January 2018 Issue of Wines & Vines

Wineries Diverge on Profitability Concerns

Small wineries wary of consumer demand; large producers eye consolidation by wholesale and retail tiers

by Paul Franson

Both small and large wineries agreed that labor supply, pricing and government regulations are among the most prominent challenges affecting their profitability and growth, according to a recent survey by The Wine Business Institute at Sonoma State University. However, on many other topics there was surprising divergence based on the size of the winery being surveyed.

Wineries of all sizes were equally concerned about labor. One CEO stated emphatically: “Who will be picking the grapes if we deport everybody?”

The No. 1 concern among small companies was continuing demand for wine in the face of competition from other beverages. But large companies were less apprehensive. Likewise, both were concerned about state and local regulations, but small wineries were more worried. Other issues that concerned at least half of respondents were pricing and water.

Three issues getting great attention from large companies were less concerning to small ones: wholesaler and retail consolidation—perhaps because smaller wineries have largely given up on the three-tier system—and grape and wine supply.

The owner of a Sonoma County company selling more than 1 million cases of wine annually admitted: “For small wineries, getting representation is tough. Who wants you if you’re under 25,000 cases?”

Premiumization remains hot topic
Premiumization is a big discussion point in the industry, as the trend toward good growth at higher price points and poor growth at lower price points continues. Interestingly, 29% of survey respondents felt unaffected by price changes, and about the same percentage had raised prices around 5%, while 17% of those surveyed had raised prices more than 5%.

The names and companies of all those surveyed were made public, but individual comments were not linked to the survey participants’ names in the report.

One CEO complained: “We can’t raise price. We’re moving up slowly, creeping up. This is true for everybody. The workhorse brands like Mondavi and Far Niente can’t raise price.”

Another said, “We’re riding the curve gently upward. We fit in a slot where we previously could be under-$10 in hot deals, but now that category is under-$15. Volume has moved from under-$9 to under-$15.”

One CEO pointed out: “By-the-glass premiumization has grown while by-the-bottle on premise has been off.”

The COO of a large winery said, “We cannot raise prices on our three-tier distribution wines, but we are creeping up. We can raise prices in our DtC (direct-to-consumer) channel.”

The president of a small winery said, “You need to create a new higher priced brand to compete in grocery stores, not just raise prices. People are spending more but buying different brands.

“The traditional partnership between wholesalers and producers has dissolved. The idea of ‘brand building’ is now quaint and old-fashioned.”

In response to cost pressure, 69% of survey respondents planned to increase prices; 50% will hedge with a mixed portfolio, and 48% plan to develop a premium wine brand. Only 8% plan to acquire a premium brand and 6% to divest a value brand in response.

One executive thinks the current premiumization trend will soften, and people will trade down when the economy turns. “With good technology in the vineyard, the consumer doesn’t have to spend as much as they did previously to get higher quality wine.”

Disagreement about the future 
The industry seems to be better at recognizing trends in hindsight than in advance, and the biggest number of survey and interview respondents couldn’t identify coming trends. The most popular response to a question about trends was “not sure.” 

However, some named Italian blends, and many mentioned Tempranillo, Cabernet Franc and domestic Malbec, noting how the popularity of Pinot Grigio and rosé started with European imports but has migrated to U.S. production. A few saw a trend toward Albariño, Rhône blends, Viognier and even Zinfandel, which seems to make periodic comebacks.

Few are convinced enough that they’re investing in these possibilities, however.

One trend may not be a type of wine, but its origin. A winery CEO noted, “Regions outside of Napa in particular offer better bang for the buck; consumers will look to other regions.” Some executives said the hottest trend might well be other regions gaining ground at the expense of wines from Napa and Sonoma counties.

“Napa pre-eminence is coming to an end. More-than-$60 bottles (at $6,000 a ton) will be unsustainable, and we’re seeing a limit to the number of iconic wines being sold in the market. Grape prices can’t continue to rise.”

Another CEO thought a change in perception is more important than types of wine: “Millennials are more focused on experiences. Whether that is wine or a trip to Patagonia, they want their time to be valuable.”

Another noted that Amazon, which now owns Whole Foods markets, could be a game changer by bringing convenience and selectivity. “It could fundamentally change how we go to market.”

Are spirits a threat?
With the excitement about craft spirits, especially among younger drinkers, many wineries have been concerned that spirits could hurt their sales. Yet 55% of respondents were not aware of any impact on their business, and 21% saw an increase in on-premise wine sales due to the popularity of spirits, versus 16% that saw a loss. The impact in off-premise sales was even smaller, with 12% seeing a gain, 13% a loss.

