event an offer is received at a higher price for
a purchase of all of the outstanding shares of our common stock, DBR has agreed
to either match the higher priced offer or to vote its shares in favor of the
higher priced transaction. A special committee of the Companys board of directors, comprised
entirely of directors not affiliated with DBR, was established to evaluate and
negotiate the merger on behalf of the Companys board of directors and
subsequently recommended that the board of directors approve and adopt the
merger agreement. At a special meeting held on October 30, 2004, the Companys
board of directors approved and adopted the merger agreement and approved the
merger. Completion of the merger is subject to the satisfaction of closing
conditions set forth in the merger agreement, including approval by the
affirmative vote of a majority of the outstanding shares of the Companys
common stock (which approval must include the affirmative vote of a majority of
the votes cast by the shareholders other than DBR and its affiliates) and the
receipt of certain regulatory and other approvals. The Company currently
anticipates that the merger will close in the first quarter of 2005. 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION In the ordinary course of business, we have made a number of estimates and
assumptions relating to the reporting of results of operations and financial
condition in the preparation of our financial statements in conformity with
accounting principles generally accepted in the United States of America.
Actual results could differ significantly from those estimates under different
assumptions and conditions. We believe the following addresses our most
critical accounting policies, which are those that are most important to the
portrayal of our financial condition and results. We constantly re-evaluate
these significant factors and make adjustments where facts and circumstances
dictate. Historically, actual results have not significantly deviated from
those determined using the necessary estimates inherent in the preparation of
financial statements. Estimates and assumptions include, but are not limited
to, customer receivables, inventories, assets held for sale, fixed asset lives,
promotional allowances, contingencies and litigation. We have also chosen
certain accounting policies when options were available, including:  t
    
    The first-in, first-out (FIFO) method to value a majority of our inventories;t
    
    The intrinsic value method, or APB Opinion No. 25, to account for our common stock incentive awards; andt
    
    The recording of an allowance for credit losses based on estimates
of customers ability to pay; if the financial condition of our
customers were to deteriorate, additional allowances may be required. We applied these accounting consistently for all periods presented. Our
operating results would be affected if we used other alternatives. 9




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FORWARD LOOKING STATEMENTS From time to time, information provided by us, statements made by our
employees, or information included in our filings with the Securities and
Exchange Commission, including this Form 10-Q, may contain statements which are
not historical facts and are so called forward looking statements that
involve risks and uncertainties. Forward-looking statements are made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act
of 1995. When used in this Form 10-Q, the terms anticipates, expects,
estimates, intends, believes and other similar terms as they relate to us
or our management are intended to identify such forward looking statements.
Our actual future results may differ significantly from those stated in any
forward-looking statements. Factors that may cause such differences include,
but are not limited to: (i) reduced consumer spending or a change in consumer
preferences, which could reduce demand for our wines; (ii) competition from
numerous domestic and foreign wine producers which could affect our ability to
sustain volume and revenue growth; (iii) interest rates and other business and
economic conditions which could increase significantly the cost and risks of
borrowings associated with present and projected capital projects; (iv) the
price and availability in the marketplace of grapes meeting our quality
standards and other requirements; (v) the effect of weather, agricultural pests
and disease and other natural forces on growing conditions and, in turn, the
quality and quantity of grapes produced by us; and (vi) regulatory changes
which might restrict or hinder the sale and/or distribution of alcoholic
beverages. Each of these factors, and other risks pertaining to us, the
premium wine industry and general business and economic conditions, are more
fully discussed herein and from time to time in other filings with the
Securities and Exchange Commission, including our annual report on
Form 10-K
for the year ended December 31, 2003 DESCRIPTION OF THE BUSINESS We produce, market and sell super premium, ultra premium and luxury-priced
white and red varietal table wines, primarily Pinot Noir, Cabernet Sauvignon,
Merlot, Syrah, Chardonnay and Sauvignon Blanc. We own and operate wineries in
various counties of California and Washington State. We make our wines
primarily from grapes grown at Chalone Vineyard, Edna Valley Vineyard, Moon
Mountain Vineyard, company-owned vineyards adjacent to the Acacia Winery and
Hewitt Vineyard in California and the Canoe Ridge Vineyard in Washington State,
as well as from purchased grapes. We primarily sell our wines under the labels Acacia, Canoe Ridge®
Vineyard, Chalone Vineyards®, Dynamite Vineyards®, Echelon, Edna
Valley Vineyard®, Jade Mountain®, Moon Mountain Vineyards®, Provenance
Vineyards and Sagelands Vineyard®. In France, we own a minority interest in fourth-growth Bordeaux estate
Château Duhart-Milon (Duhart-Milon) in partnership with Les Domaines Barons
de Rothschild (Lafite) (DBR). The vineyards of Duhart-Milon are located
adjacent to the world-renowned Château Lafite-Rothschild in the town of
Pauillac. RECENT DEVELOPMENTS On October 30, 2004, we entered into a merger agreement with DBR and
Triple Wines, Inc., a wholly owned subsidiary of DBR. Under the terms of the
merger agreement, at the effective time of the merger, each outstanding share
of our common stock (other than those shares held by DBR) will be converted
into the right to receive $11.75 in cash. Following consummation of the
merger, we will be a wholly owned subsidiary of DBR. DBR currently owns
approximately 49% of our outstanding stock. The merger agreement provides, among other things, that we may continue to
solicit acquisition proposals from third parties at a higher price than $11.75
per share. In the event an offer is received at a higher price for a purchase
of all of the outstanding shares of our common stock, DBR has agreed to either
match the higher priced offer or to vote its shares in favor of the higher
priced transaction. A special committee of our board of directors, comprised entirely of
directors not affiliated with DBR, was established to evaluate and negotiate
the merger on behalf of our board of directors and subsequently recommended
that the board of directors approve and adopt the merger agreement. At a
special meeting held on October 30, 2004, our board of directors approved and
adopted the merger agreement and approved the merger. Completion of the merger is subject to the satisfaction of closing
conditions set forth in the merger agreement, including approval by the
affirmative vote of a majority of the outstanding shares of our common stock
(which approval must include the affirmative vote of a majority of the votes
cast by the shareholders other than DBR and its affiliates) and the receipt of
certain regulatory and other approvals. We currently anticipate that the merger
will close in the first quarter of 2005. 10




