DF1- 000-I

THE NESTL / PERRIER MERGER

Original written by professor Daniel Fernndez Kranz at IE Business School. Original version, 2 April 2009. Published by IE Publishing Department, Mara de Molina 13, 28006 Madrid, Spain. 2009 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.

BACKGROUND AND THE EC DECISION

In 1991, IFNIT, an Italian company belonging to the Agnelli family, launched a bid to gain control of the French company Perrier, operating in the mineral water industry. The bid was followed by a counter-offer from Nestl, a Swiss multinational, which had previously reached an agreement with BSN, both firms being active in the mineral water industry. After a period of uncertainty, the takeover battle was won by Nestl. Under the terms of the agreement, Nestl would have sold the Volvic source of Perrier to BSN. In June 1992, after a detailed investigation, the European Commission (EC) decided that with the acquisition by Nestl of Perrier, and the transfer of Volvic to BSN, the merged firm and BSN would jointly hold a dominant position in the French market for bottled source water. However, the merger between Nestl and Perrier, plus the transfer of Volvic to BSN, were allowed under the condition that Nestl would sell to a third party the brands Vichy, Thonon, Pierval, Saint-Yorre as well as

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some minor local spring waters. According to the EC, these waters would represent a 5% of the 1 market. The EC also argued that if Nestl had taken over Perrier and kept the Volvic brand for itself, it would have enjoyed a single-firm dominant position. On 26 January 1993, Nestle indicated to the Commission a purchaser, the Castel group, already operating in the beverages sector. That purchaser declared itself interested in taking over three of the major sources, which Nestle had undertaken to resell (Vichy, Thonon and Saint-Yorre), and a number of less important sources. As the Commission did not consider that that transfer met all the terms of the decision, the Nestle and Castel groups concluded a new agreement on 18 February 1993, which included transfer of the Pierval source as well as those mentioned above.

THE UNDERTAKINGS AND THE PRODUCTS

Founded 126 years ago and still headquartered in Vevey, Switzerland, Nestl is the worlds largest food manufacturer. Ever since Helmut Maucher (the first German to run Nestl) took over as CEO in 1981, the once-sleepy giant embarked on an aggressive expansion strategy, acquiring foodrelated businesses all over the globe (Carnation in the US, $3 bn; Rowntree in the UK, $4.5 bn; and Buitoni in Italy, $1.4 bn). Although unusual for Europe, Nestl did not shy away from hostile bids to acquire what it believed were strategically important target companies. Nestl operates 423 factories in 62 countries and employs about 200,000 people. In 1991, it earned Sfr2.5 bn ($1.6 bn) on sales of Sfr50.5 bn ($33.6 bn). Geographically, its most important markets are Europe (46% of sales), USA (21%), Latin America (17%), Asia (8%) and Africa (5%). The most important products are instant beverages, milk and dairy products, culinary products, frozen food, infant and dietary products, chocolate and candy, beverages and some non-food businesses such as cosmetics and pharmaceuticals. The company has well-established brands such as the flagship Nescafe. In the US, Nestl owns brands such as Nescafe, Tasters Choice, Carnation, Quick, Stouffer frozen foods, Contadina, Beringer wines, and several chocolate and candy brands. It also owns 25% of the French cosmetics firm LOreal. It is Nestls stated goal to double its sales worldwide within the next decade. The company wants to maintain a high-quality food image with brands that are in the top three in their respective markets. Furthermore, it aims to develop new products for changing consumer tastes that take advantage of changing lifestyles. The company felt that this necessitated expanding its position as the worlds leader in food related technologies and R&D. Nestl entered the mineral water business in 1969 when it acquired Vittel (France), and subsequently Blaue Quellen (Germany) and Ashbourne (UK) in the 1970s. Nestl strives to be a dominant global player in the mineral water market. In this business, the product itself can hardly be physically differentiated, and much depends on the strength of the brand name. Perrier S.A. is the worlds largest mineral water company. The company owns strong brands such as Perrier, Contrex, Volvic, Vichy St. Yorre and a 35% stake in Italian San Pellegrino. In the US, Perrier owns Arrowhead, Great Bear, Calistoga, and Poland Springs. Perrier derives about twothirds of its sales from mineral water and the rest from cheese (Roquefort and Sorrento, accounting for about 26%), and other miscellaneous items (7%). It had FF13.2 bn in sales in 1991 and operating income of FF1.1 bn, generating a net income per share of about FF36. Its top mineral water brands included Contrex, Volvic, Arrowhead, and Perrier, accounting for about 65% of the companys water sales by volume. BSN belongs to the Danone group and is Europes fourth largest packaged food concern with FF53 bn ($10 bn) in sales in 1990. The company has strong market positions in dairy products and mineral water, with its sales concentrated in France and Europe. Its major brands include Danon
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The EC estimates that these waters represent 20% of the capacity of Nestl, Perrier and BSN together. The 5% measure has been estimated using information about the post-merger HHI in Nuttall and Seabright (1993).

