Friday, May 20, 2005

Oenophiles rejoice! (And it’s not too bad for the vineyards either)

With all apologies to the movie Sideways, “If they want to drink [California] Merlot, we're drinking [California] Merlot.”

All over the United States, wine lovers are celebrating a Supreme Court ruling this past Monday that paves the way for direct shipments of wine from throughout the country. The decision overturns New York and Michigan state laws that allowed in-state wineries to ship directly to residents but made it illegal for out-of-state wineries to do the same. The ruling will likely cause legislatures in 24 states to review similar statutes. The decision has been lauded as a boon to smaller vineyards that were previously shut out from the nationwide marketplace due to the industry’s distribution structure and the bans on out-of-state shipments in many states, most notably New York. While wine lovers and small vineyards are clear beneficiaries of the decision, the biggest winners have yet to step forward to claim their prizes.

Wine lovers have been a bit too quick to pop the cork on their favorite California sparkling. What the Supreme Court decision actually outlawed was the discrimination by states between in-state and out-of-state producers. The main rationale given for these laws was the ability for states to collect taxes and to monitor sales to minors. Many observers have jumped to the conclusion that the decision means inter-state trade in wines will be legalized. However, the head of Michigan’s Liquor Control Commission has already come out and said she would pursue a ban on all online sales of wine rather than opening up the market to out-of-state vineyards in order to prevent sales to minors. While the exact legal ramifications have yet to play out, the decision has the potential to drastically alter the wine industry.

The industry is currently divided into three regulated segments: producers, wholesalers and retailers, which are outlawed from integrating vertically in most states. The original role of the wholesalers was an efficient means to collect excise taxes. The difference today is that in the past, a few thousand distributors competed, whereas today, there are only several hundred who have effective monopolies in many geographic areas. A study done by the FTC found that direct purchasing of wine could save consumers between 8 to 13 percent on wines costing more than $20 per bottle and 20 to 21 percent on wines costing more than $40 per bottle. The effect on consumers of the additional layers, especially the monopoly of the distributors, is quite clear.

The first reaction by many has been to focus on the effect inter-state shipping would have on smaller wineries. These vineyards have generally not been carried by the large distributors and therefore are only available on-site or locally. The decision could lead to a “snowball effect” benefit, according to Jim Trezise, president of the New York Wine & Grape Foundation. National availability of smaller vineyards will lead reporters to write about their wines, which will lead to consumers trying them, which, in turn, would create even more demand through word of mouth. The decision has the potential to expand the size of the market as people explore these newly available wines. Smaller producers gain the benefit of increased visibility as well as the increased pricing power created by the newfound demand.

What about the large producers? They have remained conspicuously quiet regarding the ruling, but the implications to them could be many times larger. A spokesman for Diageo, the worlds’ largest alcohol beverage company, has only said the company is in the process of reviewing the decision but it is “committed to the three-tier system.” With the implications of the decision still being determined, it is not surprising that these large producers would not want to alienate the distributors. If the ruling does indeed open up inter-state shipment in wines, it could dramatically alter the industry dynamics. Wine producers will be able to capture more of the value by creating their own direct to consumer online businesses. The effect of the three-tier system was that distributors “sold” access to their respective monopoly markets and extracted their piece of the pie in exchange. Internet sites like were only able to sell online by establishing a physical presence as a retailer in each state they did business and were limited to selling only wines distributed in that state.

The wine industry is stratified by price and the largest segment, wines under $7, so-called “everyday wines,” will probably remain unchanged. The cost of shipping cancels out the consumer’s savings on these wines, and sales in this price range will remain at the brick and mortar outlets. The impact on mid- and high- end wines is potentially a very different story. These “premium” wines make up 32% of the volume of California wines but 64% of the revenue. As you move further up the price range, consumers generally know which wines they want and make fewer impulsive purchases. A shift to direct sales on these wines would allow producers more opportunity to capture economic rents generated from these high-volume consumers that were previously siphoned off by the wholesalers. The benefit to producers is very direct and any gain in value capture would flow directly to the bottom line. It is feasible to imagine a scenario where consumers, who know which wines they want, whether from experience or a publication, will go online to ensure they find the vineyard and vintage they are seeking, rather than taking the chance on the local store. Online direct to consumer marketplaces would offer the wide selection and lower prices that would form a formidable one-two punch that could dominate the mid to higher end market.

No one is saying much publicly yet, but the decision has the potential to drastically shift the way wine drinkers purchase their wine. Considering that California alone shipped $9.6 billion of “premium” wine in the United States in 2004, the stakes are high.

Brian Home
Terence Lee


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