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RESULTS OF OPERATIONS  THIRD QUARTER AND NINE MONTHS OF 2004 COMPARED TO
THIRD QUARTER AND NINE MONTHS OF 2003 The following table sets forth the data from our consolidated statements of
income for the three and nine-month periods ended September 30, 2004 and 2003,
shown as a percentage of net revenues. Three months ended
    
    Percent
    
    Nine months ended
    
    PercentSep 30,
    
    Sep 30,
    
    Change
    
    Sep 30,
    
    Sep 30,
    
    Change2004
    
    2003
    
    2004 vs 2003
    
    2004
    
    2003
    
    2004 vs 2003Net revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    0.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    0.0
    %Cost of wines sold
    
    
    -67.1
    %
    
    
    -66.6
    %
    
    
    0.8
    %
    
    
    -67.7
    %
    
    
    -66.7
    %
    
    
    1.5
    %Gross profit
    
    
    33.0
    %
    
    
    33.4
    %
    
    
    -1.2
    %
    
    
    32.3
    %
    
    
    33.3
    %
    
    
    -3.0
    %Other operating income (expense), net
    
    
    -0.7
    %
    
    
    0.0
    %
    
    
    -100.0
    %
    
    
    -0.2
    %
    
    
    0.1
    %
    
    
    -300.0
    %Cost associated with proposed acquisition
    
    
    -3.9
    %
    
    
    0.0
    %
    
    
    -100.0
    %
    
    
    -2.0
    %
    
    
    0.0
    %
    
    
    -100.0
    %Depreciation and Amortization
    
    
    -1.2
    %
    
    
    -1.4
    %
    
    
    -14.3
    %
    
    
    -1.3
    %
    
    
    -1.5
    %
    
    
    -13.3
    %Selling, general and administrative expenses
    
    
    -21.7
    %
    
    
    -19.5
    %
    
    
    11.3
    %
    
    
    -21.9
    %
    
    
    -20.9
    %
    
    
    4.8
    %Operating income
    
    
    5.4
    %
    
    
    12.5
    %
    
    
    -56.8
    %
    
    
    6.8
    %
    
    
    10.9
    %
    
    
    -37.6
    %Interest expense, net
    
    
    -8.0
    %
    
    
    -8.4
    %
    
    
    -4.8
    %
    
    
    -8.8
    %
    
    
    -8.5
    %
    
    
    3.5
    %Other income
    
    
    0.5
    %
    
    
    0.4
    %
    
    
    25.0
    %
    
    
    0.6
    %
    
    
    0.4
    %
    
    
    50.0
    %Equity in net income of Chateau Duhart-Milon
    
    
    -0.4
    %
    
    
    -0.2
    %
    
    
    100.0
    %
    
    
    1.1
    %
    
    
    0.9
    %
    
    
    22.2
    %Minority interest
    
    
    -0.4
    %
    
    
    -0.4
    %
    
    
    0.0
    %
    
    
    -0.5
    %
    
    
    -0.3
    %
    
    
    66.7
    %Income (loss) before income taxes
    
    
    -2.9
    %
    
    
    3.9
    %
    
    
    -174.4
    %
    
    
    -0.8
    %
    
    
    3.3
    %
    
    
    -124.2
    %Income taxes
    
    
    1.2
    %
    
    
    -1.6
    %
    
    
    -175.0
    %
    
    
    0.3
    %
    
    
    -1.4
    %
    
    
    -121.4
    %Net income (loss)
    
    
    -1.7
    %
    
    
    2.3
    %
    
    
    -173.9
    %
    
    
    -0.5
    %
    
    
    1.9
    %
    
    
    -126.3
    %
 Net Revenues Net revenues for the three months ended September 30, 2004 decreased
approximately $368,000, or 2.2%, over the corresponding period in the preceding
year. This decrease was due to a 5.8% decrease in third quarter case sales
over the same period in the preceding year offset in part by a 3.8% increase in
revenue per case due to new luxury wine releases and continued growth of our
Provenance brand. Net revenues for the nine months ended September 30, 2004 increased
approximately $1,193,000, or 2.6%, over the corresponding period in the
preceding year. The increase was due to a 5.1% increase in revenue per case
which was due to the luxury wine releases and continued growth of our
Provenance brand offset in part by a 2.4% decrease in case sales and continued
competitive pricing pressures. Gross Profit Gross profit margin for the three and nine months ended September 30, 2004
decreased 0.4% and 1.0% as compared to the corresponding periods in the
preceding year. The decreases were driven primarily by continued pressure to
provide competitive promotional allowances within the marketplace. Cost associated with proposed acquisition Our board of directors formed a special committee, consisting solely of