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(yogurt), Gervais (cheese) and Badoit/Evian (mineral water). The company is run by 78-year old Antoine Riboud, who has been chairman since 1965. Umberto Agnelli is a director of BSN. The Agnellis had helped BSN to expand in Italy. BSN and the Agnellis struck a deal in 1987, where the Agnellis were to help BSN expand in Italy and BSN, in return, would help the Agnellis diversify into the food business. After the Agnellis ambitions became obvious, Riboud was afraid that the Agnellis might challenge BSNs position in mineral water in France. BSN agreed to buy Perriers Volvic brand from Nestl, should Nestls bid succeed. BSN is also the third major supplier on the French source bottled water segment. The proposed concentration between Nestl and Perrier affects primarily the business of bottling water originating from a natural spring or source ('source water'). Source waters may be labeled as 'mineral water' provided they fulfill certain legal requirements regarding their composition and their quality, and provided they obtain an authorization from the competent authorities to that effect. Source waters, which are not mineral waters, will hereafter be referred to as 'spring waters'. There is a difference between mineral and spring water. The former must contain a minimum of 2000 parts per million dissolved minerals, whereas the later just comes from a natural spring. The production and marketing of spring waters are also subject to an authorization from the competent authorities. Mineral and spring waters can be sparkling, still or flavored. Bottled water, which does not originate from a natural spring or source is referred to as purified tap water.

Bottled Water

Source Water

Purified Tap Water

Mineral Water

Spring Water

Sparkling

Still

Flavored

Sparkling

Still

Flavored

Europeans long ago discovered the health giving properties of mineral waters, and they even have water cure regimens in spas paid for by government health insurance plans. Back in 1654, the court physician of Versaille presented a bottle of Chatledon from Auvergne to Louis XIV to cure his gout and other assorted illnesses largely attributed to gourmandise and gluttony. Mineral water is a highly profitable business with margins typically around 15-20% for large producers. It had been growing worldwide rapidly during the 1980s, at about 10% per year. In Germany, for example, per capita consumption increased from 41.4 liters in 1980 to 89.2 liters in 1991, constituting the fastest growing beverage group. The annual consumption per capita was 105 liters in Italy and 77 liters in France, compared to 33 liters in the US and 6 liters in the UK. If

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more health-conscious consumers in the US and the UK developed an appetite similar to that of the French, growth in that market could be dramatic. Nestls bottling activities in the source water sector are mainly located in France with the wellknown brands Vittel and Hpar. Perrier's bottling activities in the source water sector are mainly located in France with the well-known brands Contrex, Volvic, Perrier, Saint-Yorre, Thonon and Vichy, as well as a number of local spring waters. BSN owns the brands Evian and Badoit. The three firms together hold as high as 82.3% of the French source market in value and 72% in volume. Individual market shares were not published by the Commission decision for business secrecy reasons. However, some information about them can be found in Sutton (1991), who estimates the BSN share at about 25%, Nestl at 20-25%, Volvic at 7% and other sources of Perrier at about 20-25%.

French Market Shares (Bottled Source Water) Nestl Perrier (without Volvic) - Volvic BSN Other Total Volume 20% 20% 7% 25% 28% 100% Value 25% 25% 7% 25% 18% 100%

Source: numbers have been estimated combining the information in the EC decision, Sutton (1991) and Motta (2004).

The analysis of capacities in the industry revealed that Volvic had the largest capacity in the industry. In France, Nestl is almost exclusively active in the still mineral water segment while Perrier is present in both the still and sparkling mineral water segments. Both companies export water from their sources in France to other countries. The third major supplier on the French source water market is BSN.

