COSTCO WINS: NOW WHAT?

FILED NOVEMBER 10, 2011

Dear Client:

It was a sad day for public policy advocates, law enforcement, unions, public health advocates, and really anybody who respects the orderly and staid way in which bev-alc is sold in this country. And yes, it was a blow to wholesalers too. And to the beer industry in general. As NBWA chief Craig Purser wrote to members today, "The long term effects on beer are very concerning." I couldn't agree more.

Costco managed to pass its privatization initiative in Washington after pumping almost $23 million behind I-1183 (they'll get a $4 mil refund because they simply couldn't spend $23 million in such a short time, and turns out they didn't need to). It's the largest amount ever spent on a Washington referendum in history. Simply put, they bought the election. Such is democracy.

IS THERE HOPE? Maybe. We've heard that I-1183 opponents might try to sue the state on the grounds that it violates the "single subject rule." Recall that Rocky Wirtz used that same argument in suing the State of Illinois over a measure that raised taxes on spirits in addition to a number of other things. Indeed, NBWA's Craig Purser writes that such a legal challenge "would allege that the ballot initiative violates the state's requirement that ballot issues be restricted to one subject because it deals with distribution and retail privatization as well as numerous deregulatory issues. NBWA will be working with [allies] in the coming days to determine the best, most effective course of action." So stay tuned on that.

NOW WHAT? So what does I-1183 mean for the state? Effective June 1, state-owned liquor stores will shutdown and stores larger than 10,000 square feet will start selling beer, wine and spirits. In the coming weeks and months, the state Liquor Control Board will start scaling back inventory in its retail stores and distribution center, and begin auctioning off retail licenses. They will also begin issuing licenses to qualified spirits distributors. Recall that Odom Southern and Young's Market are two large players in the state.

But there's more to the story. Now distillers can ship directly to retailers. It allows for retail-to-retail sales regarding wine and spirits. Wine and spirits wholesalers will get franchise protection. It allows for volume discounts (which will benefit large retailers, ie Costco) and central warehousing. With lower pricing on QDs, Costco presumably would gain bev-alc market share.

HERE'S THE RUB. In reality, suppliers for beer and wine can currently sell directly to retailers under Washington law. It's the contracts and the regulatory underpinning, put at risk by I-1183, which facilitates a three-tier system. And this three-tier system is what facilitated the growth of many small brewers, small wineries, and craft distilleries in the state. With route to markets slayed and the largest retailer sucking all the customers from smaller retailers -- a retailer famous for carrying very few SKUs -- what does this mean for smaller suppliers?

On the financial side, 1183 says that it will either raise $150 million for the state in its first year, or distributors will pay the difference (although it would take about $60 million from local communities, according to one source). Also, while Costco left beer out of the measure this time around, we wouldn't be surprised if they target beer next.

IS IT LIMITED TO WASHINGTON? At this point it is, of course. But I wouldn't think that Costco is stopping there. They've already said they will likely try this method in other referendum control states, which includes Oregon and Idaho. Including all states (control states and license states), there are about 21 which allow some form of ballot initiative or referendum. It's unclear how much Costco could do in a license state through a referendum without the "get government out of the liquor business" rallying cry. Still, they could make a case for "cheap liquor" through requests for quantity discounts, liquor in grocery stores, and direct shipping.

Also, control states like Pennsylvania and Virginia have considered privatization for years, and although they are not ballot initiative states, it might increase pressure on lawmakers to give privatization a closer look. It's a bad precedent.

GUV ISN'T PLEASED. Washington Gov Gregoire said after 1183 passed: "I remain concerned about Initiative 1183's unintended consequences. This initiative expands the sale of liquor, which can present risks to our public safety. Additionally, we know that Washington has one of the nation's highest 'no sales to minors' compliance rates at 95 percent - compared to the private sector, which has a 76 percent compliance rate. We must closely monitor the implementation of Initiative 1183 and work to avoid any unintended public safety risks."

A LONG AND WINDING ROAD: THE COSTCO TIMELINE

And to quote another eloquent musician: What a long strange trip it's been. Here is a timeline of the highlights of the Costco saga, from the beginning:

AUGUST 2003
Tina Kondo, the chief of the antitrust division for the Attorney General in Washington, received a letter from an attorney representing Costco Wholesale Corp. saying they would do business in Washington in the absence of alcohol regulation, explained why they felt the state's alcohol regulations violated the Constitution and initiated the near decade-long fight.

FEBRUARY 2004
Costco filed a lawsuit in US District Court against the Washington State Liquor Control Board, alleging that Washington's liquor laws violate federal antitrust laws and obstruct interstate commerce.

MAY 2004
NBWA board donated $50,000 and "in kind" services through staff and legal team to help Washington state beer wholesalers against Costco litigation.

NOVEMBER 2004
US District Court Judge Marsha Pechman heard motions from the State and the Washington Beer and Wine Wholesalers' Association.

DECEMBER 2004
Judge Pechman denies a dismissal of the case and allows Costco to continue to pursue its claims that Washington State's laws violate federal antirust laws.

SEPTEMBER 2005
NBWA pledged another $150,000 to fight the Costco lawsuit.

FEBRUARY 2006
Washington State Senate approved a bill that would legalize direct-to-retailer shipping for beer and wine supported by Costco. It later dies.

APRIL 2006
Costco wins their lawsuit as Judge Pechman ruled that many provisions in the state liquor control laws are illegal antitrust violations. But she stays her decision giving the state time to appeal.

JANUARY 2007
Washington State decided to fast-track the appeal to the Ninth Circuit Court.