independent directors, to review and evaluate a proposed acquisition of all of
our outstanding publicly held shares of common stock by an affiliate of DBR.
The costs associated with the proposed acquisition represent the legal and
financial advisory fees incurred by the committee to review and evaluate the
DBR proposal. 11




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In consideration of the costs associated with the proposed acquisition, we
reached an agreement with our bank group and private placement lenders to
exclude these costs, subject to certain annual limitations, from the quarterly
covenant calculations. We executed an amendment documenting this change in
August 2004. Selling, General and Administrative Expenses Selling, general and administrative expenses for the three and nine months
ended September 30, 2004, increased by $290,000, or 9.1%, and $702,000, or
7.4%, over the comparable periods in the prior year. The increases were due to
rising worker compensation costs, health care costs and winery and marketing
costs associated with our new luxury wine releases and Provenance brand. Operating Income Operating income for the three months ended September 30, 2004, decreased
by $1,193,000, or 58.0%, over the same period last year. The decrease was due
to lower case sales and legal and financial consulting fees associated with the
DBR proposal, offset by our new luxury wine releases and continued growth of
our Provenance brand Operating income for the nine months ended September 30, 2004 decreased by
$1,771,000, or 35.8%, over the corresponding period in the preceding year. The
decrease occurred due to the decrease in case shipments, an increase in program
allowances and legal and financial consulting fees associated with the DBR
proposal, offset by our new luxury wine releases and continued growth of our
Provenance brand. Interest Expense Interest expense for the three months ended September 30, 2004 decreased
$93,000, or 6.8%, and increased $238,000, or 6.1%, for the nine months ended
September 30, 2004 over the comparable periods in the prior year. The decrease
over the last three months was due to the conversion of our subordinated debt
to common stock on August 23, 2004. The year-to-date increase occurred as a
result in the reduction of capitalized interest. Currently, we have minimal
vineyards in development which, in the prior year, generated capitalized
interest. Equity in Net Income of Duhart-Milon We monitor our investment in Duhart-Milon primarily through our on-going
communication with DBR. Such communication is facilitated by the presence of
our chairman on DBRs board of directors, and DBRs representation on our board
of directors. Additionally, various of our key employees make periodic visits
to Duhart-Milons offices and production facilities. Since the investment in Duhart-Milon is a long-term investment denominated
in a foreign currency, we record the gain or loss for currency translation in
other comprehensive income or loss, which is part of shareholders equity. Based on forecasts received by DBR, we anticipate that equity losses will
be recorded in the fourth quarter of 2004. Minority Interest We consolidate the financial statements of Edna Valley Vineyard (EVV)
with our financial statements. We account for the interest in EVV attributable
to parties other than us as a minority interest. The minority interest in the
net income of EVV for the three months and nine months ended September 30, 2004
was $65,000 and $244,000. The increases in minority interest were $0 and
$92,000 for the three and nine month periods ended September 30, 2004, when
compared to the same periods last year. The increase was due to the higher net
income of EVV as compared to the same period in the prior year. Net Income and Earnings per Share As a result of the factors discussed above, our reported net loss for the
nine months ending September 30, 2004 amounted to $214,000, or $.02 per diluted
share, compared to net income of $883,000, or $.07 per diluted share, a year
ago. Liquidity and Capital Resources Working capital as of September 30, 2004 was $58.2 million compared to $
57.9 million at December 31, 2003. The $0.3 million increase in working
capital was primarily attributable to a $6.3 million increase in inventories,
which is a result of the 2004 harvest. This is offset by a decrease in
receivables of $5.8 million and an increase of $0.2 million in accounts
payable. 12




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We have a $55 million credit facility with Rabobank International pursuant
to which we had outstanding borrowings as of September 30, 2004 of $16,600,000
and additional available borrowings of $38,400,000. This facility expires in
May 2007, and the interest rate on borrowings as of September 30, 2004 was
3.2%. This facility contains restrictive covenants including requirements to
maintain certain financial ratios and restrictions on additional indebtedness,
asset sales, investments and payment of dividends. As of September 30, 2004,
we were in compliance with these covenants. We have historically financed our growth through increases in borrowings
and cash flow from operations. We expect that our working capital needs will
grow significantly to support expected future growth in sales volume. Due to
the lengthy aging and processing cycles involved in premium wine production,
expenditures for inventory and fixed assets need to be made one to three years
or more in advance of anticipated sales. We believe that cash flows from operations and current cash balances,
together with available external financing and the extension of existing
facilities, will be sufficient to fund operations and capital investments over
the next twelve months and longer-term. Should additional funding be required,
we may need to raise the required funds through borrowings or public or private
sales of debt or equity securities. Such funding may be obtained through bank
borrowings, from additional securities which may be issued from time to time
under an effective registration statement, through the issuance of securities
in a transaction exempt from registration under the Securities Act of 1933 or a
combination of one or more of the foregoing. We believe that, in the event of
such requirements, we will be able to access the capital markets on terms and
in amounts adequate to meet our objectives. However, given the possibility of
changes in market conditions or other occurrences, there can be no certainty
that such funding will be available in needed quantities or on terms favorable
to us or at all. RISK FACTORS The following disclosures should be read in conjunction with the foregoing
Managements Discussion and Analysis of Financial Condition and Results of
Operations. These disclosures are intended to discuss certain material risks
of our business as they appear to management at this time. However, this list
is not exhaustive. Other risks may, and likely will, arise from time to time. The Proposed Acquisition by DBR Could Harm Our Business The proposed acquisition by DBR has resulted in significant costs and
expenses for us, including costs for legal and financial advisory services, and
will continue to do so. In addition, any negative effects of the proposed
acquisition on our relationships with our employees, distributors or customers
could result in significant harm to our business. Our Revenues and Operating Results Fluctuate Significantly from Quarter to Quarter We believe period-to-period comparisons of our operating results are not
necessarily meaningful and cannot be relied upon as indicators of future
performance. In addition, we cannot assure that our revenues will grow or be
sustained in future periods or that we will be profitable in the future.
Significant factors in these quarterly fluctuations, many of which are within
our control, are changes in consumer demand for our wines, the effect of
weather and other natural forces on growing conditions and, in turn, the
quality and quantity of grapes produced by us, interest rates, inventory levels
and the timing of releases for certain wines, among other factors.
Consequently, we have experienced, and expect to continue to experience,
fluctuations in revenues and operating results. Large portions of our expenses are fixed and difficult to reduce in a
short period of time. In quarters when revenues do not meet our expectations,
our level of fixed expenses tends to exacerbate the adverse effect on net
income. In quarters when our operating results are below the expectations of
public market analysts or investors, the price of our common stock may be
adversely affected. Reduced Consumer Spending Could Lessen Demand For Our Wines and Harm Our Business Consumer spending trends and changes in consumer tastes have a substantial
impact on the wine industry and our business. To the extent that wine
purchases are negatively impacted by economic and other factors, or wine
consumers reduce consumption of wine in favor of other beverages, demand for
our wines could decrease. Our Business Is Seasonal, Which Could Cause Our Market Price to Fluctuate Our business is subject to seasonal as well as quarterly fluctuations in
revenues and operating results. Our sales volume tends to increase during the
summer months and the holiday season and decrease after the holiday season. As
a result, our sales and earnings are typically highest during the fourth
calendar quarter and lowest in the first calendar quarter. Seasonal factors
also affect our level of borrowing. For example, our borrowing levels
typically are highest during winter when we 13