RELEVANT PRODUCT MARKET

The EC defined the relevant product market as the market for bottled source water. Nestl has submitted in its notification that there is no separate market for bottled source water, and that the relevant market to assess the proposed concentration should be that of non-alcoholic refreshment beverages, including both bottled source water and soft drinks. This market definition is argued on the basis that all beverages have as basic function to quench the consumer's thirst.

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Non-alcoholic drinks

Bottled Source Wate r

Soft drinks (Including Purified Tap Water)

Mineral Water

Spring Wate r Sparkling Still Flavored

Sparkling

Still

Flavored Relevant Market according to E.C.

Relevant Market according to Nestl

The EC conducted a qualitative analysis. The Commission considered that several factors indicate the existence of a distinct market for bottled source waters, where operators are able to act with a significant independence of the actions of companies selling soft drinks, in particular in the area of pricing. In particular, the EC interviewed consumers and retailers and found that bottled source water, in particular in France, is bought and regularly consumed because of its image as a natural product (water originating from a natural source) and its association with purity, cleanliness, absence of contamination and, in general, health and a healthy style of life. According to the EC, three main factors indicate that it cannot be reasonably expected that an appreciable non-transitory increase in the price of source waters compared with that of soft drinks would lead to a significant shift of demand from source waters to soft drinks for reasons of price only. First, there exist substantial price difference in absolute terms between bottled water and soft drinks. A comparison of manufacturer's price lists in 1991 shows the following price ranges: Still spring waters (PVC bottles of 1,5 liters): between FF 0,85 and 1,4. Still mineral waters (national brands in PVC bottles of 1,5 liters): between FF 2,49 and 2,56. Sparkling mineral waters (national brands): between FF 2,99 and 3,47 (PVC bottles of 1,25 liters), FF 2,98 (PVC bottle of 1 liter) and FF 3,65 (glass bottle of 1 liter, non-returnable). Soft drinks: FF 6,1 for Coca-Cola (PET bottle of 1,5 liters), between FF 6,1 and 9,4 for tonics (PET bottles of 1,5 liters), between FF 6,1 and 8,76 for still orange flavors (PET bottles of 1,5 liters).

Taking as a reference still mineral waters, which account for the bulk of consumption in France (over 70 %), soft drinks are, at the manufacturer level, in the range of two to three times more expensive than source waters.

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Retail prices (prices for the end consumer) reflect this same gap. The Canadean Report, Nielsen and Secodip statistics provided by suppliers of source waters and soft drinks and information provided by the main food distributors all confirm this. Nestl denied the existence of such gap. Its representatives submitted that about 50% of all soft drinks sold within France are colas. The normal consumer price per liter of Coca-Cola (nonreturnable 1,5 liters PVC bottle) is, FF 3,73, whereas the price per liter of Perrier (non-returnable glass bottle) is FF 4,10 and of Vittelloise flavor is even FF 5,23 (non returnable 1,5 liters PET).

Prices for Bottled Water and Soft Drinks according to the E.C. and Nestl Consumer Price (per 1.5 liters) Perrier Vittelloise Coca-Cola 6.15 7.84 5.59 Still-Spring Still-Mineral Sparkling-Mineral Sof-Drinks -Coca-Cola -Tonics -Orange Manufacturer price (per 1.5 liters) 0.85-1.40 2.49-2.56 3.60-4.15 6.10 6.10-9.40 6.10-8.76

