HOSTILITY IN A DIFFERENTIATED MARKET
by Donald V. Potter
The table wine industry has reached he point where there are too many producers chasing too few customers. Table wine producers are displaying the classic symptoms of the toughest stage in the evolution of an industry: "hostility." Some companies will emerge as large and profitable concerns; most will fail.
In the past, winemakers often considered their work a unique business, less a commercial enterprise than the practice of an art or the pursuit of a dream which also happens to generate income. Even this aesthetic business is undergoing the economic traumas which have been charted in more traditional industries. Windermere Associates, Inc. has studied the evolution of over 40 industries as they faced overcapacity, falling margins, and management turmoil. From the histories of these different industries, patterns of success and failure emerged. We identified these recurring and predictable phases of intense competition as the evolution of a "hostile" industry. Industry-wide competition is always hot, but in hostility, the competition intensifies and industry evolution accelerates. Many competitors end up moving directly from the frying pan into the fire. Hostility rarely ends in the short term. Surprisingly, even after demand rebounds, margins are likely to remain under pressure. For the table wine industry, several recent developments indicate that even now, hostility is turning up the heat.
What can that table wine business expect as it moves through the stages of hostility? This article examines some recent developments and their implications for the future of the table wine industry.
Weak Demand: 1992 marks the sixth year of declining per capita wine sales in the United States. Weak demand in a hostile environment means that
every supplier – even the best – will see reduction in its margins and returns as volume falls for everyone.
When customers cut back their demand for wine, they reduce purchases from
all of their suppliers. Some table wine producers may think the quality of their product or their customer base is better than industry average and may even, at the beginning of hostility, think themselves immune from the effects of falling demand. Unfortunately, most producers in a hostile marketplace, no matter how varied or how select their customer base, end up with excess capacity. A well-respected wine vintner in Sonoma, California recently sold his vineyard to a larger foreign corporation. The vintner lamented that, in spite of his reputation, "
I couldn't sell the requisite amount of wine. I don't think any of us had an inkling that the market would level off and competition would increase several-fold." Customers do eventually shift their purchases to take advantage of the better suppliers, but such shifts take time. In the meantime, even the best suppliers will usually have overcapacity.
Price Wars: In response to persistent excess capacity, some competitors have restored to discounting, which triggered the industry's price wars. Winemakers have increasingly relied on discounts, rebates and special promotions to sell wine to distributors. In hostility,
price competition is almost certain to last for several years, although it gradually loses its effectiveness.
In the early stages of hostility, price discounting can successfully move shares, especially when industry leaders do not match the discounts. Price wars, especially pronounced in the so-called "jug wine" segment, train the customer to focus their purchase criteria on the least attractive benefits a producer offers. Customers learns to choose products based simply on price, rather than on differentiating factors such as feature, quality, or ease of purchase.
For many, jug wine is now in the same category as pork and cement. It has come to be regarded as a "commodity." In a hostile market, one or even several products may become "commodities." Most believe that commodities are indistinguishable and that price determines the purchase decision. In fact, the opposite holds. Price becomes indistinguishable and service differences define the winning supplier.
Customer Shakeout: Consolidation is occurring in the distribution channels as well as among the producers of table wine. About 40% of wine wholesalers have closed or been bought since 1980. Consolidation tends to eliminate the weaker and often the smallest of the distributors, which will change the customer mix for many table wine producers.
Consolidation is likely to continue and accelerate.
When evaluated by traditional methods, large customers tend to be unprofitable in hostile environments because their volume commands the lowest prices in the industry. As early as 1982, E & J. Gallo was offering its distributors, among the largest in the industry, prices 20% off standard. Suppliers acquiesce to these low average prices because of the relative size of these customers: larger customers "base load" the business and have lower selling costs per unit. On the other hand, medium and small customers contribute to profitability because they pay a premium above the industry's average price. Large customers provide producers with economies of scale. On a per unit basis, they are also lower cost to serve than are the smaller customers. Small and medium customers will not replace lost large customer volume entirely. The reason for this is that the 80/20 rule applies to most markets. It tells us that 20% of the customers represent 80% of the industry's volume. The total volume represented by the small and medium customers does not represent as much volume as the few large customers in the market. Competitors serving a greater proportion of small and medium-sized customers could face higher costs as scale economies diminish. Nonetheless, this potential for higher cost may be offset be the tendency of small and medium customers to pay higher prices than the larger customers.
In hostile times, the key to earning the best returns in the industry is the ability to balance the better unit prices that come from medium and small customers with the lower unit cost of serving large customers . An optimal customer mix insures better than average profitability.
Marketing Niching: Competitors, trying to differentiate themselves, seek more profitable market niches – varietal or premium wine – as margins in the heart of the market fall. In a hostile market, the exclusive pursuit of
a niche strategy can be attractive but must be undertaken with great care and discipline by both large and small producers.
Adding price points in the upper end of the market may be a very smart thing to do. Choosing to make a stand in a niche without a foothold in the higher-volume segment of the market, however, is a much more risky strategy. Smaller, relatively less competitive niche markets are not safe from the effects of the hostile conditions at the heart of the market. Larger companies, buffeted by lower margins in the so-called "commodity" part of the market, often make successful forays into specialty niches. These companies substantially expand their price point coverage and put pressure on niche competitors who have no place to left to run. In table wine, there has been a veritable stampede into veritable stampede into varietal and premium wines by the larger jug wine producers. Sebastiani successfully refocused its product line from 70% generic wine in the late 1970's to only 15% by 1988. Seagram sold Taylor and Masson, but kept premiums brands, Monterey and Sterling. Christian Brothers uprooted its generic grapevines and replanted with varietals. Even Gallo joined the herd when it introduced an ultra-premium wine in 1990.
