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________________________________________________________________________________________________________________ Professor Michael E. Porter and Research Associate Gregory C. Bond prepared this case. The case draws on research performed by Lucia Marshall and the report, “The California Wine Cluster,” prepared by Harvard MBA students Romy Alexander, Rick Arney, Neil Black, Elizabeth Frost, and Alex Shivananda, May 1997, for Professor Porter’s second-year strategy seminar. It also draws on HBS No. 596-031, “Robert Mondavi Corporation,” prepared by Thomas N. Urban under the supervision of Professor Ray A. Goldberg and the unpublished case “Viña Concha y Toro S.A.,” prepared by Arturo Condo in collaboration with Professor Porter. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 1999, 2000, 2002, 2004, 2006, 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

M I C H A E L E . P O R T E R

G R E G O R Y C . B O N D

The California Wine Cluster

Over the last thirty years, California had emerged from relative obscurity to a position as a significant player in the global wine industry, challenging the centuries-old dominance of France, Italy, and other established European countries. California was the primary producer of wine in the United States, accounting for over 80% of U.S. industry employment and 90% of U.S. production volume. According to wine experts, premium California wines had achieved a quality and consistency on par with or exceeding any in the world. The roughly 740 California-based wineries posted record revenues of $5.9 billion in 1997, an increase of 11% over 1996.1 The average pre-tax return on equity for the state’s premium wineries had risen from 4% in 1991 to 23% in 1997.2 However, the robust domestic demand that was driving this improved performance (plus the outbreak of a vine-destroying pest known as phylloxera) had led to a critical grape supply shortage in California. Also, California producers, who commanded less than 3% of world wine exports by value, were searching for ways to improve their international positions, while simultaneously facing increasing competition at home from emerging competitors such as Australia and Chile.

The California Economy

With a gross state (domestic) product of $1 trillion, California would have been the seventh largest economy in the world on a standalone basis. It was responsible for nearly 17% or $109.5 billion of U.S. exports. While best known for its leadership in aerospace, biotechnology, and computer hardware and software, the state had been the largest agricultural producer in the United States for more than 50 years. Agricultural production reached $26.8 billion in 1997, easily outdistancing the $15.9 billion of second place Texas. California exported some $7.0 billion of its agricultural production annually. California’s San Joaquin Valley, home to roughly 50% of the state’s agricultural workforce, was arguably the world’s premier crop growing area. In total, agriculture accounted for nearly 10% of California’s employment.

In addition to agriculture, food processing had developed as a major industry. California accounted for 11% of the total U.S. employment in food processing or approximately 180,000 people, the largest of any state. Some notable companies with headquarters or major operations in California included Dole, Campbell Soup, Frito-Lay, and the processing cooperative Sun Maid Raisins. California had also established a reputation for gourmet restaurants and gourmet food. Another

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major sector, tourism, generated an estimated $60 billion in annual sales and employed 670,000 people. California attracted more visitors each year than any other U.S. state.

The History of the California Wine Cluster

Spanish missionaries, who began cultivating grapes for use in sacramental wines in the mid-to-late 1700s, were California’s first vintners. As settlers streamed into the state in the 1830s and 1840s in pursuit of gold and inexpensive land, the first commercial vineyards were established. The explorer George Yount planted Napa Valley’s first vineyard in 1838. Spanish General Mariano Vallejo, who planted over 70,000 vines and hired a French vintner to oversee production, founded Sonoma’s first commercial vineyard at roughly the same time.

In 1860, phylloxera, an insect that fed on vine roots, began ravaging most of Europe’s vineyards. It was discovered that phylloxera had migrated from the Eastern United States by ship and that only native American grapes had rootstocks that were resistant to it. Desperate to revive their vineyards, Europeans began grafting their grape varietals onto American rootstocks. The phylloxera epidemic crossed the Rockies and reached California in the late 1870s, leading to the opening of the Viticulture and Enology Department at the University of California at Davis. Grafting helped mute the impact of phylloxera on the European varietals growing in California, allowing the state to surpass Ohio as the country’s leading wine producer by the 1880s.3 Although sold primarily in bulk, California wines by 1889 had reached a quality level sufficient enough that the French invited American wineries to compete in the World’s Fair.

Prohibition (a legal ban on alcoholic drinks), which lasted from 1920 to 1934, nearly wiped out the art of quality winemaking in the United States. Vintners survived by making grape juice and sacramental or medicinal wines. U.C. Davis shifted its research to fruit growing and renamed its viticulture department the “Department of Fruit Studies.” The Wine Institute, a trade association of 48 California wineries, was founded in 1934 in San Francisco to help re-invigorate the state’s wine industry, playing an active role in lobbying at the state and federal levels. As Prohibition came to an end, the Depression hit the U.S. economy. Winemaking did not regain steam until the Second World War when the U.S. was largely cut off from European sources. Demand for low quality sweet and fortified wines such as Thunderbird fueled California production throughout the 1940s and 1950s.

The onset of the 1960s sparked a renewed interest in wine as young people were eager to experiment and were attracted by wine’s “of the earth” image.4 Between 1968 and 1972, U.S. consumption of table wine nearly doubled. Most wineries, led by E&J Gallo in California’s Central Valley, produced inexpensive, generically blended “jug” wines that appealed to contemporary American tastes. The Robert Mondavi Winery, founded in 1966, was widely credited as America’s first “premium” commercial winery and had been the first new winery to appear in Napa Valley since the 1930s. Other high quality producers followed Mondavi’s lead.5

Science and technology played a vital role in bridging the quality gap between European and California winemakers. Traditionally, European vintners had relied heavily on feel and time-tested practices. California winemakers of the 1960s and 1970s began using quantitative analysis and new techniques to produce higher quality, more consistent wines. Innovations flowed rapidly among the state’s vintners, especially in Napa, where most of the major wineries were located side-by-side along State Highway 29 and its eastern parallel, the Silverado Trail. Though much of the innovation took place at the wineries themselves, U.C. Davis helped introduce several new technologies such as mechanical harvesting, drip irrigation, and field grafting. In 1976, California wines attained international prominence, winning a highly publicized Paris competition against some top European vintages.

The California Wine Cluster 799-124

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The 1970s saw the development of other industries in California that helped promote wine consumption. The founding of Alice Waters’ Chez Panisse in Berkeley in 1971 marked the beginning of “California Cuisine,” a movement based on organically grown foods. Tourism in the state’s wine country picked up as well with the appearance of hotels, bed-and-breakfasts, and high-end restaurants. Wine tours also began to play an important role in consumer education. The Wine Spectator, established in San Francisco in 1979, would become the country’s leading wine publication and one of the most important promoters of California wine. Its annual lists of the world’s best wines had a major influence on U.S. consumer tastes.

Rising consumer demand for wine in the 1970s and early 1980s attracted new competitors. Of Napa’s 140 wineries in 1986, 90% had been founded after Mondavi.6 Hoping to leverage their mass marketing capabilities, large corporations, including Coca-Cola, Pillsbury, Seagram’s, and Nestlé, also entered the industry mainly through acquisitions. (Most of these companies would exit the industry by the mid-1980s with little, if any, profit to show for their efforts.) The 1970s and 1980s also witnessed an increased production of higher quality wines that were vintage-dated and varietal-labeled. Imports followed this same trend, as the growth of lower priced varietal wines, known as “fighting varietals,” from countries such as Australia proved extremely popular among U.S. consumers.

After peaking in 1986, U.S. wine consumption declined 20% over the next five years. Increasing attention to exercise and health, coupled with rising concerns for public intoxication and drunk driving, led to a general downturn in alcoholic beverage consumption. Unlike spirits, however, U.S. wine consumption began to rebound in the early 1990s, spurred in part by the November 1991 “French Paradox” broadcast on the popular news television program 60 Minutes, which extolled the health benefits of red wine.7

By 1998, California growers and wineries could hardly keep up with the growing demand for premium wines. Grape supplies and wine inventories were strained, though the 1997 wine grape harvest, which had been the largest in the state’s history, promised some relief. Compounding supply problems was a new strain of phylloxera that had appeared in Northern California in the early 1990s forcing a massive replanting effort that was still underway.