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have to pay growers for grapes harvested and make payments related to the
grape harvest. These and other factors may cause fluctuations in our results
of operations and in the market price of our common stock. We Will Need More Working Capital to Grow The premium wine industry is a capital-intensive business, which requires
substantial capital expenditures to develop and acquire vineyards and to
improve or expand wine production. Further, the farming of vineyards and
acquisition of grapes and bulk wine require substantial amounts of working
capital. We project the need for significant capital spending and increased
working capital requirements over the next several years, which must be
financed by cash from operations and by additional borrowings or additional
equity, which may not be available on reasonable terms or at all. Our Acquisitions and Potential Future Acquisitions Involve a Number of
Risks Our acquisition of Provenance Vineyards, Hewitt Ranch, Staton Hills Winery
(renamed Sagelands Vineyard) and the Jade Mountain brand, enlarging Canoe Ridge
Vineyard and buying out our partners, and expansion to the recently acquired
winery for the Provenance Vineyards, as well as potential future acquisitions,
involve risks associated with: assimilating these operations into our company;
integrating, retaining and motivating key personnel; integrating and managing
geographically-dispersed operations; integrating the technology and
infrastructures of disparate entities; the production and marketing of wine;
and replanting of existing vineyards from white wine grapes to red wine grapes. We relied on debt financing to purchase Hewitt Ranch, Staton Hills Winery
and the Jade Mountain brand, to enlarge Canoe Ridge Vineyard and to buy out our
partners and other vineyard land and related assets in prior periods.
Consequently our debt-to-equity ratio is high in relation to our historical
standards. The interest costs associated with this debt will increase our
operating expenses and the risk of negative cash flow. Our Profits Depend Largely on Sales in Certain States and on Sales of
Certain Varietals In the nine months ended September 30, 2004, approximately 88% of our wine
sales were concentrated in 20 states. Changes in national consumer spending
or consumer spending in these states and other regions of the country could
affect both the quantity and price level of wines that customers are willing to
purchase which could harm our business. Approximately 89% of our consolidated net revenues in the nine months
ended September 30, 2004 were concentrated in our four top selling varietal
wines. Specifically, sales of Chardonnay, Cabernet Sauvignon, Pinot Noir and
Merlot accounted for 36%, 21%, 17% and 15% of our net revenues. Changes in
consumer preferences with respect to these varietal wines could adversely
affect our business. Competition May Harm Our Business The ultra premium table wine industry is intensely competitive and highly
fragmented. Our wines compete in all of the premium wine market segments with
many other premium domestic and foreign wines, with imported wines coming
primarily from the Burgundy and Bordeaux regions of France and, to a lesser
extent, Italy, Chile, Argentina, South Africa and Australia. Our wines also
compete with popular-priced generic wines and with other alcoholic and, to a
lesser degree, non-alcoholic beverages, for shelf space in retail stores and
for marketing focus by our independent distributors, many of which carry
extensive brand portfolios. The wine industry has experienced significant consolidation. Many of our
competitors have greater financial, technical, marketing and public relations
resources than we do. Our sales may be harmed to the extent we are not able to
compete successfully against such wine or alternative beverage producers. Our Business is Subject to a Variety of Agricultural Risks Winemaking and grape growing are subject to a variety of agricultural
risks. Various diseases, pests, fungi, viruses, drought, frosts and certain
other weather conditions can affect the quality and quantity of grapes
available to us, decreasing the supply of our products and negatively impacting
profitability. Many California vineyards have been infested in recent years with
phylloxera. Our vineyard properties are primarily planted to rootstocks
believed to be resistant to phylloxera. However, we cannot assure that our
existing vineyards, or the rootstocks we are now using in our planting
programs, will not become susceptible to current or new strains of phylloxera. Pierces Disease is a vine bacterial disease that has been in California
for more than 100 years. It kills grapevines and there is no known cure.
Small insects called sharpshooters spread this disease. A new strain of the
sharpshooter, the glassy winged, was discovered in Southern California and is
believed to be migrating north. We are actively supporting the efforts 14




