Costco Starts a Barroom Brawl

It wants to bypass distributors of beer and winewhich could hurt profits at brewers and vintners

One of the perceived social ills inspiring Prohibition was the owning of bars by brewers. To the Anti-Saloon League and like-minded groups, this arrangement promoted alcoholism. They made the case so effectively that, even after Prohibition was lifted in 1933, most states insisted on keeping alcohol makers far away from alcohol sellers. The favored solution: a three-tier distribution system requiring manufacturers to sell to wholesalers, and wholesalers to sell to retailers.

That structure is still in place in most states today. But a closely watched federal court case filed in Seattle is now challenging the three-tier regime as outdated and anticompetitive. In 2006 Issaquah (Wash.)-based club store Costco Wholesale (COST) won an antitrust lawsuit challenging its home state's three-level arrangement. The state then appealed, arguing that the 21st Amendment ending Prohibition gave states the authority over alcohol regulation.

The Ninth Circuit Court of Appeals is expected to rule on the case soon—a decision that could have widespread ramifications for every group with a stake in the beer and wine industry. Brewers and wineries nationwide could eventually gain the power to sell their products directly to retailers. Distributors and state tax collectors, meanwhile, could lose substantial revenues. The Costco case could "radically change the rules of the game," says George Hancock, chairman of Pyramid Breweries, a craft beer brewer in Seattle.

Costco is pushing for the right to buy beer and wine just as it does soap or flat-screen TVs—bypassing middlemen and negotiating big discounts from manufacturers. Under the current system, its costs vary from one state to the next. At the time Costco sued, in 2004, the retailer was paying as much as 8% more for Washington-made wine and beer in-state than it was for the same product shipped to California. "I would like to have a business where everybody had to buy from me," says James D. Sinegal, chief executive of Costco. "I'd try to protect that too."

Distributors have already seen their onetime monopoly eroded in states where wineries, for example, can sell directly to customers on location, or indirectly over the Internet. But the Costco case represents the most serious threat yet to the distributors' bottom line. Huge chains, such as Costco, tend to be their biggest and most profitable customers, selling 40% of the $90 billion in beer gulped down each year and 38% of the $27 billion in wine.

It is much more profitable for a wholesaler to deliver 1,000 cases to one big-box store than to drop off one or two at mom-and-pop convenience stores. Distributors say the current system fosters choice for consumers while avoiding the excesses of a century ago. "This is alcohol; it's not toothpaste," says Phil Terry, chief executive of Monarch Beverage Co., Indiana's largest wine and beer distributor.

States depend on distributors to pay $1.6 billion in escrow taxes each year. Distributors also serve as a kind of unpaid police force, refusing to supply retailers that have legal problems or a track record of selling to minors.

Which side should consumers root for? The three-tier system no doubt encourages a variety of brands. But it comes at a cost. Experts agree that wholesalers add a markup of about 25%, on average—which flows right up to the price customers pay.

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