The EC also found that correlation coefficients of prices of different mineral waters range form 0.85 to 1, whereas the correlation coefficients between prices of mineral water and prices of soft drinks are either very low or even negative: during the five years before 1992 mineral water prices tended to increase whereas soft drinks prices tended to decrease. The EC argued that the market of bottled source water in France is characterized by strong marketing and promotional activities, with high advertising budgets for the three main suppliers. As a consequence of the resulting image of natural, pure and healthy product associated with source waters consumers do not recognize soft drinks as a substitute of bottled source water for daily use at home. The general image directly associated by consumers with branded source water as a consequence of the common axes of the publicity of each brand, and their additional attachment to each particular brand reduce the importance of price as purchasing criteria (small elasticity of demand). Therefore, a small increase in the price of source waters is not likely to induce a reaction of consumers resulting in a significant substitution of bottled source water by soft drinks. On the production side, the EC pointed that there exist a number of regulatory constraints in the production of mineral water, the most important being that production of mineral water needs an authorization; bottling must be done at the source; and water must be marketed with a brand name which is associated with the source. Spring waters, which have inferior characteristics with respect to mineral waters, have to be bottled at the source but they can be marketed with a different brand name. Instead, soft drink producers main input is tap water, and hence soft drinks producers do not have to follow particular production and marketing requirements. According to the EC, the conjunction of the production and marketing constraints described above make it impossible for soft drink producers to switch their installed capacity from production of soft drinks to production of source water, be it spring or mineral water. Even if soft drink producers currently had excess capacity, the legal requirement to bottle spring and mineral water at the source makes it impossible for them to use any possible spare capacity already installed to bottle source water. Nestl suggested that bottlers of soft drinks could use their bottling plants to produce purified tap water and enter the source water market with such a product. According to the EC, no evidence of

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the existence of soft drink producers with excess capacity has been produced to support the submission. Nestl further suggested that purified tap water is marketed in certain countries (United States of America, Denmark, Greece) and is starting to make inroads in Germany, where it accounts for 1,5% of total consumption of bottled water. According to Nestl the fact that purified tap water is sold in certain countries constitutes sufficient evidence that it could be marketed in France. According to the EC, Nestls submission rests on the implicit assumption that purified tap water would be considered by consumers as a substitute for source water. According to the EC, this assumption is not supported by any evidence. On the contrary, the characteristics of demand in the relevant geographic market indicate that this is not the case. In spite of strong demand growth and the considerable rate of expansion of market volumes until 1990, constant price increases (after discounts) in the French market of bottled source water, in both nominal and real terms, the decreasing trend of list prices of the leading brands of soft drinks in real terms (in the case of CocaCola, even in nominal terms), which is further aggravated when discounts are taken into account, and the technical and industrial ability of soft-drink or beer producers to bottle purified tap water, no soft-drink or beer manufacturer has ever entered the source water market in France. Past evidence strongly suggests, therefore, that supply-side substitution has not been considered as commercially viable by the companies concerned. With regard to local waters (mainly spring waters), the EC notes that the cross-price elasticity of demand of the national still mineral waters is relatively low. The three national suppliers have created extremely high consumer fidelity through long-standing and strong publicity campaigns for national mineral waters. This is confirmed by the fact that retailers, who only reflect the demand of consumers, do not consider price as the first criterion for the choice of national mineral waters and by the fact that they consider themselves dependent on the major national mineral water brands. This low cross-price elasticity of demand with regard to local waters is clearly borne out by the fact that since at least 1986 the three national suppliers have maintained and constantly increased their absolute sales volumes (which represent over 70 % of the total water market) with only a small loss in 1991 when total demand growth slowed down considerably. There thus exists a low cross-price elasticity of demand for mineral waters, which facilitates price increases or at least the maintenance of high prices without losing significant sales volumes to local water suppliers. The EC also argued that no distinction should be made between markets for sparkling, still and flavored waters. Despite some differences in prices, it appears that from the technical point of view it would be extremely easy for a producer to switch from sparkling to still waters and vice versa. Also, the EC pointed to the strong correlation of prices of sparkling and still waters.

Correlation Still-Still Still-Sparkling Sparkling-Sparkling Source: Lexecon (2003) 0.89 0.90 0.94

RELEVANT GEOGRAPHIC MARKET

The EC defines the relevant market as the French market, using the following arguments. First, transport costs of source water are extremely high with respect to its value (between ten and twenty per cent for every 300 kilometers, depending on whether plastic or glass bottles are used). Second, there exists very little trade of source water between EC countries. Third, entry into the French market is made difficult because this is a mature market with very established brand names, and a very large advertising effort would be needed to acquire considerable market shares.

