Fluent Essays

How would you assess the opportunities for above-average returns in the global wine industry? Is this industry opportunity-rich or opportunity-poor? Conduct a five-force analysis to support your analysis. THE US WINE INDUSTRY1 Armand Gilinsky, Jr. (Sonoma State University) Raymond H. Lopez (Pace University) How do firms in the US wine industry produce,... THE US WINE INDUSTRY1 Armand Gilinsky, Jr. (Sonoma State University) Raymond H. Lopez (Pace University) How do firms in the US wine industry produce, compete, and distribute their products? Wine Production Producing wines was capital intensive. Vines planted in a given year did not become productive on a sustainable basis for at least four years, with optimum output reached in the seventh year. Land upon which grapes were grown could be obtained and used in one of three ways. It might be owned and managed by the wine producer. Alternatively, the producer might contract with landowners to purchase their grapes annually. Finally, the landowner could allow the producing firm to plant and manage the growth of the vines, harvesting the grapes with its own personnel and simply paying the landowner for these privileges. As an agricultural process, grape growing was subject to a variety of risks. Varying weather and climactic conditions could have significant effects on grape yields per acre in any given year. Vines were also susceptible to pests that could adversely affect any given crop. As there was only one grape crop available per year, a combination of factors could have a significant adverse effect on grape supply and, consequently, the volume of wine produced and available for sale. Harvesting equipment, along with crushers and fermenting tanks, was expensive, and yet used only one to two months per year. They had no other use and therefore were idle for up to ten months per year. After fermentation wine was pumped into barrels for aging. These barrels cost $600 to $700 each and had a useful economic life of five years, with almost no residual value. While white wines remained in barrels for up to a year before bottling, most red wines aged in barrels for two years or more. Generally, the quality of the final red wine increased with length of barrel aging. Also, barrels needed to be “topped” every one to two weeks, since some wine was lost through the pores of the wood. Over a two-year period approximately five \% of wine volume was “lost” through the “breathing” process. Full maturation prior to sale sometimes took another two to three years. These additional maturation cycles to create quality wines tended to greatly increase inventory investment costs. Table wines comprised over 80\% of total wine industry sales in the United States. Grapes used for table wine production could be of varying quality. Varietals—such as Chardonnay, Merlot, Sauvignon Blanc, Pinot Noir, and Zinfandel—were delicate grapes from vines that typically took at least four years to mature. Regulatory Environment The US Alcohol and Tobacco Tax and Trade Bureau (TTB), prior to January 2003 had been a division of the Bureau of Alcohol, Tobacco and Firearms (BATF). The TTB was overseen by the US Treasury and regulated all alcoholic beverage sales in the United States. The TTB’s truth-in-labeling standards stated that one variety or varietal—the name of a single grape—could be used if not less than 75 \% of the wine was derived from grapes of that variety, the entire 75 \% of which was grown in the labeled appellation of origin. Appellation denoted that “at least 75 \% of a wine value was derived from fruit or agricultural products and grown in place or region indicated.” In addition to federal regulations and excise taxes, a myriad of state laws and regulations restricted the sale of alcoholic beverages. These laws in most states required wineries to sell via a “three-tier” distribution system (winery to distributor to retailer to consumer). Distributor consolidation increased substantially after the May 16, 2005, Granholm v. Heald United States Supreme Court decision that prohibited discrimination between in-state products and products from out-of-state. This decision subsequently served to increase liberalization of shipping wine across some state lines, direct from producers to consumers.2 Competition The United States wine industry was primarily segmented into two groups: private, stand-alone wineries and public, multi-industry firms. Most were relatively small firms, again located primarily in California, although every state in the United States (even Alaska and Hawaii) and the District of Columbia had at least one winery. In 2008, the 20 largest firms produced over 90 \% of all American wines by volume and approximately 85 \% by value at wholesale.3 Privately owned wineries were of a broad variety of sizes, mostly small, with the exception of the world’s industry volume leader, E&J Gallo (based in Modesto, California). E&J Gallo was probably best known for its the Bartles & Jaymes and Gallo brands, as well as Anapamu, Barefoot, Dancing Bull, Indigo Hills, Red Bicyclette, Rancho Zabaco, and Turning Leaf. The Gallos also engaged in premium wine production and branding in Sonoma County, California, under the brand names Gallo of Sonoma and MacMurray Ranch, and in the Napa Valley appellation, Louis M. Martini and William Hill. Other large private wine producers included: JFJ Bronco, based in Ceres, California, best known for its Charles Shaw brand (also called “Two-buck Chuck”); Kendall Jackson (Sonoma); and The Wine Group (a San Francisco-based marketer of well-known brands such as Almaden, Concannon, Franzia, Inglenook, and Paul Masson). A second group of competitors in the US wine industry consisted of global, publicly owned, multi-industry conglomerates, which also produced and marketed distilled spirits, beer, bottled water, and other luxury goods. The largest in terms of volume of wine sold was Constellation Brands. By 2008, upstate New York-based Constellation Brands was the sole remaining United States public company that had a prominent wine brand portfolio. That portfolio included Ravenswood, Robert Mondavi, Clos du Bois, and Blackstone wineries, among others. Consolidation trends in the wine industry had begun in 2000, as beverage conglomerates and larger producers alike began purchasing smaller, private firms, mostly situated in the middle tier of the industry in terms of production capacity, or in the 50,000-plus case production range per year (as opposed to small or boutique wineries that produced fewer than 50,000 cases of wine per year). One notable example was Australia-based Foster’s Group (a beer company), which purchased Napa-based Beringer Wine Estates for