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of the agricultural industry to control this pest and are making every
reasonable effort to prevent an infestation in our own vineyards. We cannot,
however, assure that we will succeed in preventing contamination in our
vineyards. Future government restrictions regarding the use of certain materials used
in grape growing may increase vineyard costs and/or reduce production. Grape growing requires adequate water supplies. We generally supply our
vineyards water needs through wells and reservoirs located on our properties.
We believe that we either have, or are currently planning to insure, adequate
water supplies to meet the needs of all of our vineyards. However, a
substantial reduction in water supplies could result in material losses of
grape crops and vines. We May Not Be Able to Grow or Acquire Enough Quality Grapes for Our Wines The adequacy of our grape supply is influenced by consumer demand for wine
in relation to industry-wide production levels. While we believe that we can
secure sufficient supplies of grapes from a combination of our own production
and from grape supply contracts with independent growers, we cannot assure that
grape supply shortages will not occur. A shortage in the supply of wine grapes
could result in an increase in the price of some or all grape varieties and a
corresponding increase in our wine production costs. An Oversupply of Grapes May Also Harm Our Business Current trends in the domestic and foreign wine industry point to rapid
plantings of new vineyards and replanting of old vineyards to greater
densities, with the expected result of significantly increasing the worldwide
supply of premium wine grapes and the amount of wine which will be produced in
the future. This expected increase in grape production has resulted in an
excess of supply over demand and forces us to reduce, or not increase, our
prices. We Depend on Third Parties to Sell Our Wine We sell our products primarily through independent distributors and
brokers for resale to retail outlets, restaurants, hotels and private clubs
across the United States and in some overseas markets. To a lesser degree, we
rely on direct sales from our wineries, our wine library and direct mail.
Sales to our largest distributor and to our ten largest distributors combined
represented approximately 34% and 63% of our net revenues during the nine
months ended September 30, 2004. Sales to our ten largest distributors are
expected to continue to represent a substantial portion of our net revenues in
the future. The laws and regulations of several states prohibit changes of
distributors, except under certain limited circumstances, making it difficult
to terminate a distributor for poor performance without reasonable cause, as
defined by applicable statutes. Any difficulty or inability to replace
distributors, poor performance of our major distributors or our inability to
collect accounts receivable from our major distributors could harm our
business. New Regulations or Increased Regulatory Costs Could Harm Our Business The wine industry is subject to extensive regulation by the Federal Bureau
of Alcohol, Tobacco and Firearms and various foreign agencies, state liquor
authorities and local authorities. These regulations and laws dictate such
matters as licensing requirements, trade and pricing practices, permitted
distribution channels, permitted and required labeling, advertising and
relations with wholesalers and retailers. Any expansion of our existing
facilities or development of new vineyards or wineries may be limited by
present and future zoning ordinances, environmental restrictions and other
legal requirements. In addition, new regulations or requirements or increases
in excise taxes, income taxes, property and sales taxes or international
tariffs, could reduce our profits. Future legal or regulatory challenges to
the industry, either individually or in the aggregate, could harm our business. Adverse Public Opinion About Alcohol May Harm Our Business A number of research studies suggest that various health benefits may
result from the moderate consumption of alcohol, but other studies suggest that
alcohol consumption does not have any health benefits and may in fact increase
the risk of stroke, cancer and other illnesses. If an unfavorable report on
alcohol consumption gains general support, it could harm the wine industry and
our business. We Use Pesticides and Other Hazardous Substances in the Operation of Our
Business We use pesticides and other hazardous substances in the operation of our
business. If hazardous substances are discovered on, or emanate from, any of
our properties, and their release presents a threat of harm to public health or
the environment, we may be held strictly liable for the cost of remediation.
Payment of such costs could have a material adverse effect on us. We maintain
insurance against these kinds of risks, and others, under various insurance
policies. However, our insurance may not be adequate or may not continue to be
available at a price or on terms that are satisfactory to us. 15