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COST STRUCTURES AND CAPACITIES

Nestl pointed that the major brands of the three national suppliers have similar cost structures. The manufacturing process consists basically of bottling. The need to bottle at source and the resulting multiplicity of bottling plants reduces the scope for economies of scale. As a result neither Nestl nor BSN has a major cost advantage. Nestle submitted that nearly all major sources of Nestle, Perrier and BSN were working close to their maximum capacity. The EC disagreed and noted that Perrier owned at the time two major still mineral water sources with considerable free capacities, i.e. Contrex and Volvic. The exact figures were known to the Commission but were not disclosed for reasons of trade secrecy. However, the Commission assured that the free capacity of both sources combined exceeded at that time the total still-water market volume. The EC noted that after the merger and the sale of Volvic to BSN, the two suppliers would have a considerable number of sources, the overall free capacity of which would by far exceed the total water market volume (5 250 million litres) and each one of these two suppliers would have at least one major still mineral water source with huge free capacities compared to the overall market volume and all other local water suppliers.

RELATIONSHIP WITH BUYERS

The ten largest buyers of bottled source water in France account for around 70% of the total sales of Nestl, Perrier and BSN, with the first four distribution groups (Intermarch, Lecrec, Carrefour and Promodes) representing 50% of purchases. Nevertheless none of the buyers alone go beyond 11%. Further, the leading mineral waters are brands that most consumers are loyal customer of. Large buyers would risk losing some of their clientele (and the loss would concern all the range of goods sold, not just water) if they replaced such brands with own labels, that is local spring waters sold under the distributors brand name. The majority of retailers and wholesalers interviewed by the EC indicated that the merger would further diminish their bargaining power with respect to both Nestl and BSN. The range on mineral waters they sell would be broader and this would give them further power. According to the EC, the weighted average of the share of the sales of Nestle, Perrier and BSN in the total water sales (still and sparkling 1991) of a representative sample of retailers and wholesalers amounts to approximately 78 % by volume and even higher by value. Nestle stated that the fact that bottled water represents only an estimated 1 % of the sale of a retailer, whereas those same sales represent a much higher percentage of the turnover of the supplier, creates an imbalance in favor of the retailers. According to the information provided by certain retailers, it is not excluded that a delisting of a national brand can result in a loss of one out of 10 end-consumers, who, because of their attachment to the brand, would switch retail outlet in order to find the particular brand. Therefore, and according to the EC, a delisting of one single major brand can have a much higher impact on the retailer's sales than the 1 % figure would suggest, since the loss of each client implies a loss of all the client's purchases in the retail outlet concerned. The EC also highlighted that the three national suppliers used to publish their list prices with the basic quantity rebates. Since they all supply the same customers, there is also a considerable feedback from these customers. In addition, the three suppliers provide the Chambre syndicale des eaux minerales with their monthly sales volumes and each one receives the monthly sales quantities broken down by brand of the other suppliers.

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BRAND LOYALTY AND OTHER ENTRY BARRIERS

Nestle submitted that in view of the strong market growth for bottled water almost all major beverage and food manufacturers can be considered as potential competitors which would constrain the market power of Nestle and BSN after the merger. Nestle also refered to the large number of available sources in France and to a number of new market entries both by French local suppliers and by foreign suppliers. Nestle mentioned in particular, imports into France from Spa, Apollinaris and some Italian producers. The Commission was of the opinion that there exist significant barriers and risks to enter the French bottled water market. These risks exist equally for new local water suppliers and new entrants from other neighboring geographic markets. First, although the French water market had been growing very rapidly until 1990, this growth was halted in 1991 when the annual growth rate slowed down to below 1 %. At that time, France already had one of the highest per capita consumptions of water in the Community and it was therefore expected that the French water market would in the future grow more slowly than the rest of the Community. This was admitted by Nestle. Second, the French water market is a mature market in terms of number of brands and range of products. The market is already filled with a number of well-known and well-established brands, which fully satisfy the retail stores and fill their limited shelf/stocking place. In the still water segment there are five major brands (Evian, Contrex, Vittel, Volvic, Hepar) established in virtually all distribution outlets. Entry with a sixth brand on a national or large scale basis would be very difficult. In addition, new brands with little or no reputation would not only have to be sold at much lower prices (e.g. the local waters) but would also have to offer retailers much larger discounts to induce a retailer to list a new brand which provides much less volume than any of the established well-known major brands. Third, access to French distribution is further rendered difficult by the fact that the established national suppliers grant to retailers and wholesalers annual rebates linking their respective products (rabais de quantite, rabais de gamme, rabais de progression, accords de cooperation, etc.). These rebates and cooperation agreements go beyond pure quantity rebates because they pursue the objective of binding the buyers to the full range of products of each particular supplier. This type of rebate strengthens the position of the established suppliers and raises the barriers to entry for newcomers. Any newcomer would have to offer comparatively much greater rebates given his lower volume and lower range of products. Fourth, one of the key problems of access to the French water market is the reputation of the established brands of the three national suppliers, which grants Nestle, Perrier and BSN a long-run advantage over any local supplier or newcomer. The three national suppliers have invested for many years and continue to invest considerable sums in publicity and promotion for their respective brands. In 1991, Nestle and BSN spent around 10 % of its turnover on the promotion of their brands Vittel and Evian. The same was true for Perrier and its Volvic brand. High and long-standing spending in advertising has created a low elasticity of demand and thus a significant barrier to entry vis-a-vis local spring waters and vis-a-vis potential newcomers by constantly increasing consumer fidelity to the established brands. Advertising and promotion are sunk costs, which are not recoverable in the case of failure in the market. For newcomers the establishment of a new brand is not only very costly and time consuming (consumer acceptance can take several years), but is also extremely risky because in case of failure (non-acceptance of the brand by the consumer) all the investment is lost. Nestle and BSN pointed to the fact that there exist a large number of mineral and spring sources in France which can be developed and have pointed towards a number of entries of local suppliers. However, according to the EC, none of these sources are of a size in capacity or sales comparable