Since these larger companies bring superior economies of scale, any smaller company serving the smaller market will find itself vulnerable to attack on costs and pricing. Compound the effects of the rush of larger producers to these upscale markets has been a recent slowdown in demand for varietal and premium wines. "Fighting varietals" has become all too apt a metaphor as once quietly profitable niches have turned into bloody battlegrounds for competitors of all sizes.
Competitors who are dazzled by the relatively higher margins in specialty niches may decide to abandon the heart of the market altogether. These competitors may underestimate the value of an established position with high volume "commodity" customers. In 1990, jug wines accounted for nearly 60% of table wine consumed in the United States. Since niches are rarely more than a fraction of the size of the heart of the market – in table wine, varietal and premium wines together only account for about 20% of the total markets – they usually imply a small market share for the major player seeking them. The company which decides to pursue these niches exclusively must often be prepared to shrink in relative, if not absolute, size and then face the subsequent negative economies of scale. The company may find that a bird in the heart of the market was worth two in the niche.
Consolidation Through Acquisition: There have been numerous mergers and acquisition among wineries. In the first two years of 1990s alone, there have been 14 major purchases. Contrary to industry expectation, in a hostile marketplace, mergers and acquisition do not ease pressure on margins.
Successful acquisitions retain customers and lower costs, which increases the level of competition for everyone remaining in the industry.
Despite the number of reports to the contrary, acquisition, if performed with care, can be very fortunate events for the merged companies. Since its acquisition by a large multi-national corporation, one smaller California vineyard has been provided with the capital it needed to expand production by five times and it now has marketing clout to sell its increased production. An acquisition increases the likelihood of the merged companies' long-term survival by making them much bigger.
For an acquisition to work, the key is to insure that a large percentage of the customer volume that started out with the two separate companies remains with the merged company. Customer overlap and customer loyalty determines the likelihood that customer volume will remain after the merger. Overlap refers to the percentage of customers who previously bought the same product types from both companies. Wine distributors prefer to allot limited shelf space at each price point to a few different suppliers. Suppliers in hostile industries unfortunately teach their customers to carry more than one supplier at the same price point, no matter how limited the shelf space, to protect themselves from higher prices and product availability problems. Customers who have learned to have multiple suppliers as a matter of policy will commonly bring on another when two established suppliers merge. As a rule, the higher the overlap, the lower customer retention is likely to be.
Loyalty refers to the price sensitivity of the customer. Price sensitive customers will readily move from one supplier to another. An acquired company's major asset can be a solid base of customers who are not primarily price buyers. For instance, a major new player in the U.S. observed that a boutique California winery had been an attractive acquisition because the vineyard "had a small but tremendously loyal group of customers we thought we could build upon." Companies which specialize in serving price sensitive customers usually achieve below industry average results and often position themselves as candidates for takeover. In that case, the acquisition's customer base is highly volatile and may dissipate. A disloyal customer base may be why some vineyards have found it difficult to find a buyer. One consultant notes, "Many of the wineries don't provide any reasonable rates of return at their asking price."
Beyond the customer base, there is a secondary factor which determines whether or not an acquisition is a success. Can costs be reduced significantly in the newly merged firm? The reduction of cost is especially important in the overhead functions and is never easy. Without significant cuts in overhead costs, growth through acquisition may be successful in the very long term – say over ten years – but will look bad for several years before that.
The cost reduction and consolidation of customers that take place with an acquisition make the industry more, rather than less, intensely competitive. Companies with greater size achieve lower unit costs. These lower unit costs translate into lower prices and further margin squeeze. This will usually be true until there are only a few real players left in any market or region in the industry. The wine industry remains highly fragmented; in 1988, for instance, the top five competitors held only 58% of the market. Even after years, the table wine industry still has a long way to go before the process of consolidation is complete. Until then, acquisition will make life harder for the companies who remain in the industry.
What To Do?
The outlook for competitors in hostile markets may sound pretty grim. In fact, our work has found that companies can benefit from the successful management policies developed by managers in other industries who have confronted tough times and survived – they have led their companies to real prosperity. Hostility defeats many but rewards a few with tremendous opportunity to gain share and produce long term profit. Among successful management policies for hostility are the following:
Act as if hostility will never end. Devise strategies which account intense competition a given over the long term. Tough-minded, long-term thinking encourages competitive focus and cost controls that can only serve a company well, even when things do get better.
Emphasize your primary relationship with large companies. This is the commercial version of "make new friends, but keep the old." Large customers whom producers serve as the primary supplier provide the basis for good economies of scale. The primary suppliers to large customers also attract more profitable smaller customers because of the supplier's visibility in the marketplace. Successful suppliers welcome losing their emphasis on the larger customers.
Consolidate your overhead, not your customers. Mergers and acquisitions can enable companies to survive hostile competition, but only when they result in lower levels of overhead. The newly combined company must retain as many customers as possible, and it must grow volume so that the sum of the new company is greater than is parts. Increasing the customer base requires consistent marketing policies and a consistently high quality product, no matter who owns the brand.
Take advantage of your competitors' failure. Market share becomes available in a hostile industry primarily due to failure. Weaker competitors fail to serve their customers well, and these customers, once failed in a previously satisfactory relationship, look for a new supplier. Producers who have decided to stay in the market and grow in spite of hostility can find themselves with a flourishing base of loyal customers.
(Note: This Perspective was written in the context of the economy in 1992. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)
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Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis.