SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the transition period from            to           

Commission file number: 0-13406

The Chalone Wine Group, Ltd.

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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THE CHALONE WINE GROUP, LTD.
CONSOLIDATED BALANCE SHEETS
(All amounts in thousands, except share data)

ASSETS

See accompanying notes to consolidated financial statements

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THE CHALONE WINE GROUP, LTD.
CONSOLIDATED STATEMENTS OF INCOME
(All amounts in thousands, except per share data)

See accompanying notes to consolidated financial statements

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THE CHALONE WINE GROUP, LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(All amounts in thousands)

See accompanying notes to consolidated financial statements

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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.

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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).

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):

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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):

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):

     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”).

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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:

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; and
	t		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.

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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.

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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.