U.S. Wine Consumption

Based on volume, the United States was the third largest wine market in the world behind France and Italy (see Exhibit 1). On a per capita basis, however, the United States had one of the lowest levels of wine consumption at around two gallons per year. (Californians consumed three gallons per year per person.) In comparison, U.S. consumers drank almost 56 gallons of soft drinks and nearly 23 gallons of beer per person each year. Retail sales of wine totaled $14 billion in 1997 compared with $70 billion for soft drinks, $55 billion for beer, and $34 billion for distilled spirits.8

According to the Wine Market Council, a California-based trade association, 11% of adults aged 21 to 59 drank wine on a weekly basis and accounted for 88% of total wine consumption in the United States. The 71% of adults who did not drink wine consisted of people who drank other alcoholic beverages (41%) and non-drinkers (30%). In 1997, 80% of wine by volume and nearly 60% by retail sales was purchased for home or “off-premise” consumption. The remainder was purchased through hotels, restaurants, bars, and other vendors for consumption “on-premise.”9

Wine was broadly classified into three types: (1) table, which had less than 14% alcohol by volume; (2) dessert or fortified, with greater than 14% alcohol; and (3) sparkling or champagne. California table wines were the most popular among U.S. consumers, accounting for 64% of consumption (see Exhibit 2). However, imports were enjoying a resurgence, as domestic wineries


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were unable to meet growing consumer demand. To help mitigate supply shortages, U.S. wineries had resorted to the importation of bulk wine, which they then bottled and distributed domestically.

Since 1992, volume consumption had grown 2% annually, while retail sales had risen 7% annually. Among California table wines, winery revenues from “premium” wines (i.e., wines that retailed above $3 per bottle) had grown 13% annually over the same period versus an annual increase of 3% for jug wines. Wines priced above $25 per bottle, so-called “luxury” wines, were the fastest growing segment in the premium category (see Exhibit 3). It was estimated that high-end premium California wine had historically been priced 30% to 50% below comparable French wines in the U.S. market. However, the price differential was beginning to narrow as prices for top U.S. wines increased.

Grape Production

California was the fifth largest wine grape grower in the world as of 1996 (see Exhibit 4). Including wine and traditional edible varietals, grapes were the state’s second largest farm product with a value of $2.8 billion in 1997. Approximately 4,000 growers produced wine grapes in 45 of the state’s 58 counties. The growers were represented by one of the most influential trade associations in the cluster, the California Association of Winegrape Growers (CAWG). Founded in 1974, CAWG included both wineries and independent growers that together accounted for half of the state’s wine grape production. The association played an active role in state and federal lobbying and sought to promote quality wine grape production through activities such as best-practice dissemination.

Due to replanting and new vineyard development, nearly 40% of the state’s 407,000 acres of vines had been planted after 1989 and 20% after 1994. Roughly 329,000 acres were mature enough to bear grapes. Variations in weather resulted in dramatic fluctuations in the quality and quantity of each year’s grape harvest. Following “short” harvests from 1994 through 1996, the 1997 harvest of nearly 2.9 million tons was the largest in California’s history and represented a 33% increase over 1996. Individual varietals, especially premium grapes, had much larger increases. Chardonnay, for example, the leading varietal harvested at 490,000 tons, had increased 59% from 1996. The statewide yield of 8.8 tons per acre was also the highest in at least a decade, beating the 7.6 tons per acre in 1993. The outlook for the upcoming harvest was uncertain, though most experts predicted it would be at least 15% below 1997’s.

Growing regions Most California wine grape growers were located in three broadly defined areas—North Coast, Central Valley, and Central Coast (see Figure A). The North Coast, which included Napa and Sonoma Counties, was perceived by most industry experts to have the state’s best combination of soil, climate, sunlight, topography, and water (collectively known as “terroir”) for wine grapes. The San Francisco Bay allowed cool ocean air to pass between the mountains of the Coastal Ranges, creating ideal growing temperatures. Further inland, the Central Valley, which included the San Joaquin Valley, was hotter and generally less ideal. The terroir of the cooler Central Coast fell somewhere between the other two regions. Its reputation had improved dramatically since the 1980s and was quickly approaching the quality of the North Coast in the eyes of some experts.

There was little space available for new vineyards in the North Coast, and very few commercial-sized plots of 100 acres or more were ever placed on the market. Average prices for undeveloped land ranged from $28,000 to $42,000 per acre in Napa (see Exhibit 5). One vineyard, located along Highway 29, had recently sold for $100,000 per acre. Most of Napa’s valley floor had been developed, and wineries and independent growers were beginning to plant on the valley’s hillsides. Sites that previously had been unplantable due to poor drainage and inadequate water supplies were being developed through monumental efforts. Rising demand for vineyards was also driving up


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land prices in the Central Coast and Central Valley, though both areas had undeveloped vineyard land available.

Figure A California’s Major Wine Grape Growing Regions

A

C

B

Napa County

Sonoma County

San Francisco

A. North CoastB. Central CoastC. Central Valley

Vineyard operations Vineyard layout and management had a large influence on grape quality and production cost. Vines took four to five years to reach full yield and at least ten years to produce the highest quality grapes. Vines could live longer than fifty years. As grape quality increased, vineyard yields generally fell. High quality growers were more selective and employed more aggressive pruning. Also, higher quality grapes were typically harvested by hand while lower quality grapes were extracted by mechanical methods. Gentler handling of the grapes, it was argued, produced better wines. Higher quality vineyards also employed more expensive irrigation and frost protection systems.

Historically, California growers had planted vines in rows 12 feet apart with 8 feet between vines in each row, resulting in 454 vines planted per acre. So-called “8 x 12” spacing, promoted by U.C. Davis in the 1930s, had maximized productive capacity by providing easier access for tractors and other farm equipment. Having to replant due to phylloxera and hoping to boost grape quality, many premium growers in the 1990s were moving to closer spacing. As the space between vines narrowed, budding grapes were forced to compete more intensely with one another, resulting in better grapes overall. A few California growers, mainly in the North Coast, had adopted the traditional 4 x 4 spacing (2,723 vines per acre) of top-quality French growers. Though yields increased, high-density plantings could drive operating costs up by as much as 50% to 60% in a vineyard due to increased costs for labor and materials.

Wages for vineyard employees, including contracted vineyard development personnel, totaled $1.2 billion annually in California. The number of production workers for all types of grapes averaged 36,500 in California in 1996, peaking in September at 60,600 during the height of the annual harvest. Many of these workers were migrant laborers who rotated throughout California, picking various crops during the year. Vineyard operators typically sought to rehire the same migrant workers every year in order to minimize training costs. The average grape worker earned $6.80 per hour, but wage rates varied by region and the type of grapes harvested. In the North Coast, for


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example, workers were typically more skilled and earned $8.40 per hour.10 A grape picker could harvest up to two tons of grapes per day by hand.

Wine Production

California accounted for over 90% of wine production in the United States followed by New York (5%) and Washington (1%). Its total output of 420 million gallons in 1997 placed California fourth in the world behind France, Italy, and Spain. The state’s wine production had steadily increased since 1994, while inventories had fallen to their lowest levels since the 1970s. According to the Wine Institute, there were some 740 wineries in California, roughly half of which sold fewer than 5,000 cases annually.† The state’s 10 largest wineries accounted for over 80% of production volume. (Though less reliable, available data suggested a similar concentration based on revenues.) E&J Gallo, located in the Central Coast, was the largest winery in the world, shipping almost 60 million cases of wine in 1997.

The traditional distinction between jug wine (e.g., Gallo) and premium producers (e.g., Mondavi) still existed, though jug wine producers were beginning to move aggressively into premium segments with brands they had developed or acquired.11 Attracted by growing consumer demand for California wine, several international wine producers and multinational beverage companies had started a new round of investment in California as well.

Since its founding in the 1930s, the Wine Institute had grown into a formidable association of 450 wineries. Its mission as a public policy advocacy group for California wineries had remained largely unchanged. Recently, the Institute had supported research into the health benefits of wine and was promoting efforts to position wine as the “time-honored drink of civilized life” in the minds of both consumers and regulators.12 Dissension among jug and premium producers had plagued the Institute. Mondavi and an estimated 50 small premium wineries had left the association in the 1990s claiming that jug producers dominated the Institute’s direction. Fees to the Institute were based on some metric of sales or production volume, and it was rumored that Gallo alone contributed 30% of the Institute’s annual budget.

