We published one of our favourite interviews of 2021 last week: A History of Wine and Spirits Distribution. There are two specific areas of the industry that we think are attractive:
- Scaled suppliers such as Diageo, LVMH, and Constellation Brands
- New DTC entrants such as Naked Wines and Vivino.
We interviewed an executive with over 40 years of experience across all three tiers of distribution to understand the regulatory structures that define the way alcohol is distributed in the US.
In 1933, the 21st Amendment repealed Prohibition and the organized crime groups previously distributing alcohol were in prime position to begin trading legally. Contrary to popular myth, the Act didn’t specifically require any regulatory framework such as control states or a three-tier system. The major changes that define the industry structure today came in 1975 with the repeal of alcohol fair trade laws and the introduction of franchise laws:
"Most of the franchise laws started to develop when something that we used to have in this country – primarily in the Eastern Seaboard, from New York down to Florida – which was called fair trade laws, for alcoholic beverage distribution. Basically, it said, if a producer sold a wine to a distributor, the distributor had to mark it up a minimum, no matter what, and pass that along; then the retailer had to mark it up a minimum and pass it on. That was called fair trade, but it was nothing more than fixed pricing. Most of these fair trade laws were repealed so the distributors started going to their state legislators and saying, I need protection. I built these brands, ostensibly; I’ve been doing this business and now you’re taking away my ability to fix the pricing. That was the birth of most of the franchise laws."
The franchise laws were effectively introduced to protect wholesalers after fixed pricing was repealed. One protectionist policy replaced another. Wholesalers argue that they need protection from brands that may leave after they have spent large sums marketing their products. The terms of the franchise law go a long way to protect the distributors and requires the brand to sign over lifetime rights to wholesalers:
"There are about 24 or 25 states, right now, who have some form of what they call franchise laws. I’ll give you two examples. Georgia is the worst; if I’m a producer of wine or spirits and I give my brand to a distributor in Georgia, believe it or not, they now own the rights to that brand for life; I have no say. It’s rather remarkable. They trade brands down in Georgia – even in the days when I was trying to do distribution in the 1980s and 1990s – in the same way I traded baseball cards when I was a kid. If you’re a producer, the remedy in Georgia, is that you have to pull out of the state and sell no wine in that state, for over several years, before you can leave a distributor without compensation."
The franchise laws seem archaic given the market power of distributors today. Wholesalers such as Southern Glazer’s and Reyes Holdings don’t need unwaivable statutory protection from small brewers; the distributor has all the power.
Over the last 50 years, as local brewers and retailers scaled nationally, wholesalers grew with them. Today, Southern Glazer’s and RNDC control over 50% of the $65bn alcohol market that flows through the three-tier system. Large companies like Diageo and Constellation Brands have rolled up and scaled brands globally leaving a huge long tail of wineries and distillers. The Wine Institute estimates that over 97% of wineries produce less than 50,000 cases per year and are losing between 30% and 60% of revenue. Only 56 wineries produce above 500,000 cases per year. There is similar supplier fragmentation for brewers and distillers. This is why the shift to DTC is so interesting; it democratises access to customers and reduces the regulatory barriers to scale.
There appear to be at least two interesting implications of distributor power:
- Distribution moat for scaled suppliers
- DTC opportunity to disintermediate distributors
Distribution Moat of Scaled Spirit Suppliers
Firstly, the power and scale of distributors deepens the competitive advantage of large suppliers like Diageo or LVMH. There are too many brands and too few wholesalers; a distributor cannot afford to drop Veuve Clicquot or Jack Daniels to sell a smaller brand. The gross margin from carrying a 100,000 case brand isn’t worth the distributors’ time. Scale begets scale: suppliers with national distribution agreements not only get national reach but also better pricing than smaller suppliers that can be reinvested to grow.
"I was the largest Clicquot distributor at one time, when I was CEO of the Henry Wine Group on the West Coast, before they did the Faustian deal with Diageo, back in 2004. Most of those wines and those brands are now marketed like liquor. Remember what I said about liquor before, in terms of margin. They will get price concessions and distributors will work with them because the volume is so significant and the turn is so guaranteed. They are almost like liquor products. The bar has to have Jack Daniels; they’ve got to have certain call brands of liquor. If you look at Champagnes and some of these big mega wine companies, their brands are like call brands now, so they have to have them."
The three-tier structure is a regulatory barrier to scale that protects large suppliers like Diageo or Constellation. This also highlights why the Southern Glazer’s deal with Fever Tree is so important. In August 2018, Fever Tree, a business we recently covered, signed an exclusive distribution agreement across 29 states as the single mixer partner to Southerns. The national distributors have the scale to drive adoption at hundreds of thousands of on-premise accounts; bars and restaurants are crucial to build on the foundation of Fever Tree’s brand equity. This relationship in combination with Fever’s co-marketing agreements with companies like Diageo highlights how Fever Tree behaves more like a spirits company than a typical consumer beverage business. The consolidation and regulatory protection of the wholesale tier protects the moat for scaled suppliers.
Over the last two decades, the consolidation at the two top tiers of the industry has led to distributor gross margins increasing from ~25% to ~30%:
"When I started selling wine, back when I was building the William Hill brand in the eighties and then Sonoma-Cutrer in the late eighties and early nineties, the distributors demanded and needed to make somewhere in the 25 gross profit margin; that was their floor. They would go down to 22, sometimes even 21 gross profit, depending on the volume. Today, their mandatory minimum is well over 30 points. They have continued to raise their margins, at the expense of the producer. If you want to do any discount promotions, you almost have to pay them, dollar for dollar, what your discount promotion has backed. After the fact, you will give them the money back so that they can meet their margin requirements."