MARCH 2007
The Ninth Circuit Court of Appeals heard oral arguments from both sides and decided to extend the stay of Judge Pechman's ruling giving Washington some time.

JANUARY 2008
The Ninth Circuit Court of Appeals reversed most key elements of the lower District Court decision. Victory for wholesalers.

JUNE 2009
In a bizzarre turn of events, despite losing the case, the Judge orders Washington State and distributors to pay Costco's legal fees, which are $1.9 million. Unfair.

MAY 2010
Costco announced that they are supporting privatization efforts in the state of Washington by backing Initiative 1100. Wine and spirits later put a competing referendum on the ballot as well. NBWA and Beer Institute and others unite to contribute funds to counter both referendums.

SEPTEMBER 2010
Costco donated another $202,000 to the cause.

OCTOBER 2010
Costco has donated an additional $2,237,100 million to Initiative 1100.

NOVEMBER 2010
I-1100 and the W&S referendum are defeated in the polls. Victory for wholesalers.

JANUARY 2011
Costco evp John McKay said they would not give up the fight for privatization even though I-1100 failed to pass. Later Costco ceo Jim Senegal retires. Some thing Costco will lose its fire for this fight as a result. They are wrong.

JULY 2011
Initiative 1183, backed by Costco, collected some 354,000 signatures putting it on the November ballot.

AUGUST 2011
Costco brought donates $2.27 million.

OCTOBER 2011
Costco's contributions to I-1183 total over $22.5 million in cash and in-kind contributions to the campaign backing ballot initiative I-1183. Even though beer isn't included, both NBWA and Beer Institute donate funds against it.

NOVEMBER 2011
Initiative I-1183 privatizing alcohol sales in Washington State passes with nearly 60 percent of votes. Victory for Costco.

CONCLUSION: With all of this effort, internal resources, legal fees, in-kind contribution, etc. BBD believes this retail giant has spent nearly $50 million -- $50 million -- to get what it wants in one state, its home state, where it is revered and trusted. And years of focus. As a publicly traded company, and one subject to consumer criticism and shareholder protest, known for fewer choices and ruthless dictation of terms (throwing Coke out in 2009 over pricing, etc), will it be interested in picking fights like this outside of its home market? Only time will tell.

A-B POSTS A DECENT Q3

Anheuser-Busch's U.S. shipments were a dog in the third quarter, but that was just inventory paring and price timing. While shipments were down 3.4%, distributor sales to retailers where down just 0.9%, an improvement over the previous quarter and better than its main competition. For the nine months, STRs were down 2.2% and shipments are in-line.

But be warned, there's lots of noise in the numbers. For one thing, the third quarter results were impacted by the timing of 2011 price increases were three weeks later than in 2010, resulting in easier comps for 2011. But it proved to be a harder comp for revenue per barrel (pricing and mix).

MARKET SHARE. Market share is the most important metric, however, in my opinion. So let's take a look: Their market share declined 0.25% mostly due to sub-premium declines (due to price increases to narrow the gap with premiums), while all of their focus brands increased share. Bud Light, Michelob Ultra and Stella Artois all grew share, and Budweiser's share decline continued to decelerate.

Q3 INNOVATIONS. A-B's brewing and packaging scale, which is of course a function of market share, allows them to be more aggressive with brand/pack variants, and there were quite a few in the quarter. The sleek 8oz can for Bud, Bud Light, Bud Light Lime and Mich Ultra rolled out in October as a sampling tool and for "consumer convenience." They also rolled out Natty Daddy (higher 8% abv), Tilt Long Island Tea, Shock Top Pumpkin Wheat and the Shock Top sampler pack. Expect more where that came from.

PRICING AND MIX. A-B's revs per barrel were up only 1.9% "impacted by the timing of the price increase," but it's up 3% in the nine months. Also, the brand mix contribution to revs per barrel was neutral as buy-in was skewed toward sub-premiums which had a higher price increase.

BUD LIGHT. Or as Howard Stern says, Buuuuuud Liiiiight. The brand gained a nominal 0.05 points of market share in the third quarter and 0.1 points for the nine months. "Although it is too early to reach conclusions, there are indications that the brand is starting to benefit from the new NFL sponsorship with the property providing rich content for branded packaging, in-stadium promotions and full 360 degree retail execution," said ABI. "We are also launching themed thermochromatic Bud Light Lime cans to support our NFL Pro-Bowl activation." And of course they are launching higher octane Bud Light Platinum in January.

BUDWEISER. ABI is "pleased with the progress" on this brand, as it has basically cut its share losses in half in a year. I have to say that I was skeptical of A-B's ambitions to stem the bleeding on Bud -- a full calorie mature brand with its stereotypical drinker, WWII vets, dying off -- but they seem to be making some headway on this. In fact, it is its veteran all-American heritage that is showing them the way on new marketing. Will young drinkers embrace it? They have embraced Yuengling and PBR. That's what they're gunning for. The new packaging and new bowtie can are now available in all markets.

HIGH END. Their high end shipment volumes increased 17% in the quarter and 19% for the nine months. STRs were even better, up 23% in the quarter. Year-to-date in 2011 they've added 330,000 additional points of distribution for high end brands. The STRs of their top six (Mission Six) high end brands (Stella Artois, Beck's, Leffe, Hoegaarden, Land Shark and Shock Top) collectively grew by 29% in Q3. Stella Artois was up 28%, Leffe was up 44%, and Shock Top was up 116%.

BREWPIC: The states in red and yellow represent states in which referendums/ballot initiatives are allowed.




"We'll keep fighting it."
-Costco ex-ceo Jim Sinegal, when he lost his appeals court decision on bev-alc issues. He was true to his word.


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