Grape procurement Grapes represented 40% to 60% of total wine production cost. One ton of grapes yielded roughly 60 to 70 cases of finished wine, with case yields falling as wine quality increased. Though California wineries typically owned some vineyard acreage, the state’s independent growers produced roughly 85% of the state’s wine grapes in 1997.13 In general, a winery used its own vineyards to supply grapes for its highest quality wines.

Jug winemakers were often willing to accept year-to-year contracts with growers but would sign longer-term deals if the terms were attractive. Hoping to ensure consistent grape quality, premium producers generally sought long-term contracts lasting three to seven years. Spot market purchases could also be made to meet supply shortfalls. Grape prices were fairly transparent. At the time of purchase, prices, tonnage, and sugar content (a measure of quality) were reported by law to the state government. Keeping buyers and suppliers anonymous, the state published the results annually for each grape varietal by growing district in California. A separate report, based on voluntary submissions from growers, contained wine grape acreage by varietal and by growing district.

The tight supply for high quality grapes in the mid-1990s, compounded by the phylloxera outbreak, was forcing premium wine producers to establish alternative grape sources. California wineries were importing more grapes and bulk wine from overseas, and several producers had established joint ventures with international winemakers and growers. Total bulk wine imports had

† The industry standard case held twelve 750 ml bottles or 2.4 gallons of wine.


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increased from 600,000 gallons in 1995 to over 20 million gallons in 1997.14 Wineries were also looking to increase their vineyard ownership. Beringer Wine Estates, one of the leading premium producers in California, estimated that the average cost per ton of producing Chardonnay grapes in its Santa Barbara vineyards was $825 in 1996 compared to an average market price of $1,450 for comparable grapes.15

Crushing, fermentation, and aging Though red and white wine production involved slightly different steps that necessitated separate production lines, the winemaking process was similar for both types. After harvesting, all grapes were transferred immediately to the winery by truck for crushing. The pressed juice or “must” was pumped or gravity flowed into large temperature-controlled concrete, steel, or oak tanks for fermentation during which natural and/or added yeast metabolized the grapes’ sugar into ethanol and carbon dioxide. Fermentation typically lasted one to five weeks. The production of higher quality wines was typically less automated and in smaller volumes, and the winemaker adopted a more “artistic” role. Lower quality wines were made in larger volumes and were more “formula” based. High-end premium producers were careful to keep grapes from different growers in separate fermentation tanks for quality control purposes. Jug wine producers typically used large, common vats for grapes drawn from several growers.

Following fermentation, premium wines were transferred to tanks or American oak barrels for aging for 8 to 12 months. The highest quality wines were typically aged in small (60 gallon) French oak barrels for up to two years.16 During aging, a second distillation process called malolactic fermentation took place which softened the wine’s taste. The oak contributed “aromatic and flavor compounds that marr[ied] with the wine for added dimension and complexity.”17 After grapes, barrel aging was the biggest factor in determining the cost incurred and the quality of wine produced. Gross profit margins for jug wine were estimated to be 30%, while premium gross margins were generally higher at around 40% for the average popular premium wine and 50% for ultra premium wines (see Exhibits 6 and 7).

Oak barrels were used just once for the highest quality wines and up to a decade for popular premium wines. American oak barrels, sourced primarily from cooperages in Kentucky and Missouri, cost approximately $300 apiece. Top quality French barrels could run as high as $600 each. Mondavi, which produced 6.7 million cases of wine in 1997, spent roughly $5 million annually on new barrels and had over 100,000 American and French barrels in inventory.

Bottling and packaging The final steps in wine production involved filtering, bottling, and labeling (or bagging and then boxing in the case of some jug wines). Premium wines could also be “bottle-aged” for up to an additional year. Higher quality wines used heavier, more expensive bottles. Wine bottle costs were rising due to consolidation in the glass industry. Wine related glass revenues totaled over $1 billion annually for California-based glass suppliers. Owens Illinois and Ball-Foster Glass, two major glass companies with multiple operations in California, were the principal suppliers of wine bottles to the state’s wineries. Both companies were also major glass container suppliers to California’s other food processing industries.

Natural cork had been the stopper of choice for wine bottles since the seventeenth century for premium winemakers. Jug wines typically utilized cheaper metal or plastic screw tops. The benefits of cork were subtle, though some believed the minute amounts of air let in by cork enhanced the bottle aging process. Artificial corks had been developed, but premium winemakers still generally preferred natural ones. Portugal controlled almost 80% of world cork exports, followed by Spain (7%) and Italy (4%). Cork costs ranged from about $0.07 each for artificial corks to as high as $0.25 each for the highest-grade natural cork. Several dealers in California distributed cork. Sales of corks, capsules, and screw tops by California-based suppliers totaled roughly $175 million per year. Sales of labels accounted for another $100 million annually.


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Bottle shape and labeling had a significant influence on customers’ perception of quality. Bolder labeling and design were typically used for lower premium and jug wines in an attempt to differentiate them from the ever-increasing number of brands on store shelves. Higher-end wines were packaged conservatively in order to portray a refined image.

Labeling requirements Because a wine’s quality depended heavily on its source of grapes, harvest year, and varietal, domestic and foreign wineries were required to follow several federal guidelines when labeling wines for U.S. distribution. The Bureau of Alcohol, Tobacco, and Firearms (ATF), a federal regulatory body, dictated all labeling requirements in the United States. Geographic designations were made through an ATF-approved “Appellation of Origin” on the label. Appellations ranged in specificity from multiple states (e.g., Washington/Oregon) to a particular “viticultural area” (e.g., Napa Valley).18 For a wine to be designated “California,” 100% of the grapes used to make it must have been sourced from within the state. The threshold for other state appellations was 75%. California grape growers had successfully lobbied for the higher threshold. A viticultural area designation required that at least 85% of the grapes were sourced from that area.19 A vintage date could be applied to a wine if it had an appellation and at least 95% of the grapes used to make it were harvested in the same year. A varietal wine contained at least 75% of the grape designated on the bottle’s label. Most premium wines were varietal wines with narrow appellations and vintage dates, while jug wines were often blends of multiple varietals.

Distribution

The distribution of alcoholic beverages in the United States was tightly regulated. The twenty-first amendment to the U.S. Constitution, which repealed Prohibition in the 1930s, gave states the right to regulate the consumption, production, importation, distribution, and retail sale of all alcoholic beverages. Winery executives often commented that distributing wine in the United States was like “selling to fifty different countries.” In most states, alcoholic beverage producers were not allowed to ship products to either resellers or consumers in other states unless they had a physical presence (usually a distillery or winery) in that state.20 This had created a legally mandated “three-tier” system (i.e., producer to wholesaler to retailer) through which almost all alcohol was funneled.

Most states were considered “open” in that all wine and liquor distribution was performed by the private sector. Five states were “control” states in which the state functioned as the exclusive wholesaler and often retailer of table wine.21 Producers and wholesalers were prohibited from having direct ownership in retailers by the Federal Alcohol Administration Act, which also forbade other “tied-house” arrangements such as the supply of free equipment or advertising. In several states, wineries were subject to franchise regulations that restricted them from dropping a particular wholesaler and switching to another. In addition, the ATF assessed producers an excise or “sin” tax of $1.07 per gallon ($0.21 per 750 ml bottle) for table wine. State excise taxes varied substantially but could reach $0.45 per bottle for table wine. California’s table wine excise tax was $0.04 per bottle.

A typical retail dollar split for off-premise sales was 50%/16%/33% to the winery, wholesaler, and retailer, respectively. Restaurants and other “on-premise” distributors typically charged two to two-and-a-half times the price of a comparable wine sold through an off-premise retailer. Alcoholic beverage wholesalers enjoyed among the highest mark-ups and margins in the wholesaling industry. In contrast, liquor stores were among the least profitable retailers.

Wholesalers typically handled dozens to hundreds of individual wine brands, as well as distilled spirits, beer, and non-alcoholic beverages. Wholesalers generally had the right to sell a brand within a specific geographic area and typically employed a sales staff that serviced all classes of retail outlets.22 Wine and spirits companies with larger brand portfolios and large volumes, it was believed, held more leverage over distributors. Large wineries often established their own wholesaling


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companies in states where it was allowed. Gallo, for example, operated wholesaling companies in as many as twelve states including California.