over $1.5 billion in 2000. Other global transactions during the early 2000s included the Pernod Ricard (France) acquisition of Allied-Domecq, another French conglomerate, from which it then divested (with the exception of Jacob’s Creek and Mumm Champagne) most of its acquired premium wine brands to California-based Beam Wine Estates and the Ascentia Group in 2005. Other global conglomerates that purchased wineries during that period included Kentucky-based Brown-Forman, which added Sonoma-Cutrer, Fetzer, and Bonterra Winery to its beverages portfolio, which was nonetheless dominated by bourbon whisky (Jack Daniels). Diageo, a London, UK-based conglomerate holding a portfolio of well-known brands in various categories such as whisky (Johnny Walker, Bushmills), gin (Tanqueray), vodka (Smirnoff), rum (Captain Morgan), and Guinness (beer), purchased Sterling Vineyards, Beaulieu Vineyards, and Chalone in 2005 and 2006. Finally, LVMH, a French luxury goods conglomerate best known for Louis Vuitton leather goods, purchased Chateau d’Yquem, Möet & Chandon (champagne), and Krug (champagne) in 2005. These strategic moves were initially envisioned to exploit opportunities for economies of scale in marketing, and economies of scope in gaining access to more varied brands and channels of distribution. The acquired vineyards and production capacity were then expected to increase the negotiating power of these producers with respect to the declining number of large, regional distributors. As sales of wine direct to consumers grew in response to reduced regulations on alcoholic beverage distribution, larger firms could also negotiate more favorable terms with regional and national transportation companies. The consolidating firms were for the most part publicly owned and could offer smaller, family-owned or closely held businesses an option to achieve greater liquidity of their investment and reduced risks of holding shares in larger, more diversified firms.4 By early 2009, however, thanks to disappointing earnings from wine sales due to high fixed production costs and inability to achieve the envisioned scale and scope economies, just about every large beverage conglomerate mentioned above was actively seeking to divest or spin off the winery assets acquired during the 1990s and early 2000s (or had already done so). Yet at the same time the attractiveness of wine production across the US resulted in a growing number of entrepreneurs purchasing winery assets from small producers, or starting new, small operations.5 According to the 2008-2009 State of the Wine Industry, an annual report prepared by Silicon Valley Bank, there were about 6,000 wineries in the United States that produced about 7,000 wine brands. Those brands had to be squeezed through approximately 550 trade intermediaries (distributors and wholesalers), approximately half the number from 1999. Distribution The ‘Big Five’ distributors in the United States were Southern Wine & Spirits, Charmer, Republic/NDC, Glazer’s, and Young’s Market. These five distributors owned an estimated 52 \% market share in 2008, a share that had grown from about 39 \% since 2003. Their market share was forecasted by Silicon Valley Bank to increase substantially over the course of the next decade, as an increasing number of smaller or “boutique” wine distributors were expected to exit the industry via acquisition or liquidation after default on bank loans. Nevertheless, those distributors that were still in the game found that they had aggregated too many wines in inventory in 2008-2009. Due to adverse trading conditions brought on by the financial markets’ collapse in fall 2008 and the difficult recovery, it became increasingly challenging to deplete their stocks of wine inventory. Also, a wholesaler or distributor that once represented a few wineries now in many instances represented hundreds of producers. Some wine producers decided to utilize higher quality grapes in their lower priced wines in order to move inventory. Though profit margins were likely to suffer, a producer might be able to ride out the downturn in sales. Yet as a new grape harvest arrived every year, bottled product needed to be sold in order to keep generating positive cash flows. Hoping to move some unsold finished goods inventories, some wine producers moved into direct-to-consumer sales via wine shops, websites, and wine clubs. Wine clubs gave producers an opportunity to not only track consumers, but also sell direct to consumers, as these clubs offered price breaks or “specials” and quantity discounts to their members. Although the producer had to assume the burden of shipping, licensing, and tracking different state regulations on wine shipments, bypassing the three-tier system often resulted in gross margins higher than those afforded by the normal 50 \% markdown from retail prices offered to distributors and wholesalers. For smaller wineries selling high-end brands, it was becoming less possible to rely on wholesalers and distributors to carry their message (product information). Many small wine producers were forced to take on the burden and cost of developing their own sales and marketing programs. Low cost “Buzz Marketing” promotional programs began to emerge on the Internet, via social media channels such as YouTube, Twitter, Facebook, and Yelp! Younger consumers —“Millennials” born after 1976 in particular — were not brand loyal, preferring to experiment with imported wines, new varietals, and unknown brands so long as the price was perceived as low relative to quality. These Millennial consumers also gravitated to social media and blogs, seeking opinions about value-priced wines that were of good quality and convenient to purchase. 1 This case was developed by Armand Gilinsky, Jr. (Professor of Business at Sonoma State University) and Raymond H. Lopez (Professor of Finance at Pace University) to be used for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. It was first published as A. Gilinsky, Jr. and R. H. Lopez, 2014, A note on the US wine industry in 2009, Case Research Journal, 34 (4): 20–23. © Case Research Journal, Armand Gilinsky, Jr., and Raymond H. Lopez. Reprinted with permission. 2 A. E. Wiseman & J. Ellig, 2007, The politics of wine: Trade barriers, interest groups, and the commerce clause, Journal of Politics, 69(3): 859–975. 3 M.-C. Tinney, 2008b, Review of the industry: Number of US wineries tops 6,000, Wine Business Monthly, February. 4 D. Steinthal & J. Hinman, 2007, The perfect storm, revisited, Wine Business Monthly, December: 88–93. 5 R. Macmillan, 2009, Silicon Valley Bank 2009-2010 State of the Wine Industry, April: 1–24, http://www.svb.com/pdfs/wine/StateoftheWineIndustry0910.pdf.