A Fourth Tier: How the Evolution of Alcohol Regulation May Change What's In Your Glass
- Carolyn Kissick
- Apr 1, 2021
- 10 min read
Updated: Apr 22, 2021
2020 has been a year of adjustments. We now work remotely, interact with friends and family on screens, and purchase the things we need, online, to be safely delivered to us at home. To that last point, we find ourselves in an advantageous position. Over the last two decades, enormous strides have been made in the ecommerce sector that help to facilitate a better connection between consumers and brands in the marketplace.
However, the alcohol industry still finds itself restrained and outside of the true
ecommerce and direct to consumer models, due to legal restrictions within the three-tier distribution system. Companies like Drizly and Reservebar are creating workarounds, but no one has truly achieved what DTC actually stands for: direct to consumer.
The U.S. online beverage volume alone is forecasted to grow 37.1% year-over year by 2024, with agave-based spirits like Tequila and Mezcal projected to be 10.6% of that expansion. Yet the laws and regulations are not adjusting to fit this growth, or to account for all of the wonderful technology we have available at our fingertips. The three tier system, as it is now, is in need of a fourth tier or, perhaps, a reimagining of the way consumers gain access to beverage producers online. In this paper, as well as in a series to follow, we explore and expose the data points that justify and encourage this evolution, from the need for true access to diversity and choice for
consumers, to a more accessible path to market for producers, why data and technology matter, and a deeper look at the current regulatory structure.
In this initial paper, we argue that regulation allowing DTC sales in the alcohol industry is not only good for the economics of the industry but, most importantly, the consumers and producers who make it all possible.
THE THREE-TIER SYSTEM
Alcohol sales in the United States are all regulated by what is known as the Three-Tier System, which separates the distribution of alcoholic beverages to the public into three distinct groups 1) manufacturers, 2) wholesalers, and 3) retailers; and was created in 1933 after the Prohibition experiment was finally deemed unsustainable. The original intention and concept was simple: reduce corruption and monopolistic practices that had run rampant prior to and during Prohibition, and protect the American public from overconsumption and poor quality products. Manufacturers would sell only to wholesalers, wholesalers would sell only to retailers, and retailers would sell only to consumers. No single company could participate in more than one category and any kind of “vertical integration”—the kind that made tied houses such an issue—was strictly prohibited.
To break this down further, let’s take a look at the three-tier system in the real world illustrated by the graphic on page 2, using the example of Patrón, acquired by Bacardi in 2018 for $5.1 billion dollars, marking the largest deal and acquisition the Tequila industry has seen to date.
In the first tier are the manufacturers. For Patrón, this starts in Jalisco, Mexico, with agave growers who sell their crops to The Patrón Spirits company, which processes them into 100% agave Tequila, which is then bottled and labeled for export. Bottles of Patrón are imported by The Patrón Spirits Company in Coral Gables, Florida, and now get passed to the second tier—the distributor.
Southern Glazer’s Wine and Spirits, as a distributor, purchases inventory from The Patrón Spirits Company at a wholesale price and now assumes the second-tier responsibility of selling and transporting the Tequila to the third tier: retailers.
The third tier is split into two categories, dictated by regulatory licensing: on-premise, where alcohol can be consumed on site, such as a bar or restaurant; and off-premise where alcohol can be sold for private and personal consumption: supermarkets, liquor stores, and online retailers.
Important to note here is that the federal government left the regulation of this system up to each state to decide. Thus, nearly 90 years after it was implemented, no state’s laws were created with other states in mind. So while this three-tier system works fairly well within each state, it’s fundamentally problematic for intrastate commerce, the foundation of all things ecommerce and direct to consumer.
THE DTC ECOMMERCE EXPLOSION
Online retail found its roots in the dot com explosion of the late 1990s, and although that particular bubble burst, online commerce as a segment of retail has grown without bounds.
Over the following decade, companies like Warby Parker and Casper went further by selling online, and only online, revolutionizing industries that were previously known for their less than joyful in-person customer experiences.
Prior to Warby Parker, purchasing a new set of eyeglasses required a visit to a physical location and a consultation with an expert. This kind of high touch experience built in tremendous amounts of costs, waste, and time, without transparency on where money spent by the consumer was really going. A customer could walk in and be presented with options at $100, $500, even $800, all coming in the form of an upsell from the clinician, because the margin from the wholesaler must be filled by the local shop. Furthermore, the same consumer could be told this was a “special” pair and hard to get, so the lead time on actually having the glasses in their hands would be long. Not only did that customer have to pay more, they had to wait, and weren’t sure exactly what they’d get when it arrived.
Warby’s initial model cut down on costs and time. A customer would select a few pairs of glasses online to be shipped to their house, try them on, and make the choice to purchase or return the sets.
Now, with the integration of technology that allows a customer to virtually try on the glasses before selecting which will be sent home, the model cuts down not only on costs and time but also on the anxiety a customer experiences in a highly intimate purchasing decision. Casper engaged in a similar anti-anxiety methodology with their 100 night trial period in which a mattress can be returned if the customer is losing sleep over the decision, or the comfort of the mattress itself.
Patrón Supply Chain
CONSUMER INTIMACY AND TECHNOLOGY
Now, eyeglasses and mattresses may not be categorically defined as intimate, but if we take a closer look at the role they play in our lives, they’re two of the most intimate purchases we make. Eyeglasses become a part of the personal image, who a person is seen as and perceived as on a daily basis. Every night, we go to sleep on our mattresses, and every morning we wake up on them. Not to mention the rest of intimate activities engaged on them, for years. Why should either of those be a guessing game when we are buying them, and potentially a mistake?
This potential for making mistakes, costly ones, is where the three tier system is failing the alcohol beverage consumer. Personal choices for flavor, in what we taste and feel when consuming food and beverage, are two of the most intimate preferences we have. Yet the current distribution system pushes brands based on marketing budgets and sales teams, not by consumer preference, and makes it nearly impossible for smaller producers to break through, thus stifling market variety. Of the top 100 spirits brands in the world, 18 belong to beverage giant Diageo, followed by 10 brands from similarly massive Pernod Ricard.
THE BATTLE FOR SHELF SPACE
While the journey for Patrón, illustrated on page 2, may seem like it would be smooth sailing for anyone entering the alcohol industry, unless a producer has not only tens of millions but hundreds of millions of dollars behind them, this is hardly the case.
The problem here is that the second tier is a highly monopolized facet of the system. Southern Glazer’s, the largest distributor in the U.S. by a considerable amount, holds 32% market share of its home tier, while its next largest competitor RNDC owns 19%. Together, they influence over 50% of all business. Even more astounding, the top 10 distributors combined account for 75% of the total market.
For producers in the first tier, this means there are only a few handfuls of buyers. These chosen few are the only ones that have access to nearly all of the market in that third tier. Without the big distributors, the channel to bars, restaurants, liquor stores, and ultimately consumers’ mouths is very narrow, and highly cost prohibitive. Yet the wider channel — the one that the distributors own — is ruled by volume, and is already flush with high volume brands. In Tequila this could mean Casamigos (Diageo), Don Julio (also Diageo), and of course, Patrón.
The problems here are that regardless of the path a producer chooses from either of the above, the ability to scale is very difficult, and the ability to gather feedback and information from your end consumers is even more challenging.
First, the scale problem. A producer decides to sign with a smaller distributor. They will be listed in a portfolio that is likely regionally based and have access to fewer resources, but will retain a higher margin on their wholesale price. They’ll need to decide which markets to focus on first, and how many sales people they’ll hire as an internal team. Salaries for people in the top markets — New York, LA, and San Francisco — are expensive, so perhaps they’ll hire in secondary markets and have the salespeople travel. But travel is expensive, and sales are always slow for emerging brands. Over time, the business can’t justify the costs of the salespeople, but they can’t survive without them either.