With the development of the Internet, direct shipping had become a much-debated topic within the industry. Concerned that wineries would sell directly to underage drinkers and avoid paying excise taxes, states were becoming tougher on enforcing existing regulations. Twenty states prohibited all direct sales and a few like Georgia and Florida had made direct shipping a felony. (Convicted felons were prohibited from obtaining a federal license for making alcoholic beverages.) Another 18 states imposed strict regulations on direct shipments. Twelve states allowed direct shipments of small quantities of wine to states that provided reciprocal treatment. The wine industry had lobbied heavily for fewer restrictions, arguing that states’ rights to control alcohol distribution were in direct conflict with federal protection of interstate shipping.

Distribution channels were becoming more concentrated due to consolidation. For example, three, two, and one firm dominated wholesale distribution in California, Florida, and Texas, respectively. Both Mondavi and Beringer relied on one distributor, Southern Wine & Spirits (SWS), for 30% of their sales. It was estimated that SWS had revenues of $2.5 billion with its California subsidiary alone accounting for over $1 billion. On the retail side, supermarkets were also consolidating, creating fewer but larger chains. Club stores (e.g., Wal-Mart’s Sam’s Clubs) were dominated by just a few players. Also, large restaurant and hotel chains were increasingly buying wine centrally.23

California wines accounted for 90% of the total value of U.S. wine exports. Roughly 8% of California wine production volume was shipped overseas, nearly all of which passed through the Port of Oakland, just east of San Francisco. Most wineries employed a relatively small international sales force, relying heavily on national and regional importers for brand development and marketing. A few wineries had established distribution companies abroad. Though the value of U.S. exports had grown 25% annually from 1985 to 1997, U.S. wines had tiny market shares in many of the largest wine markets in the world, especially in major wine producing countries such as France and Italy (see Exhibit 8).

California wineries typically faced higher tariffs and retail sales taxes abroad than foreign rivals did selling into the United States. Tariff rates ran roughly $0.75, $0.15, and $0.05 per bottle in Japan, the European Union, and the United States, respectively. Excise taxes ranged from negligible amounts in France and Italy to $1.85 per bottle in the United Kingdom. Sales tax or VAT rates were also typically higher, ranging for example in the European Union from 5% to 25%.

The U.S. Congress had recently revamped export promotion assistance for U.S. wineries, shifting more dollars toward collective marketing programs operated by the Wine Institute and away from individual wineries. Total export assistance was budgeted for $4.5 million annually with almost 75% going to the Wine Institute. The remaining 25% was allocated to small and medium-sized wineries (less than 500 employees) who also spent matching funds of their own. Expenditures on export promotions typically involved trade shows and advertising in target markets.24

Sales and Marketing

Sales and marketing costs varied widely. Established boutique wineries could sell an entire vintage simply by word-of-mouth. Large jug and popular premium wineries faced more competition on store shelves, necessitating much higher expenditures on advertising and promotions.

Large volume wine producers, whose sales forces could number in the hundreds, relied heavily on mass marketing, utilizing both print and broadcast media extensively and making little use of


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wine tours and tastings. Total ad spending reached an apex in the 1980s due largely to the promotion of wine coolers such as Gallo’s Bartles & Jaymes brand. The decade also saw several jug producers, particularly Gallo, attempting to reposition themselves as more sophisticated winemakers. One of the most famous campaigns was created for a leading jug wine brand, Paul Masson, which featured actor Orson Welles declaring that Paul Masson would “sell no wine before its time.” Falling consumption led to a downturn in overall spending in the late 1980s and early 1990s. In the late 1990s, expenditures on advertising were beginning to rebound. The launch of new premium brands by traditional jug wine producers was responsible for much of the increase. Gallo, the traditional industry spending leader, accounted for more than a quarter of the industry’s $101 million in total advertising expenditures in 1997.25 Wineries used San Francisco-based advertising firms extensively.

Until the late 1990s, the premium wine industry had focused its marketing efforts primarily at the distributor level. Sales forces provided wholesalers and retailers with a variety of promotional programs. Distributors took an active role in building wine brands. They were typically more responsive to the launch of an entirely new brand than to a new varietal or other brand extension. In on-premise settings, wine-by-the-glass and winery-sponsored dinners were often important marketing tools. Direct marketing was typically limited to wine tours, tastings, and print ads in high-end wine magazines such as the Wine Spectator. Eight million visitors came to California’s wine country each year, spending roughly $300 million in restaurants, hotels, and other retail establishments.

Advertising and marketing directly to consumers had become paramount for both premium and large volume wineries in the late 1990s. The Wine Market Council, headquartered near San Francisco, was formed in 1995 to bring together players from various parts of the cluster including grape growers, wineries, wholesalers, retailers, and restaurants as part of a cooperative marketing effort. The Council had 250 members though some notable companies such as Gallo had chosen not to join. The Council planned to launch a generic ad campaign beginning in 1999 that would promote wine as a general consumption beverage. Premium wineries had also ramped up advertising activities including both television and radio spots.

Technology Development

Several viticulturists and winemakers in California had graduated from The Department of Viticulture and Enology at the state-run U.C. Davis, one of the world’s leading wine research institutions. It offered formal research programs and specialized courses of study related to wine production techniques with considerable input from the scientific disciplines of chemistry, biology, and genetics. Three other state-run universities, U.C. Berkeley, U.C. Riverside, and Fresno State, also offered highly regarded programs. Wineries had extensive apprenticeship programs of their own that trained new winemakers in all aspects of the winemaking process.

Many academic researchers in California were concerned that private and public funding of university-based R&D, which totaled less than $4.0 million annually, had become inadequate. The budget for U.C. Davis’ programs fell 18% between 1990 and 1995. Straining industry/university relations further, U.C. Davis had come under fire for its recommendation of AXR-1 rootstock which proved susceptible to phylloxera, necessitating the massive replanting effort in the 1990s. Larger wineries had established in-house research staffs of their own with state-of-the-art laboratories.

The American Society for Enology and Viticulture (ASEV), founded in 1950 by University of California researchers and winemakers and headquartered at U.C. Davis, was the principal R&D association for the wine industry in the United States. ASEV founded The American Vineyard Foundation (AVF) in 1978 as a conduit for industry funding of academic research. Davis, Berkeley, Riverside, and Fresno were the primary beneficiaries of AVF funding. In 1996, private R&D funding


11

reached $1.2 million or approximately 0.3 cents per gallon of wine produced in California. Private funding in other states was much higher on a per gallon basis: New York (0.7 cents); Washington (1 cent); and Oregon (11 cents). California had eliminated mandatory contributions by growers and wineries to university-research in the 1980s. In the 1990s, all funding was completely voluntary.26

Financing

Most California vineyards and winemakers financed their ongoing operations through bank loans, many of which were made by banks located in San Francisco or in wine producing areas. A number of financial institutions, such as Bank of America, had developed specialized financing offerings for grape growers and wine producers, including long-term loans tied to the time required to establish a harvestable vineyard or to age a wine stock. For such loans, the real estate or wine often served as collateral. Wineries were also beginning to access capital through the public markets. Mondavi (1993), Beringer (1997), and Golden State Vintners (1998), a premium bulk wine and grape supplier, had all gone public in the 1990s.

On average, it took a new winery at least five years to reach profitability. For example, a relatively small 30,000 annual case winery targeting $14 per bottle at retail required a total investment of approximately $8 million over a ten-year period to reach full sales levels.27 The costs, assuming all grapes were purchased from independent growers, included $3.5 million for the land and processing facility, $3.5 million in inventory, and the funding of nearly $1.0 million in operating losses. Adding vineyards could increase the total investment by $5 to $8 million. In the tenth year, when the winery reached 30,000 case sales, net income margins were estimated to be just over 8%.

Competition

In the late 1990s, France and Italy still led the world wine market in terms of production, consumption, and exports. Over the past decade, “new world” wine producers including California, Australia, and Chile had made great strides in developing their wine clusters but together accounted for less than 10% of world exports. Like California, Australia and Chile benefited from a topography and climate that offered ideal grape growing conditions. Some experts believed that the terroirs of the new world countries were superior to or at least more reliable than those of the old world producers. Other regions, particularly in Latin America, Eastern Europe, and China, were also expected to become more significant producers in the world wine industry. These regions had always possessed the necessary terroir for wine grape growing but had not developed competitive wine clusters.

