The Category Captain and the Consolidating Food Industry

May 16 2001

FTC:WATCH No. 566 ISSN. 0196-0016

by Albert A. Foer

The food sector of the American economy is clearly undergoing a major restructuring that involves rapid and inter-related consolidation at the retail and manufacturing levels, as well as relatively new forms of vertical integration at these and at the commodity processing level. Will the antitrust system be creative enough to recognize and deal with the challenges presented by this trend?

Faced with the merger of Heinz and Beechnut, which would have reduced the number of competitors in the jarred baby food market from three to two, the Federal Trade Commission drew a line in the sand. Despite a strong efficiency argument that persuaded the District Court to reject the FTC's request for a preliminary injunction, the U.S. Court of Appeals for the District of Columbia recently upheld the FTC and Heinz and Beechnut withdrew their plans. Most of the commentary on this case has focused on issues relating to efficiencies, but the case's treatment of access to retail shelf space leads to new perspectives on food industry mergers.

By way of quick background, the three players in the jarred baby food market are Gerber (by far the dominant firm), Heinz, and Beechnut. Gerber is on the shelf in 90% of American supermarkets. Generally, there is only one other brand along with Gerber. The FTC produced evidence demonstrating that Heinz and Beech-Nut are locked in battle at the wholesale level to gain (and maintain) position as the number two brand on retail shelves. Part of their competition involves offering the retailer slotting allowances and pay-to-stay lump payments.

The District Court ignored the loss of competition at the wholesale level that would occur if the merger were permitted, saying that the FTC could not prove this would have an impact on consumers. The Court of Appeals held, to the contrary, that the merger's effects on the wholesale market for baby food are important to a determination of whether the merger is likely to reduce competition in the baby food market overall.

In recent years, the FTC has investigated dozens of supermarket mergers, and has become increasingly aware of the importance of access to shelf space. The FTC's workshop on slotting allowances last spring and the subsequent staff report focused on the dynamics of such competition. It also introduced important information about the role of category captains, largely developed by AAI Advisory Board member Robert Steiner (whose article about this is on our website). The Heinz opinion opens the way for increased focus on category captains and the flow of sensitive information in the context of merger analysis.

Consider, for example, Nestle's proposed acquisition of Ralston Purina, which the FTC is currently investigating. This merger will unite the largest manufacturer of dry pet foods with the largest manufacturer of wet (canned) pet foods, creating the largest pet food company in the U.S. with three times the pet food sales of its nearest rival. Under standard merger analysis, the FTC would likely conclude that at least in one market (dry cat food), and possibly in several additional markets, the concentration level would become so high that the merger would be illegal absent divestiture of one or more brands. The FTC and the two companies will likely negotiate a "fix" for the merger, a consent order will be signed, and the merger will be approved, conditioned on some divestitures.

So narrow a merger analysis is no longer sufficient. Based on our investigation, the FTC should also be examining the dynamics of shelf space acquisition and the way the flow of competitively significant information may change as a result of the merger.

Think of sophisticated category expertise as a functional service, like most others, that can be employed by a retail firm in-house or purchased in the market. For a variety of reasons, most food retailers lack in-house expertise for most of the numerous stock-keeping units (sku's) in their inventory. In the pet food industry (and in many other industries that bring products into the supermarket), most retailers designate a "category captain," typically the dominant supplier. Although the precise influence of a category captain varies at different retailers, it is usually significant. From the supplier's perspective, being designated a category captain is economically valuable and suppliers compete for this position even though it entails substantial expense. Category captains have access (often in advance) to information, including pricing and promotional plans, about all the products in the category, so that they can develop comprehensive plans (including shelf-allocation planograms, pricing, and promotions) for the retailer. This gives them enormous knowledge about their direct and potential competitors. If, as is common, they serve as category captain for multiple, competing retailers, it also gives them enormous knowledge of the retailing part of the industry.

As the FTC Report on Slotting Allowances suggests, this unique position could be used in a variety of anticompetitive ways. A category captain who holds that position at many retailers has the opportunity to serve as a "hub," facilitating collusion among the retailers. Such a category captain can also coordinate oligopolistic price leadership among its rivals because of its special access to competitors' marketing plans. Further, it can provide advice that is intended to disadvantage its rivals. Since a retailer is not obligated to take the advice it is offered, the influence of a category captain is difficult to quantify and therefore uncongenial to current modes of antitrust analysis. Nevertheless, we believe the category captain's ability to skew competition is real and can be significant.

In the pet food industry, prior to the Nestle/Ralston merger, three firms apparently have competed to be category captains-Nestle, Ralston, and Mars. Because each is strong in a particular segment of the market (e.g., Ralston in dry dog food; Nestle in wet cat food), no one firm has been captain for the entire category. After the merger, the FTC needs to ask, will Nestle/Ralston become so dominant in all parts of the pet food market that it will be category captain for the whole pet food market? Will competitive information about both the manufacturing and the retail levels be centralized in Nestle/Ralston? Will Nestle/Ralston be able to use its leverage as the retailer's expert to disadvantage other manufacturers? Will it be able to coordinate competition among retailers as the hub of a difficult-to-prove hub-and-spokes conspiracy? Will its advice to retailers reduce innovation in the industry by making it more difficult for new entry or brand extension by anyone other than Nestle/Ralston? Will it be able to engage in unilateral, anticompetitive opportunistic conduct, e.g. by employing the combination of its category captaincy and its enhanced market power to bid up the cost of access to shelf-space in limited circumstances, thereby raising the cost of targeted rivals who might be weaker but threatening to gain space in a particular supermarket chain?

If the answers point to an increased likelihood of anticompetitive behavior, then what remedy would be appropriate? Divestiture of a few brands will probably not restore competition. Can another remedy (e.g., limiting the combined market share of retailers for whom one company can be a category captain) be designed? Or must the FTC deny the merger outright?

The age of innocence is over. In the food industry, there is no longer any escaping the need to examine how mergers at one level can affect competition at another. The linkage of category captaincy and its potential effects on a market must now be confronted.