I have often argued that to really understand an industry you first need to understand where the bottlenecks are in the value chain.  Bottlenecks disrupt the efficient flow of resources and so industries tend to evolve around them.  I believe that this observation holds especially true for wine. Herewith a brief update on the current situation.

Do the Math

Silicon Valley Bank released their annual State of the Wine Industry Report yesterday.  SVB is a major lender to US wine producers and thus has a strong interest in producing clear, relevant wine economics research. (I also admire the wine economics research produced by the Dutch agricultural lender Rabobank.)

The report provides some good news along with many worrisome  observations (click on the link above to download the study) and fresh data on the biggest single bottleneck in the U.S. wine industry — distribution.

Here’s the basic math.  SVB estimate that there are 6000 wineries actuve in the US market producing about 7000 wine brands.  All these brands need to squeeze through the U.S. three tier distribution system bottleneck.  This means they need to go from maker (first tier) to state-licensed distributor (second tier) to local retailer (third tier). That’s the law here in the United States,  where we still think of wine as a controlled substance.

There are only limited opportunities for producers  to skip a step.  I understand that Bronco Wines, for example, can sell its Charles Shaw brand directly to Trader Joe’s in California because of a legal loophole there, but has to use an independent  distributor in other states. That’s why Two Buck Chuck costs $1.99 in L.A. but $2.99 here in Washington State.  That extra buck is the cost of the extra distribution layer.

The Big Squeeze

Now we get to the big squeeze. These 7000 brands get funneled through about 550 major distributors according to SVB (obviously this does not count many smaller Mom-and-Pop and specialized distributors that I am familiar with), which is about half as many as a few years back.  Hopefully you can appreciate the bottleneck — 7000 brands worth $30 billion in retail sales have to squeeze  through 550 distributors in 50 states on their way to 76 million wine consumers.  Any blockage in the distributor tier backs up the whole industry.

And the problem gets worse because the distributors are obviously getting squeezed themselves by the economy — falling sales, trading down, shrinking margins, credit limits and counter-party risk.  Expect distributors to consolidate in some cases and pull back to reduce cost and risk in others.

The net effect is clear — distributors are reducing their SKUs (stock keeping units to non-economists) and focusing a smaller number of  reliably profitable products lines.  This means that it is harder and harder for new and niche wineries to get on the warehouse pallet.

The Missing Middle

I’m not sure exactly how this all will shake out, but I suspect the problem will be worse in the middle market. Very small wineries can often successful self-distribute.  Very large ones will probably get distribution because of the volumes they can generate.  The middle falls awkwardly in between — too big to sell it all yourself, too small to be worth a major distributor’s time. The fact that the distribution system is fragmented into 50 (plus DC) pieces just makes the situation worse.

In the same way, SVB data suggest that lower priced fine wines ($35 and less on their scale — remember that a lot of SVB’s customers are in Napa Valley) are still selling pretty well and very expensive icon wines apparently are doing OK, too.  The mid-range is in trouble.  SVB calls $35-$50 a “gray area” and $50-$125 a “dead zone.” Ouch.

I would hate to be a new 3000-5000 case winery trying to sell wine made to be priced in the dead zone.  Unfortunately, I think there may be a lot of new wineries coming on line now who planned to do just that back when economic conditions were sunnier. It will take exceptional effort (or truly exceptional wine) to make this business model work in the current economic environment. I recently talked with one middle-sized premium winemaker who has already figured this out and pulled back — lower output, lower prices — to get clear of the dead zone.

This is the “missing middle” effect that economists are familiar with in other contexts (small family operations and huge corporate businesses survive, the middle simply disappears).  The distribution bottleneck isn’t necessarily the cause of the coming missing middle effect in the wine industry, but it will certainly make it worse.