France France’s per capita consumption, which was the highest in the world at over 16 gallons of wine in 1996, had fallen 2.5% annually since 1980. However, wine, as in most European countries, remained a commonly consumed beverage. About 30% of French consumers drank wine on a regular basis, while 39% were occasional wine drinkers, mainly during meals with friends or in restaurants.28 The French were increasingly quality conscious and spent greater sums per bottle than many other nations. Imports, which accounted for roughly 15% of consumption, consisted primarily of bulk table wines that were typically blended with domestic wines. Imports of wines from developing countries or “third” nations were expected to increase over the next few years in France and the European Union due to the reduction of the EU’s minimum or “reference” price levels for imported wine.

France was the world’s second largest wine grape grower and largest wine producer in 1996. Approximately 75,000 growers and almost 60% of France’s 2.2 million wine grape acres were devoted to the production of grapes for “quality” or VQPRD (Vins de Qualité Produits dans les Regions Déterminées) wines.29 Over 105,000 growers produced grapes for French “table” wines, which were


12

roughly equivalent to jug or popular premium wines in the United States. Many growers produced grapes for both types of wines (and other crops as well) so that the total number of growers was somewhat less than 180,000. It was estimated that some 58,000 growers produced wine grapes exclusively and controlled 90% of the VQPRD acreage and 70% of the table acreage. In Bordeaux, the largest producer of VQPRD wines in France and one of the country’s most renowned wine regions, there were nearly 14,000 growers alone farming an area roughly 70% of California’s total wine grape acreage.

Wine production was one of the largest agriculture products in France and represented 14% of the country’s final agricultural output in 1996, trailing just behind its production of grain. Top French wines were considered among the best in the world, and the different regions of France prided themselves on their unique grape varietals and wine types. Most French wines, including those of the highest quality, were typically blends of multiple varietals. Appellation designations such as Burgundy or Bordeaux predominated, though varietal labeling was becoming more common.

Historically, most French wineries and grower cooperatives were too small to bottle and store their own wines. Rauzan, for example, a cooperative of 300 growers controlling 5,250 acres, was the largest producer of VQPRD wine in France. Of its four million gallon annual production, roughly 70% was sold in bulk.30 “Negociants” played an intermediate role, purchasing bulk wines in the open market and then handling blending, bottling, and marketing. Though wineries were becoming more integrated in the late 1990s, negociants remained the largest players in the French wine cluster accounting for 56 of the 58 wine companies in France with revenues exceeding $25 million.31

As in California, prices and production costs varied by region and by wine quality. The average winery revenue for VQPRD still wines equaled $3.10 per bottle in 1997 for whites and $3.40 for reds. Table wines averaged roughly $1.05 per bottle for both wine types. Bulk wine prices ran 40% to 50% below bottled wines. Modest Chateaux in Bordeaux fetched about $4 per bottle in the late 1990s, while top French wines could demand an average of $20 to $30 per bottle. Labor costs in France were generally thought to exceed California’s. In Languedoc-Roussillon, a region known primarily for table wines, land prices ran $4,000 to $8,000 per acre for undeveloped land and $10,000 to $20,000 per acre for a producing vineyard. Development costs could total $9,000 per acre. In Bordeaux, prices reaching $150,000 to $200,000 per acre were common for top quality vineyards. AXA, a large French insurance company, had recently invested $200 million in seven Bordeaux properties, expecting a long-term return on equity of 15%, a number consistent with the results obtained by other investors in the region.32

France was the world’s largest wine exporter commanding 40% of world exports in value terms. It also had the highest unit prices due to a high perceived quality and large proportion of sparkling wine shipments. Other members of the EU were the largest markets for French wines with Germany and the U.K. accounting for 22% and 20% of total exports, respectively, in 1997. The United States was France’s fifth largest market with a 9% share. EU table wine producers benefited from export refunds which compensated them for differences between domestic prices, for which the EU had established minimum levels, and international wine prices. Total export refunds in the EU reached $60.5 million in 1997 with roughly $6.5 million allocated to France. French expenditures on export promotion totaled $24 million in 1997.

France had long-established apprenticeship programs at individual vineyards and winemaking establishments. The French had an aversion to what they viewed as the “mechanistic” and overly scientific methods of Californian production, seeing the discipline much more as an art handed down over the generations. Despite this, the French had a well-established research network and base of trained scientists. The National Institute of Agronomic Research was known for its work in both viticulture and enology.


13

As in most European countries, France suffered from chronic over production. The EU, under the Common Agricultural Policy for wine, had taken several steps to reduce wine output in its member states through an array of subsidies reaching nearly $1.0 billion in 1997. Subsidies in France alone exceeded $85 million. New vineyard planting of table wine grapes was prohibited and re-planting of existing vineyards was allowed only every eight years. Most EU support went to subsidized “grubbing-up” of lower quality vineyards, having permanently removed over 1.2 million acres from production by the middle of 1998. As a result, the overall acreage in France and other European countries was declining though the areas devoted to VQPRD wines were increasing. In addition, mandatory and voluntary distillation, which transformed wine into alcohol for human consumption or fuel, removed wine from the open market. In France, over 20% of wine production went to distillation or further processing. Other support and output reduction devices included mandatory storage of wine for up to nine months in anticipation of distillation and aid for the conversion of grape must into grape juice for human and animal consumption. Some experts believed that the EU’s tight control over yields and wine production prevented or at least reduced the incentives to experiment with new varietals and wine types.

The French government took an active role in the wine industry, which was viewed as a “national treasure.” The government played a major role in regulating quality standards and safeguarding the French tradition of appellations or quality grades, which were attributed to different geographic areas. These assignments were based on history and largely had not changed in over 200 years. The government was extremely protective of French labeling and nomenclature, supporting aggressive legal action to enforce protection of the use of, for example, the name “Champagne” (only to be used for a specifically defined production process). Strict (some felt overly strict) French government regulation covered zoning and uses of vineyard land.

Italy At 15 gallons per person in 1996, per capita consumption in Italy was second in the world behind France. Italians typically consumed lower quality, less expensive wines. As in France, overall consumption was declining. Imports had very little impact in the Italian market, accounting for less than 1% of consumption. Wine represented 9.8% of Italy’s final agricultural output in 1996. Between 1990 and 1995, Italian wine production exceeded that of the French in volume terms but generated less than half the value. Grape vines for VQPRD wines accounted for less than 30% of the vineyards in Italy. There were over 700,000 grape growers for table wine, of which one-quarter grew wine grapes exclusively, and 134,000 VQPRD growers. Overall, the quality of Italian wines was increasing.

The cluster boasted the world’s oldest and largest national organization of winemakers to which 90% of Italy’s 3,500 winemakers belonged. The Italian wine industry was becoming increasingly polarized between those winemakers adhering to a traditional focus on local markets and those targeting the global arena. The latter group was growing as wine makers such as Antinori of Tuscany brought in experts, including consultants from California, to modernize their facilities and processes to better address the needs of international markets. Germany, France, the United States, and Switzerland were the major destinations for Italian exports. Almost all exports to France were bulk wines while exports to the United States consisted primarily of bottled wines. As in France, the Italian government maintained strict laws governing labeling to ensure origin, quality, and vintage. The government also provided export promotion assistance of about $6 million per year.

Australia Australia’s per capita wine consumption of 4.8 gallons in 1996 placed it among the top 20 countries in the world. Australia was one of the few wine producing countries in which per capita consumption was rising. As in the United States, domestic table wines (here, using the U.S. rather than EU definition) dominated, accounting for 78% of consumption in 1997. Imports represented roughly 4% of volume sales.


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The first wine grape vines were introduced to Australia in the late 1700s, but it was not until the mid-1800s that significant wine production took place. Through the mid-1960s, few premium grape varietals were grown, and the country produced primarily bulk wines. As Europeans began to migrate into the country and the general prosperity of Australians improved, wine consumption and production began to climb. As in the United States, demand for lower quality wines fueled domestic production. Per capita consumption doubled from just over one gallon in the early 1960s to over two gallons in the early 1970s. By 1969, table wine production exceeded the volume of fortified wines.33 Wine production continued to expand rapidly in the ensuing years, breaking the 100 million gallon mark in 1977, up from 50 million a decade before. Consumption had surpassed four gallons per capita by 1979. Australian winemakers and policymakers credited much of the wine industry’s success to heavy investment in and reliance on innovations in viticulture and winemaking technology. Scarce water resources stimulated much of this activity.