However, that doesn’t mean there’s been no impact. One exec put it this way: “Our revenue increases might have been larger had it not been for the entertaining effect of the mixologist.”

In response to the perceived threat from spirits (or for other reasons), 13% of large wineries are developing spirits brands, and 3% are acquiring them. Even 10% of small wineries plan to develop a spirits band.

But maybe there’s more to be gained from emulating spirits than acquiring them. The CEO of a small winery said, “In the three-tier market, spirits companies do a better job at branding.” Another observed, “Spirits and soft drinks promote brands and utilize large, high-ticket, high-exposure promotions.” That seems to work for them.  

Yet the chief marketing officer of a large winery noted, “Wine is doing much better at DtC than spirits.”

Another executive stated, “The other potentially greater threat than spirits is baby boomers drinking less wine as they get older. Millennials are driving premiumization, and the wine sector should be planning to focus on that segment.”

The CEO of a small winery stated, “I think the resurgence in spirits is hurting beer more than wine. People still don’t want to drink spirits with food.” The survey didn’t specifically look at the impact of craft beer on the wine business this year.

What to do about threats?
Large and small wineries diverged considerably on how to respond to issues facing the wine business. 

Small wineries are overwhelmingly focusing on selling wine direct to consumers, which isn’t as big an issue for large wineries. However, large wineries are very focused on their relationships with distributors. They’re also more likely to add new products and acquire new vineyards.

A small number of wineries are adding grape varieties, a move likely intended to have more choices for wine clubs and tasting room visitors, which isn’t happening with bigger wine producers.

Issues identified by retailers
The retailers surveyed were critical of wine companies’ promotional efforts, and they also warned Napa and Sonoma wineries not to implement multiple price increases: “There’s much competition from Paso Robles, Monterey, Washington state and Bordeaux.”

They also said that wineries need to do a better job of marketing. “They focus on the distributor and don’t seem to focus on the consumer.”

Retailers asked wineries to do more in-store demos and tell their stories to the end consumer. They should also make sure their wine is stocked in local restaurants so consumers can taste it and then shop for it in the local grocery store.

One winery head said, “We’re putting disproportionate dollars into teams and marketing. Big quality is not enough.”

A bright future
As a whole, the industry is bullish about the future. Eighty-six percent of respondents forecasted increased profitability for 2018; 90% expected increases in 2019, and 87% were also bullish about 2020.

Their chief concerns include a proliferation of brands coupled with ever-consolidating distributor and retail channels and fickle consumers dabbling in other categories such as spirits. Private-label brands are contributing to disruption and a concern, respondents indicated.

Rising labor costs and decreased availability are big issues. The supply of skilled labor is particularly challenging, survey participants noted, especially in areas where other ag products like cannabis compete for workers.

The rising cost of grapes specifically bothers wineries. Respondents observed there’s a relatively static amount of grape acreage and a mismatch between supply cost and bottle price. There’s no price elasticity to recapture lost margin. The situation has become critical in some regions of the North Coast. Many wineries are facing margin compression, especially those heavily dependent on the three-tier system.

The leader of one medium-sized company said it was taking a number of steps to increase profitability: achieving efficiencies through volume growth or other utilization rates, raising prices and shifting the mix more toward direct-to-consumer sales. The company’s CEO didn’t see reducing costs for materials and labor as practical or desirable.

Another company about the same size disagreed: It expects to reduce the cost of materials and inputs, e.g., grapes, barrels, lower labor costs, perhaps through outsourcing or other efficiencies like mechanization.

The CEO of a medium-size company in Napa said, “The shortage of skilled labor will become a material problem. We’re investing and experimenting with mechanization; it is what we have to do.”

Strategies to drive profitability
Summing up the results of the survey and interviews, Ray Johnson of Sonoma State highlighted what wineries can do to maintain profitability:
• Increase marketing to the end consumer and make more connection, even if you sell through distribution. Create memorable experiences with the brand at the winery and beyond at stores and elsewhere. Leverage the power of customer relationship management.
• Create authentic product innovations and leverage them as consumers adopt the premiumization trend. Innovate with new products within existing brands or develop new brands at higher price points. 
• Invest in your business rather than harvesting profits to take advantage of this era of premiumization.
• Finally, Johnson reminded executives to focus on cost control and efficiencies and consider mechanization and stretching geographic sourcing while retaining brand essence. 

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