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Contamination of Our Wines Would Harm Our Business We are subject to certain hazards and product liability risks, such as
potential contamination, through tampering or otherwise, of ingredients or
products. Contamination of any of our wines could result in the need for a
product recall, which could significantly damage our reputation for product
quality, which we believe is one of our principal competitive advantages. We
maintain insurance against these kinds of risks, and others, under various
general liability and product liability insurance policies. However, our
insurance may not be adequate or may not continue to be available at a price or
on terms that are satisfactory to us. The Loss of Key Employees Would Damage Our Reputation and Business Our success depends to some degree upon the continued services of a number
of key employees. The loss of the services of one or more of our key employees
could harm our business and our reputation, particularly if one or more of our
key employees resigns to join a competitor or to form a competing company. In
such an event, despite provisions in our employment contracts, which are
designed to prevent the unauthorized disclosure or use of our trade secrets,
practices or procedures by such personnel under these circumstances, we cannot
be certain that we would be able to enforce these provisions or prevent such
disclosures. Shifts in Foreign Exchange Rates or the Imposition of Adverse Trade
Regulations Could Harm Our Business We conduct some of our import and export activity for wine and packaging
supplies in foreign currencies. We purchase foreign currency on the spot
market on an as-needed basis and engage in limited financial hedging activities
to offset the risk of exchange rate fluctuations. There is a risk that a shift
in certain foreign exchange rates or the imposition of unforeseen and adverse
trade regulations could adversely impact the costs of these items and have an
adverse impact on our operating results. In addition, the imposition of unforeseen and adverse trade regulations
could have an adverse effect on our imported wine operations. Export sales
accounted for approximately 2% of total consolidated revenue for the nine
months ended September 30, 2004. We expect the volume of international
transactions to increase, which may increase our exposure to future exchange
rate fluctuations. Infringement of Our Trademarks May Damage Our Brand Names or Our Business Our wines are branded consumer products, and we distinguish our wines from
our competitors by enforcement of our trademarks. We cannot assure that
competitors will refrain from infringing our marks or using trademarks, trade
names or trade dress which dilute our intellectual property rights, and any
such actions may require us to become involved in litigation to protect these
rights. Litigation of this nature can be very expensive and could divert
managements time and attention. The Market Price of Our Common Stock Fluctuates All of the foregoing risks, among others not known or mentioned in this
report, may have a significant effect on the market price of our shares. The
stock markets have experienced extreme price and volume trading volatility in
recent months and years. This volatility has had a substantial effect on the
market prices of securities of many companies for reasons frequently unrelated
or disproportionate to the specific companys operating performance and could
similarly affect our market price. Decreased Cash Flow Could Limit Our Ability to Service Our Debt As a result of incurring debt, we are subject to the risks normally
associated with debt financing, including the risk that cash flow from
operations will be insufficient to meet required payments of principal and
interest. Our ability to satisfy our obligations to pay interest and to repay
debt is dependent on our future performance. Our performance depends, in part,
on prevailing economic conditions and financial, business and other factors,
including factors beyond our control. Our Debt Financing Agreements Contain Restrictive Covenants with Which We
May Not Be Able to Comply Our existing line of credit and long-term debt financing agreements
contain restrictive financial covenants. These covenants require us, among
other things, to maintain specified levels of net income, working capital,
tangible net worth and financial ratios. Our ability to comply with
restrictive financial covenants depends upon our future operating performance.
Our future operating performance depends, in part, on general industry
conditions and other factors beyond our control. If we default on our
financial covenants, our lenders may require that we immediately repay the full
outstanding amount that we owe them. In such event, we may have to pursue
alternative financing arrangements, which may not be available on favorable
terms or at all. 16