By the 1990s, Australia had established itself as a cost-competitive producer of high-quality wines, with 3,000 growers and 1,000 wineries. Its vineyards were believed by some to be near the forefront of technological development in the world with yields at or above those in California. The country had a well-respected research network, and Australian winemakers and technicians worked in most wine-producing countries around the world. Premium varietals accounted for 60% of the tons harvested each year. The state of South Australia grew nearly half of the country’s grapes and produced over half of its wine. While most wineries were small, the nation’s four largest companies accounted for 60% of production volume. Twelve wine producing companies were publicly traded on the Australian stock exchange.

Relative to California, Australia had higher labor costs. However, land prices were generally lower. Costs ranged from about $3,000 per acre for undeveloped vineyard areas to $7,500 per acre for land with vines. It was estimated that development costs ran roughly $10,000 per acre with ongoing operating expenses at about $2,500 per acre per year.34

Australia’s growth in the world export market had been nothing short of remarkable (see Exhibit 9). The country’s exports in value terms had grown 36% annually from 1985 to 1997. Australia’s export value per gallon over much of the same period had exceeded both the U.S. and Chile (see Exhibit 10). The United Kingdom (45%), United States (22%), and New Zealand (6%) accounted for almost 75% of Australia’s export value. Though it did not provide export subsidies, the Australian government had historically provided funds for export promotion totaling $4 million per year typically spent on wine tastings in target markets. With government funding scheduled to end, the wine industry supported the creation of an export levy totaling 0.25% on the first $7 million of export sales, 0.15% on the next $30 million, and 0.05% thereafter to maintain funding. Australia had also established Wine Bureaus in several countries including the United Kingdom, the United States, and Germany to coordinate promotional activities.

The Australians, under the auspices of the privately funded Australian Wine Foundation, had developed a 30-year strategic plan called Strategy 2025. By 2025, the industry wanted to “achieve [USD $3.5] billion in annual sales by being the world’s most influential and profitable supplier of branded wines, pioneering wine as a universal first choice lifestyle beverage.” The plan assumed that Australia could grow its export revenues to $1.5 billion by 2025, increase domestic sales by $660 million, and expand tourism from under $300 million to over $800 million in sales. Some $3.9 billion in investment would be required, with independent growers, corporate retained earnings, and equity and debt borrowing, accounting for $630 million, $1.1 billion, and $2.2 billion of the investment, respectively. The plan was divided into three segments: Volume Growth (1996-2002); Value Growth (2002-2015); and Pre-eminence (2015-2025). By 1998, the Volume Growth plan was well ahead of schedule, having planted almost 65,000 of the 100,000 new wine grape acres called for by the plan.


15

Research and development expenditures by Australian wineries were matched dollar for dollar by the federal government up to 0.5% of the gross value of their wine production. Additional public funding of research and development was channeled through a variety of organizations in Australia. The Grape and Wine Research and Development Corporation, a statutory authority established in 1991, funded almost $2 million of R&D projects annually. The Corporation’s budget was split evenly between government and industry levies. The Australian government also funded the Cooperative Research Center for Viticulture with about $1.5 million annually.

Chile Chile, one of the most dynamic economies in Latin America, had domestic wine consumption of 4.2 gallons per capita, slightly less than Australia’s. Chilean consumers historically preferred inexpensive, highly acidic wines typically packaged in tetrapacks or boxes. Though tariffs were low, imports accounted for less than 1% of consumption.

Chile had a long history in winemaking dating back to the 1500s when Spanish conquistadors planted mission grapes to make bulk wines. It was not until the mid-1800s, however, that French varietals were first planted. The country had three growing regions, The Aconcagua, the Central Valley, and the Southern region, all naturally protected by the Pacific Ocean, Patagonia ice fields, and Andes Mountains. When phylloxera struck France and California in the late 1800s, Chilean grape vines proved immune and were the only French varietals still grown on their original rootstocks in the 1990s.

The deregulation of the wine industry under the Pinochet government in 1974 sparked rapid growth and upgrading. Led by the Spanish entrepreneur Miguel Torres, wineries began to shift to higher quality wine production using imported technologies and experts from the United States and Europe. Replanting of lower quality vineyards with premium varietals was initiated. By the late 1980s, Chile began to make significant exports to world markets. In the late 1990s, Chile’s winemaking industry was led by three players, accounting for 80% of industry production. In 1994, Chile’s largest winery Viña Concha y Toro became the first winery in the world to list on the New York Stock Exchange. Boutique wineries had also begun to emerge. Generally small in size, these firms focused on exports and high-income niches within the domestic market. They had exports of about $15 million in 1995.

Roughly half of Chile’s total production went to domestic markets and consisted primarily of wines made using lesser quality, high yield grapes. Mission grapes were still the most common varietal harvested in Chile. Domestic wines were usually packaged in tetrapacks and boxes. Wines geared for exports were not widely available in Chile, except at top restaurants and hotels.35 Only recently had premium wine retailers, called Wine Houses, begun to appear in the country.

Exports had grown 36% annually from 1985 to 1997, while the number of wineries exporting from Chile had increased from 14 in 1990 to almost 100 in 1996. Chile exported both bulk and bottled wines to more than 100 countries. The U.S. and U.K. were Chile’s biggest markets for bottled wine, while Canada was the biggest importer of Chile’s bulk wines. In 1997, the U.S. accounted for roughly 44% of total Chilean exports with Europe (34%), Latin America (16%), and Asia (4%) representing the remainder.

Attracted by lower land and labor costs, French, Spanish, U.S., and Australian companies were establishing production facilities in Chile either through direct ownership or through joint venture agreements with Chilean wineries. Good vineyard land could cost $3,000 to $7,000 per acre and laborers earned $10 to $15 per day. Industry sources estimated the production cost of premium varietals at roughly $550 per ton in the Chilean Central Valley. Though costs were much lower, international wineries were hampered by the country’s poor infrastructure, especially in the wine


16

producing regions. Poor electricity, roads, and a limited supply of high quality labor had been among the chief complaints.

Chile’s wine cluster was supported by two export-oriented trade associations, the Association of Finest Export Wine Producers (Chilevid) and the Wine Bottlers and Exporters Association, that collected wine-related trade data and lobbied government officials on behalf of the cluster. Also, the government’s export promotion office was taking a more activist role in supporting the cluster. In 1995, the Chilean government established viticultural zones and stepped up regulation of wine labeling.

799-124 -17-

Exhibit 1 World Wine Market Consumption by Major Country, 1996

Total Per Capita 1996 Importsa 1996 Off-Premise Consumptionb

Country

1996 Gallons

(mil)

CAGR 1991-96

1996

Gallons

CAGR 1991-96

Gallons

(mil)

% of Country(volume)

% of World

(volume)

Import Value ($ mil)

% of World (value)

Value per

Gallon

% of Country(volume)

Retail Sales ($ bil)

Sales per 750 ml

France 940.7 (0.7%) 16.12 (1.2%) 139.7 14.9% 10.1% $520.0 4.6% $3.72 71.9 $14.07 $3.69

Italy 866.5 (1.4) 15.14 (1.5) 7.9 0.9 0.6 155.0 1.4 19.72 85.9 5.38 1.35

U.S. 541.8 3.4 2.01 2.4 93.9 17.3 6.8 1,554.5 13.6 16.56 78.3 10.54 6.22

Germany 500.2 (0.1) 6.10 (0.6) 296.8 59.3 21.4 1,848.7 16.2 6.23 79.5 5.62 3.01 Spain 404.2 (1.9) 10.19 (2.0) 31.7 7.8 2.3 80.2 0.7 2.53 43.4 0.86 1.26

Argentina 358.2 (5.3) 10.17 (6.5) 1.3 0.4 0.1 12.6 0.1 9.35 85.0 1.73 1.14 South Africa 221.0 (2.6) 5.21 (4.7) 4.4 2.0 0.3 9.5 0.1 2.17 66.1 0.45 0.31 U.K. 187.9 1.7 3.22 1.5 195.5 104.1 14.1 2,077.2 18.2 10.62 80.0 7.41 8.68

Portugal 155.0 0.8 15.80 0.9 15.4 9.9 1.1 51.0 0.4 3.31 90.0 0.73 2.19 Romania 142.6 1.3 6.29 1.8 1.5 1.1 0.1 1.8 0.0 1.21 NA NA NA Russia 117.4 NA 0.79 NA 66.1 56.3 4.8 386.8 3.4 5.85 83.0 2.58 2.08