Conversely, the producer signs on with a top-10 national distributor. In exchange for lowering their wholesale price, they’ll be listed in a national portfolio, and have access to resources like a sales team and marketing department. Unfortunately, these resources are also governed by volume of sales, and until certain thresholds are met, it’s unlikely a brand will have access to much other than a sales representative or two, regionally assigned, but not one in every market like the volume brands have. The problem is further exacerbated by the fact that representatives are commissioned based on sales, and clearly the volume brands will be the priority when it comes to shelf space. In turn, the producer will need to hire a sales team of their own, to make sales in the markets where they are not represented by the distributor.
At this point, the problem becomes sales. As the industry is now, alcohol sales are still very much an in-person, handshake deal. It takes time and resources to send sales people in to each retail license holder, and convince them to carry a product. The costs here are high, very high, as we mentioned at the beginning of the paper, and unless the company is very well funded, success and scale are unlikely. Many brands find a slow death in this lower level of sales, achieving some success, but never enough to meet the thresholds required by distributors to break through.
Sales become much less complicated in the ecommerce DTC model. Money and resources can mostly be directed towards digital marketing in the beginning, while the brand is getting lift. Over time, a larger salesforce will be needed to fulfill distribution in the traditional sense, liquor stores, bars, etc., but online sales will help bolster this, building exposure for the brand, accessibility to a broad range of markets, and building volume to either present their case to a larger distributor or raise further capital to grow and scale the business.
WHY DATA MATTERS / THERE IS NO DATA
The difficulty with data is fairly equal in both the red and blue pill options, and is similarly lessened in the ecommerce DTC model. We’ve illustrated this in The Journey of Brand Information & Data in the Current 3-Tier System to show the scale of the ladder that data from a consumer must climb back to the producer when engaged in the traditional model. Contrast this to The Journey of Brand Information & Data in ecommerce & Direct to Consumer Retail where we can clearly see the advantage of technology and direct interaction with the consumer.
The bigger reality is this: at this point in time, the alcohol industry has very little information about its consumers.
As the chart follows the journey of feedback from the consumer back to the producer, it becomes clear that the data sit in silos, may never actually get there, or have played an extensive game of telephone when they arrive.
The data that are available are all related to purchasing and are at such a high level that they aren’t helpful to anyone outside of a massive distribution company. Liters produced by country, liters sold by wine grape variety, and global revenue by beverage company is economic data, but not data that help the industry create more products that connect in a more intimate way with its consumers.
Technology and ecommerce allow producers and distributors to look at the way consumers are buying right now — what is selling, what is not — in real time. No need to wait for the end of the year for an annual report that canvasses publicly traded companies and make a guess for what might work next year. The more data that become available the better the entire supply chain will be able to produce better products, retire products that may not be working, and do that all in real time.
There are also data points that are hard to quantify — the aforementioned flavor and feeling — but technology is finally giving us the opportunity to do so. For example, online platforms allow sellers to tag products with certain flavors and characteristics. If one product were tagged as the following—
Flavors: vanilla, caramel, oak, mesquite.
Feeling: full bodied, high alcohol.
—and we assume that all other products on the site have been as thoroughly tagged based on the analysis of professional tasters. Not only will the seller have the data on what is selling or not, but an additional layer that may say “products tagged with vanilla are selling at an 80% higher rate than those that are not.” Now this may not be the most thorough analysis of consumer preferences based on flavor, but it’s a start. The consumers can also search based on these tags and help themselves based on flavors they know they enjoy. Furthermore, they may have access to an expert in that particular alcoholic beverage at their fingertips via chat, email, or social media, who can make recommendations or answer questions all from their living room or office chair.
WHAT COMES NEXT
The alcohol beverage market is ripe for disruption and ready for change. Consumers deserve better variety, and producers deserve a better path to market. Approaching this market with a fresh perspective based on flavor, preference, and actual consumer data can revolutionize an industry shrouded in layers of ancient legislation and business practices.
In the next paper we’ll dive deeper into the aspects of technology and data as it applies to informing customer decisions, product development, as well as keeping the marketplace free from abuse and exposure to those outside the legal drinking limits.
Author:
Carolyn Kissick
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