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Item 4. Controls and Procedures We maintain disclosure controls and procedures that are designed to ensure
that information required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the SECs rules and forms, and that such information is accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating our disclosure controls and
procedures, our management recognizes that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, and our management is required to
apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures. As of September 30, 2004, the end of the quarter covered by this report,
we carried out an evaluation, under the supervision and with the participation
of our management, including our Chief Executive Officer and Chief Financial
Officer, of the design and operation of our disclosure controls and procedures.
Based on the foregoing, our Chief Executive Officer and Chief Financial
Officer concluded that our disclosure controls and procedures were effective at
the reasonable assurance level. There has been no change in our internal controls over financial reporting
during our most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal controls over financial
reporting. 
 PART II.  OTHER INFORMATION 
 Item 1. Legal Proceedings On May 18, 2004, a purported stockholder class action lawsuit was filed in
Superior Court of the State of California, County of Napa, against Chalone,
each of our directors, DBR and Constellation. The initial complaint in the
lawsuit, entitled Wiedamann v. The Chalone Wine Group, Ltd., et al. (Case No.
26-25479), alleged that DBR and each of our directors breached, and that
Chalone, DBR and Constellation aided the other defendants breaches of, their
fiduciary duties of care, loyalty, candor and independence owed to the public
stockholders of Chalone in connection with the merger. Specifically, the
initial complaint alleged that the defendants failed to take steps to maximize
the value of Chalone to its public shareholders, took steps to avoid
competitive bidding, capped the price of Chalone stock, gave DBR an unfair
advantage by failing to solicit other potential acquirors or alternative
transactions and failed to properly value Chalone. From May 18 to May 21, 2004, four other purported class action lawsuits
were filed in the Superior Court of the State of California, County of Napa,
alleging substantially identical allegations as those in the Wiedamann action.
On May 25, 2004, the Court ordered these four lawsuits consolidated with the
Wiedamann lawsuit. On June 2, 2004, the Court ordered that the defendants did not have to
respond to the initial complaints and that the lead plaintiff should file a
consolidated complaint to which the defendants would respond. On June 17,
2004, the Court appointed a lead plaintiff and lead counsel. While the lead
plaintiff has not filed a consolidated complaint, his initial complaint sought
to enjoin Chalone from proceeding with the proposed merger with DBR.
Additionally, the initial complaint sought certification of a class; a
declaration that the proposed merger is in breach of defendants fiduciary
duties; an injunction barring the proposed merger unless and until Chalone
adopts and implements a procedure or process to obtain the highest possible
price for its stockholders and directing Chalone to pursue a transaction in the
best interests of its stockholders; imposition of a constructive trust upon any
benefits improperly received by the defendants as a result of the proposed
merger; and costs, attorneys fees and experts fees. To date, no motions have been filed by any of the parties to the lawsuit.
We believe that this consolidated action is meritless and we intend to
vigorously defend against any allegations that may be asserted in any
consolidated complaint. On May 20, 2004, a purported stockholder class action lawsuit was filed in
Superior Court of the State of California, County of San Francisco, alleging
that Chalone and each of our directors breached, or aided the other defendants
breaches of, their fiduciary duties of care, loyalty, candor and fair dealing
owed to the public stockholders of Chalone in connection with the proposed
merger. On July 9, 2004, the plaintiff voluntarily dismissed this lawsuit
without prejudice. 
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Item 5. Exhibits

10.66
    
    Amended and Restated Credit
Agreement10.67
    
    Amended and Restated Security
Agreement10.68
    
    Security Agreement10.69
    
    Second Amendment to the Amended and Restated
Note Purchase Agreement10.70
    
    Amendment to the Intercreditor and
Collateral Agency Agreement10.71
    
    Third Amendment to the Note
Purchase Agreement10.72
    
    Amendment to the Amended and
Restated Credit Agreement and Post-Closing Undertakings10.73
    
    Change of Control Severance Agreement10.74
    
    Change of Control Severance Agreement10.75
    
    Change of Control Severance Agreement10.76
    
    Change of Control Severance Agreement10.77
    
    Retention Bonus Agreement10.78
    
    Retention Bonus Agreement10.79
    
    Retention Bonus Agreement31.1
    
    Certification of Chief Financial Officer.31.2
    
    Certification of Chief Executive Officer.32.1
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Dated: November 12, 2004
    The
Chalone Wine Group, Ltd.(Registrant)/s/ Thomas B. SelfridgeThomas B. SelfridgePresident and Chief Executive OfficerDated: November 12, 2004
    /s/ Shawn M. Conroy BlomShawn M. Conroy BlomVice President and Chief Financial Officer 19