Privatization of Virginia's State Owned Liquor Stores

This post is not about the morality or public safety issues related to privatization of liquor sales. It is simply a discussion of the financial framework for evaluating the idea.

Virginia currently owns and controls the liquor distribution and retail package stores in the state.  That means all restaurant and bar owners serving liquor have to buy it from the state as do the citizens.  Sales in 2009 from the state’s 332 stores were over $665 million.  Profits were 17%, or $111 million and tax revenues of $109 million were generated (about $3 for every liter sold).  Projections for 2010 are somewhat higher, forecasting $120 million in profit.  It is not clear whether the $109 million in taxes includes sales tax or is just the liquor excise tax.

Governor Bob McDonnell has proposed that the state get out of the liquor business, citing four scenarios to consider:

1.  Sell all stores to one buyer;  
2.  Allow private companies to operate the stores as agents of the state;
3.  Allow all 3000 presently licensed beer and wine outlets;
4.  Auction of a limited number of licenses.

My opinion is that all these ideas have serious drawbacks.  One buyer means another monopoly and continuing high prices, encouraging Northern Virginians and those who travel to buy their booze in less expensive locals.  (Example:  1.5 liters of my favorite whiskey is $54 in Virginia, I can find it for at least 20% less elsewhere.)  Agency operation means the state is still in the business, just using proxies.  Plus, I doubt the sale of the businesses would bring as good a price.  Issuing liquor licenses to every drug store, convenience store and grocery store currently selling beer and wine for off premises consumption just sounds like overkill.  Most states that have privatized liquor sales require liquor stores to stand alone.  Auctioning off a limited number of licenses does not sell the current stores and inventory, nor does it get the state out of the 332 leases it is obligated to pay for store and warehouse rental.  There is also the matter of limited licensing creating a government supplied windfall.  A Florida retail liquor license that costs a few hundred dollars annually from the state sells for over $70,000 on the resale market because of limited entry.

In these tough economic times, the legislature is understandably concerned about losing the income from this state monopoly.  Discussion of the subject invariably includes the tax revenue, but the state can and will collect that regardless of who does the selling.  So the only relevant revenue to consider is the profit.  That is somewhat complicated by what costs are included in the current operations that will still be required to license and regulate the 3000 beer and wine retailers and the distributors that supply them and the restaurants.   Then whatever is required to license and regulate the liquor package stores and wholesalers must be considered.  These figures are not readily available, so I am going to assume that the licensing fees and taxes will take care of those costs with no gain or loss from the present structure. The chance of a bureaucracy really shrinking is always small.

Now we are left with the problem of replacing $111 (or 120) million dollars in the state budget representing the liquor store profits.  If the state businesses are sold according to typical business valuations (and there is no reason they shouldn’t be), they will bring 3-10 times cash flow, plus assets and inventory.  The cash flow in this case is just the profit since there is no interest, depreciation, tax, or owner compensation to add back.  So that is $360 million to $1.2 billion plus inventory, trucks, cash registers, shelving and other leasehold improvements.  I’m going to estimate the leasehold improvements at an average of $12,000 per store which is conservative.  I estimate the stock on the shelves represents 2.5 months sales, or 20% of $665 million.  That is $133 million at retail or about $70 million at cost.  To recap:

        Value of cash flow            $360-1200 million
        Value of inventory            $  70 million
        Value of improvements   $    4 million

I believe some of the high volume stores would sell for 8-10 times cash flow and the smaller ones 3-4 times cash flow.  My assumption is that the average would work out to about 6 times cash flow, or $720 million.   So the state could realize a one time cash injection of over $700 million, or 6 years of the foregone cash flow at today's level of profitability.

However, the state should look at the $720 million as a return of capital and a return on investment for the business it has built.   That means the legislature still needs to be convinced there is over $100 million a year somewhere in the equation, at least beginning in the year after the sale.  Where could that money come from?  I see several sources that can be considered.

1.  If the state doubled the tax on a liter of liquor, that would raise another $110 million or so; however, it would lessen the benefits of competitive pricing.
2.  Competitive pricing may prevent Virginians from shopping across state lines, increasing overall revenue and the state’s liquor excise and sales tax revenue.
3.  Competitive pricing may result in higher sales because consumers buy more expensive brands because they are priced lower.
4.  The state could realize a couple of million in increased license revenue and more tax revenue by licensing more than 332 stores.  

Florida has a store for every 8,500 residents, Maryland has one  per 7,300 residents, and  Virginia has one for every 23,000 residents.  These numbers suggest Virginia could support about 1000 stores ---- one for every 7,700 residents.

5.  The private owners will have to pay state (and federal) income taxes on what they earn.

I believe a combination of all these revenue opportunities will provide the best approach.  A preliminary calculation follows; however, I am keeping an open mind because there are so many things I don’t know about the current financial structure of the state’s liquor business.  

All the figures relate to liquor taxes, sales taxes, income taxes and license fees.  Due to competitive pricing, gross sales may fall slightly.  While this will affect sales taxes, license fees and liquor taxes are not impacted.  I believe any loss in sales tax on liquor will be more than offset by additional sales of snack foods, non-liquor items like wine bottle openers, gift baskets, and other merchandise not currently sold by the state stores.  

    1.  Decreased out of state shopping (add 5% in revenue)               $   7.35   million
    2.  Competitive pricing up-sell and volume increases (10%)              14.70   million
    3.  Increased license revenue from 700 stores at $2500 per                1.75    million
    4.  ABC manager licenses (avg. 4 per establishment at $250)            1.00    million
    5.  Increased volume due to wider distribution (25%)                          36.75    million
    6.  Business income taxes (4% of $120 million)                                     4.80    million

                                             Total from business changes                      $ 66.35   million

As you can see, it would be hard to project over $100 million in revenue without making some pretty unlikely sales assumptions or adding almost $2 to the per liter alcohol tax.  If that much tax is added, it would tend to block the effects generated from more competitive pricing, making the goal harder yet to meet.  Based upon this preliminary analysis, I won't hold my breath waiting for privatization.