China 111.0 6.9 0.09 5.5 2.8 2.5 0.2 44.7 0.4 16.12 NA NA NA Australiac 87.3 1.6 4.83 0.5 3.8 4.3 0.3 49.2 0.4 13.06 42.9 1.31 2.98 Switzerland 79.4 (0.3) 10.99 (1.3) 49.0 61.7 3.5 603.6 5.3 12.32 62.8 0.94 3.53

Austria 70.3 0.2 8.67 (0.6) 8.5 12.0 0.6 73.4 0.6 8.68 74.2 1.93 6.03 Hungary 68.7 (2.8) 6.83 (2.3) 1.4 2.0 0.1 3.2 0.0 2.31 NA NA NA Belgium-Lux. 61.5 0.3 5.81 (0.1) 64.4 104.8 4.6 680.2 6.0 10.56 56.5 1.09 3.89

Chile 60.5 (1.4) 4.20 (3.0) 0.2 0.3 0.0 1.0 0.0 6.35 54.7 0.45 1.02 Brazil 59.4 (7.6) 0.37 (8.8) 6.2 10.4 0.4 43.1 0.4 6.97 NA NA NA Netherlands 53.7 (2.8) 3.45 (3.4) 57.4 106.7 4.1 561.2 4.9 9.78 NA NA NA

Canada 53.7 2.2 1.81 1.1 45.8 85.3 3.3 385.0 3.4 8.41 75.9 1.45 4.18 Japan 53.0 8.5 0.42 8.2 29.0 54.7 2.1 514.1 4.5 17.74 38.3 0.56 6.00 Other 691.2 (3.8) — — 267.3 38.7 19.2 1,747.6 15.3 6.54 NA 20.55 2.93

World 5,885.2 (0.6%) — — 1,389.7 23.6 100.0% $11,403.8 100.0% $8.21 NA $77.65 $2.91

Sources: Food and Agricultural Organization (FAO) of the United Nations and Euromonitor (for off-premise consumption data).

aImports in some cases exceed total consumption due primarily to allocation to wine stocks. Import values are c.i.f., except for Australia, Canada, South Africa, and Russia which are f.o.b.

bExcludes hotel, restaurant, and caterer consumption. Excludes non-grape wine, vermouth, and wine coolers.

cData for years ending June 30 except for off-premise consumption data.


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Exhibit 2 Wine Consumption in the United States (millions of gallons)a

1996 1997 1997

% of Total % Change

1996-97 By Type Table

California 339 336 64% (1%) Other table 104 126 24 21

Dessert & fortified 32 31 6 (2) Sparkling 30 30 6 1

Total 505 523 100% 4%

By Origin California 375 372 71% (1%) Other states 43 40 8 (7)

Foreign wine imported in bottles Italy 34 36 7% 7% France 21 27 5 25 Chile 10 12 2 18 Australia 5 7 1 37 Other countries 16 17 3 5

Subtotal 86 98 19% 14%

Foreign bulk wine bottled in U.S. 1 13 2 ++

Total 505 523 100% 4%

Source: Adapted from Gomberg, Fredrikson & Associates, “1997 Annual Wine Industry Review,” The Gomberg-Fredrikson Report (February 28, 1998): 17-12.

aIncludes bottled wine consumption only.

Exhibit 3 Domestic California Table Wine Revenues by Price Category, 1985-1997 (in billions)a

Source: Adapted from data from the Robert Mondavi Corporation and Gomberg, Fredrikson & Associates.

aRevenue to California wineries; excludes wholesale and retail mark-ups.

1992-97 CAGR

Luxury (>$25 per bottle) 29% Ultra premium ($14-$25) 11%

Popular premium ($3-$7) 9%

Jug (<$3) 3%

Total premium segment

13%

Super premium ($7-$14) 17%

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Exhibit 4 World Wine Grape and Wine Production by Major Country, 1996 (ranked by wine production)

1996

Wine Grape Production Wine Production Estimated

Destination of Production (%)a Exports

Country Acreage (000s)b

Tons (000s) Yield

Gallons(mil)

% of World

CAGR 1991-96 Domestic Export Processing

Value ($ mil)

% of World

Value per Gallon

France 2,152 8,350 3.9 1,575.8 22.1% 6.9% 57.9% 21.9% 20.1% 4,854 41.1% $14.04 Italy 2,034 8,740 4.3 1,552.6 21.7 (0.3) 58.2 24.8 17.0 2,288 19.4 5.94 Spain 3,025c 5,342c 1.8c 789.1 11.0 (1.0) 52.2 24.1 23.7 1,141 9.7 6.00 U.S. 311d 2,172d 7.0d 498.7 7.0 1.9 91.3 8.7 — 308 2.6 7.06 Argentina 487 2,198 4.5 335.0 4.7 (2.6) 90.1 9.9 — 68 0.6 2.05 Portugal 604 1,400 2.3 251.7 3.5 (0.6) 74.3 20.5 5.2 538 4.6 10.45 South Africa 219 1,266 5.8 248.3 3.5 (0.6) 87.2 12.8 — 187 1.6 5.89 Germany 253 1,429 5.6 228.3 3.2 (4.2) 69.6 30.4 0.0 503 4.3 7.26 Australiae 160f 1,198f 7.5f 177.9 2.5 11.3 55.3 34.8 9.9 430 3.6 6.95 Romania 568 1,403 2.5 153.2 2.1 3.0 91.6 8.4 — 34 0.3 2.68 Hungary 229 NA NA 110.6 1.5 (1.9) 74.3 25.7 — 96 0.8 3.36 China NA NA NA 109.0 1.5 6.6 99.2 0.8 — 6 0.0 6.92 Greece 171 570 3.3 108.5 1.5 0.6 37.1 11.8 51.1 71 0.6 5.57 Chile 138 602 4.4 101.0 1.4 5.7 46.8 53.2 — 294 2.5 5.47 Other NA NA NA 906.4 12.7 (2.2) 64.7 24.3 11.0 993 8.4 4.50

World NA NA NA 7,146.1 100.0% 1.0% 65.1% 21.6% 13.3% 11,811 100.0% $7.66

Sources: USDA, Office International de la Vigne et du Vin (wine grape data), and Food and Agricultural Organization (FAO).

aAssumes no re-exports and that imports are used for only human consumption purposes.

bExcludes vines not yet in production.

cFor all grape types and acreage includes vines not yet in production. Non-wine grapes, which accounted for 91% of Spain’s grape production in 1996, typically had higher yields than wine grapes.

dCalifornia only. Total wine grape production for the U.S. was 3.0 million tons in 1996.

eData for years ending June 30.

fFor all grape types. Non-wine grapes accounted for 28% of Australia’s grape production in 1996.


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Exhibit 5 Wine Grape Growing Comparison by Region in California, 1997

Napa Other

North Coast Central Coast

Central Valleya

Total California

Tons crushed (000s) 144 268 319 2,162 2,893 Planted acres (000s) 36 58 65 249 407 Bearing acres (000s) 29 48 50 202 329

Yield (tons per bearing acre) 5.0 5.6 6.4 10.7 8.8 Wt. avg. price per ton:

All varietals $1,716 $1,495 $1,254 $393 $603 Premium varietalsb $1,903 $1,670 $1,377 $780 $1,157

Annual operating expense per

acre $6,000 $5,000 $4,000 $2,500 Start-up costs per acre: Land $28-42,000 $10-20,000 $7-10,000 $5- 7,000

Planting & developmentc (spread over 3 years) $25-35,000 $15-25,000 $14-23,000 $11-14,000

Sources: California Department of Food and Agriculture (grape production, price, and acreage data), American Society of Farm Managers and Rural Appraisers: California Chapter (land values), and industry interviews (land values and other costs).

aIncludes other wine grape producing regions in California totaling 6,600 bearing acres. bBased on weighted average price for Chardonnay, Cabernet Sauvignon, and Merlot grapes. cThese costs were typically capitalized and then depreciated (usually over 25 to 30 years) once the vineyard became commercially productive. Cost range based on variations in vine spacing, need for frost and drainage systems, and vineyard terrain (hills vs. level).