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to the major sources of Nestle, Perrier and BSN and there is no indication that any of these sources would be able to develop quickly to a point that they could significantly restrain the market power of the two remaining national suppliers.

THE REACTION OF THE STOCK MARKET

The following chart shows the evolution of the share price of the Danone group, which controls BSN, and the evolution of the French stock market, represented by the SBF 250 Index (Socit des Bourses Franaises 250 Index). The SBF 250 is made up of 250 stocks that together reflect the branch structure of the French economy.

0.70

0.50

0.30

0.10

Danone SBF250
Feb-91 Feb-92 Feb-93 Feb-94 Oct-91 Oct-92 Oct-93 Aug-91 Aug-92 Aug-93 Aug-94 Jun-91 Jun-92 Jun-93 Dec-90 Dec-91 Dec-92 Dec-93 Jun-94 Oct-94 Apr-91 Apr-92 Apr-93 Apr-94 Dec-94

-0.10

-0.30

-0.50

Nestl offers to buy Perrier

EC Decision favourable to the merger

Agreement between Nestl and EC

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QUESTIONS FOR DISCUSSION

1. Discuss the product market definition by the EC. Do you agree with this definition? Which test did the EC follow to define the relevant product market? Relate your answer to the concepts of supply and demand substitutability. Is there another market definition that you would have considered possible and reasonable in this case? If yes how the final decision of the EC would have been affected by this alternative market definition? Discuss the level of concentration of the industry in the relevant market. Compute the market shares and HHI before and after the merger. Compute also the HHI after the merger but without the conditions imposed by the EC to see how this condition affected the final market structure. The EC challenged the operation on the basis of joint dominance. Do you agree with the EC? Justify. What about single-firm dominance? Would you say these are potentially important? Relate your answer to the significant lessening of competition test and the dominance test. What do you think of the EC decision allowing the transfer of Volvic to BSN? Discuss your answer in relation to both, single firm dominance and joint dominance. Is buying power a significant constraint on the potential power of sellers? What is your opinion on the efficiency gains of the merger? In particular, do you think that synergies in marketing and advertising could be important? Could they affect the level of prices in the industry? What is you interpretation of the evolution of the stock market data? How would you relate this evolution to the pro and anti-competitive effects of the merger? What is your overall conclusion of the decision taken by the EC?

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REFERENCES
European Commission. 92/553/EEC: Commission Decision of 22 July 1992 relating to a proceeding under Council Regulation (EEC) No 4064/89 (Case No IV/M.190 - Nestle/Perrier. Official Journal L 356, 05/12/1992 pp. 0001 0031. Lexecon. 2003. An Introduction to Quantitative Techniques in Competition Analysis. Neven, D.J., R. Nuttall and P. Seabright. 1993. Merger in Daylight: The Economics and Politics of European Merger Control. London: CEPR. Sutton, J. 1991. Sunk Costs and Market Structure. Cambridge, MA: MIT Press.

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