Exhibit 6 Typical California Premium Wine P&L (per 750 ml)

Popular Premium (Retail $6.99)

Ultra Premium (Retail $20.00)

Net winery revenuea $3.29 $9.79 Grapesb 0.92 2.25 Wine production 0.25 0.42 Aging 0.17 0.58 Barrels — 0.50 Bottling and packaging 0.58 0.83 Gross profit $1.37 $5.21 % of net revenue 42% 53% Sales & marketing 0.54 2.46 Administration 0.17 0.67 Operating profit $0.66 $2.08

% of net revenue 20% 21%

Source: Adapted from Motto, Kryla & Fisher data. aAfter excise taxes totaling $0.21 per 750 ml. bBased on Chardonnay grape prices of $700 and $1,650 per ton, respectively.


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Exhibit 7 Revenue per Case and EBIT Margins for Premium Wineries, 1996

Revenue per Case

Average EBIT (%)

Highest EBIT (%)

By Price Segment Ultra premium $117 24% 52% Super premium 74 22 37 Popular premium 38 13 20

Overall 48 17 52

By Winery Size (cases) 2 – 7 million $42 17% 37% 250k – 750k 58 11 25 100k – 250k 70 12 33 50k – 100k 105 26 52 25k – 50k 134 21 43 10k – 25k 94 12 31 Under 10,000 171 23 50

Source: Adapted from Motto, Kryla & Fisher, “Record Profits for Premium Wine,” Wine Industry Business Update, (1997): 9-1.

Note: Based on a sample of 200 wineries representing 67% of premium wine sales in 1996.

Exhibit 8 U.S. Wine Exports to Selected Countries, 1996

U.S. Export Value U.S. Market Share

Country $ mil Per Gallon Total

Consumption Import

Volume

Top U.S. Export Markets U.K. $80.1 $8.16 5.22% 5.02% Canada 67.9 7.62 16.62 19.49 Japan 29.7 6.18 9.07 16.59 Germany 18.2 7.80 0.47 0.78 Switzerland 14.1 6.11 2.91 4.72 Netherlands 9.7 6.18 2.92 2.73

Major World Wine Markets France $3.7 $5.54 0.07% 0.48% Spain 1.4 6.09 0.05 0.70 Italy 0.7 5.34 0.02 1.75

Other Producing Countries Australia $0.3 $2.09 0.19% 4.41% Chile 0.2 10.03 0.04 13.09 South Africa 0.1 3.46 0.01 0.52 Argentina 0.0 2.58 0.00 1.21

Other markets 81.3 6.48 0.85 2.90

World $307.6 $7.06 0.82% 3.36%

Source: Food and Agricultural Organization (FAO) of the United Nations and U.S. Department of Commerce National Trade Data Bank.

Note: Imports can exceed total consumption due primarily to timing differences in consumption.


22

Exhibit 9 Growth in Wine Export Value, 1985-1997 (1985 = 100)

Source: FAO. Excludes vermouth and grape must.

Exhibit 10 Export Value Per Gallon, 1985-1997

Source: FAO. Excludes vermouth and grape must.


23

Endnotes

1 Gomberg, Fredrikson & Associates, “1997 Annual Wine Industry Review,” The Gomberg-Fredrikson Report (February 28, 1998): 17-12.

2 Deloitte & Touche’s “Winning Strategies in the Wine Industry” annual survey of around 60 premium wineries, news reports of the surveys, and casewriter’s calculations of data provided by Deloitte & Touche.

3 P. Lukacs, “The Rise of American Wine,” American Heritage, December 1, 1996. 4 Ibid. 5 See Gregory C. Bond and Michael E. Porter, “Robert Mondavi: Competitive Strategy,” HBS Case No. 799-125 (Boston: Harvard Business School Publishing, 1999).

6 R. P. Hinkle, “Napa Valley Wineries: They Just Keep Sprouting Up,” The San Diego Union Tribune, January 29, 1986.

7 Despite their generally fatty diet, heart disease among the French was markedly low, which doctors attributed in part to high levels of red wine consumption.

8 ABM Publishing Group, Adams Wine Handbook, 1998. 9 Ibid. 10California Agricultural Bulletin, 1996. 11 For profiles of selected wineries see Gregory C. Bond and Michael E. Porter, “Robert Mondavi: Competitive Strategy,” HBS Case No. 799-125 (Boston: Harvard Business School Publishing, 1999).

12 D. Armstrong, “Message in a Bottle,” San Francisco Examiner, March 14, 1999. 13 Eighty-five percent represents grapes purchased in the open market divided by total grapes crushed. Figures varied by region: Napa (68%); Other North Coast (74%); Central Coast (60%); and Central Valley (91%). Source: Preliminary Grape Crush Report 1997 Crop (Sacramento, CA: California Department of Food and Agriculture), p. 10-11, 16-17.

14Gomberg, Fredrikson & Associates, “1996 Annual Wine Industry Review,” The Gomberg-Fredrikson Report (February 28, 1997): 16-12. Gomberg, Fredrikson & Associates, “1998 Annual Wine Industry Review,” The Gomberg-Fredrikson Report (February 27, 1999): 18-12.

15Beringer Wine Estates Holdings Inc., October 28, 1997 IPO prospectus (Napa, CA: Beringer Wine Estates Holdings Inc., 1997), available from Primark, Global Access, <http://www.primark.com>, accessed October 10, 2002.

16 White wines were usually aged for longer periods than red wines. 17 Robert Mondavi and Paul Chutkow, Harvests of Joy (New York: Harcourt Brace, 1998). 18 Note that some viticultural areas were quite large. For example, the “Ohio River Valley,” covered some 16 million acres in four states. As a result, having a viticultural area designation did not necessarily indicate a high quality wine.

19 Though not technically an appellation, the vineyard from which the grapes were sourced could also be designated as long as its grapes constituted 95% of the grape stock.

20 G. Dutton, “California Wineries Press On,” Management Review, May 1, 1997. 21 For fortified wines and distilled spirits, there were 12 and 18 control states, respectively. Beer could be sold by the private sector in all states. Source: Wine Institute, “Alcoholic Beverage Control States,” Wine Institute Web site, <http://www.wineinstitute.org/reflib/pub/otherstate/controlstates.htm>, accessed October 11, 2002.

22 Beringer Wine Estates Holdings Inc., October 28, 1997 IPO prospectus (Napa, CA: Beringer Wine Estates Holdings Inc., 1997).

23 Thomas N. Urban and Ray A. Goldberg, “Robert Mondavi Corporation,” HBS Case No. 596-031 (Boston: Harvard Business School Publishing, 1995).

24 T. Appel, “Congress Cuts Export Subsidies to Wine Giants, Funds Diverted to Industry Program,” The Press Democrat, July 30, 1998.

25 Alice Z. Cuneo, “Canandaigua Pits Mystic Cliffs Wine Against E&J Gallo,” Advertising Age, October 19, 1998, available from Factiva, <http://www.factiva.com>, accessed October 10, 2002. “Amount Spent on Alcohol Ads Last Year,” Associated Press Newswires, October 22, 1998, available from Factiva, <http://www.factiva.com>, accessed October 10, 2002.


24

26 M. Winters, “U.S. Wine/Grape Researchers Decry Money Woes,” Wine Business Monthly, May 1997. 27 Vic Motto, “The Economics of Making Wine,” PowerPoint presentation, March 11, 1998. University of California Berkeley Haas School of Business, Berkeley, CA.

28 Many of the figures presented here and in the other country profiles come from Rabobank Nederland’s “The World Wine Business: Developments and Strategies,” 1996, The European Commission’s “Situation and Outlook: Wine,” 1998, the USDA’s “Northern and Southern Hemisphere Wine Situation and Outlook,” 1998, and various USDA Attache Reports.

29 VQPRD, a European Union designation, did not necessarily reflect the true quality of a wine, since it was up to each member country to specify which wines received the designation. Some were stricter than others.

30 P.E. Hiaring, “There’s a New Ballgame in Bordeaux: Brands,” Wines & Vines, May 1994. 31 Source: Rabobank Nederland. 32 A. Lazareff, “Profits on the Grape Vine,” The European, February 2, 1998. 33 G. Walsh, “The Wine Industry of Australia, 1788 to 1979,” Wine Talk, 1979. 34 A. Hoy, “Boutique Winegrowers Just Won’t Be Undermined,” Sydney Morning Herald, January 3, 1998. 35 “New wine, old traditions,” BusinessWorld (Philippines), May 7, 1998.

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