Finding a niche
How Dakota Growers Pasta co-op found success in a highly competitive market
By Michael Boland and David Barton
Editor’s note: Michael Boland is an associate professor of agricultural economics at Kansas State University in Manhattan, Kan. David Barton is professor of agricultural economics and Director of the Arthur Capper Cooperative Center at Kansas State University.
Dakota Growers Pasta (DGP) is a defined- (or closed) membership cooperative organized in 1991 as a vertically integrated operation that assembles its members’ durum wheat, mills durum wheat into semolina, produces pasta from semolina and markets the pasta. DGP’s success in adding value to its members durum has made it one of the nation’s more noteworthy “new- generation” cooperatives and one which other grower- owned cooperatives are attempting to emulate.
It has succeeded in a highly competitive industry characterized by wide swings in the price and availability of the key input: durum wheat. The price paid to memberproducers for durum wheat has been substantially higher than the market price once the processing net margin is distributed to members. The net earnings of DGP and net price received by members appear to influence the market price of stock.
DGP’s earnings on a per bushel, or per share, basis increased from 1994-1998 and then declined in 1999-2000. Year-to-date results for the first two quarters of 2001 were negative, but it is projected that it will turn a profit again for the last two quarters of 2001. Dakota Growers Pasta continues to face significant competitive challenges. Following is a description of the competitive environment in which the co-op operates and its history, based on a soon-to-be published case study of Dakota Growers Pasta.
Grower marketing agreements are commonly used by closed-membership, or new-generation, cooperatives as a mechanism to acquire member-producer commodities that the cooperative processes into finished products. These contractual agreements create a delivery right and an obligation for members. Members are required to purchase one share of stock for each commodity unit (such as bushels of a crop or number of animals) which they want to deliver and sell annually to the cooperative. The total number of shares sold usually matches the capacity of the processing plant.
The stock is an investment and asset that can be privately traded or exchanged between eligible members at a negotiated price. This means the stock price can appreciate or depreciate in value from the initial issue price or subsequent exchange price. However, the stock is always carried on the balance sheet of the cooperative at its nominal issue, or book, price. And it is carried on the balance sheet of the member at the purchase, or exchange, price.
Over time, the stock market price increases and decreases in value due to privately negotiated agreements. Producers often have questions about what causes these changes in prices. This article is based on a cooperative agreement research study funded in 1998 by the Rural Business-Cooperative Service of USDA Rural Development. The study sought to evaluate changes in stock prices of two closed-membership cooperatives, one of which was Dakota Growers Pasta.
Dakota Growers Pasta (DGP) used grower agreements with its members which obligate producers to deliver one bushel of high-quality durum wheat for every unit of stock. Stock was initially offered at $3.85 per bushel and conveyed a right and an obligation to deliver durum wheat as specified in the growers’ agreement. The growers’ agreement obligated each member to deliver a set amount of durum wheat to the cooperative from their own production, based on the number of shares they had purchased. If the member could not supply the wheat with the desired quality, DGP would purchase the wheat on behalf of the member and charge them purchase or the current market price, plus a service fee.
In order to best understand why the value of stock changes over time, it is useful to conduct a competitive analysis of the industry and then examine the individual firm’s actions within that competitive environment. In addition to DGP’s vertically integrated durum milling and pasta manufacturing plant in Carrington, N.D., the cooperative also operates a second pasta plant in Minneapolis, Minn., which it acquired in 1997.
Porter’s Five Forces economic model will be used below to analyze competition in the durum milling and pasta manufacturing industries. Rivalry between firms, barriers to entry, substitute products and the competitive power of buyers and sellers are five forces that affect an industry and, ultimately, influence a firm’s profitability within that industry. Availability of substitute products is not a major influence on this industry, so it is not included in the following discussion.
Buyers include retail supermarkets, food service providers and food manufacturers that use pasta as an ingredient in other processed foods. In the case of non-vertically integrated firms, buyers are pasta manufacturers that purchase semolina flour and process it into pasta product. Ultimately, consumers represent the final buyer based upon their demand for pasta.
Pasta consumption in the United States was relatively stable between 1967 and 1984, at approximately six-to-seven pounds of durum wheatbased food products (pasta) per capita. Since then, U.S. pasta consumption rose about one pound per year, reaching a maximum of 14 pounds per capita in 1994, and then decreasing slightly.
The U.S. Department of Agriculture (USDA) notes that there are four primary reasons for the per capita increase in demand for pasta: changing lifestyles, increased availability of pasta sauces, increased attention to healthy eating and increased numbers of Italian restaurants. In addition, the number of American households with two working parents has increased, leading to changes in where and how meals are prepared and eaten.
Meals that are healthy, easy and relatively quick to prepare have become commonplace, and pasta fit this description. The abundance of prepared sauces has served as a “complementary catalyst” and has improved the quality and variety of the choices available for consumption.
The increase in the number of Italian-style restaurants fueled the growth in the food service sector of the pasta industry. Italian food has become a mainstream food, evident by the growth in the number of Italian restaurants. Consumers are eating outside the home more often, they are eating healthier foods, and per capita incomes are increasing, causing the uptrend in restaurant numbers. Americans spent 46 percent of their food expenditures on away-from-home meals in 1998, up from 34 percent in 1970 and 39 percent in 1980.
Five billion pounds of pasta (4.5 billion in dry pasta and 0.5 billion in frozen and fresh pasta) were consumed in 2000, compared to about four billion pounds in 1992. The 2000 total value was $2.6 billion. There are four principal dry pasta market segments: ingredient (which accounts for about 43 percent of the market), private and brand label retail (37 percent of the market), food service (10 percent) and government bids (10 percent).
Within each segment, there are both private-label and brand-label products. Private-label products are products manufactured by a firm that had another firm’s label on it. For example, a company such as Mueller’s which has brand assets, but no manufacturing assets, would contract its brand production with a company that had manufacturing assets, such as American Italian Pasta Company.
Within the retail market segment, private-label pasta had been growing at a faster rate than brand-label pasta as private labels increased from 19 percent to almost 24 percent of the market from 1994 to 2000. In the ingredient market segment, 75 percent is manufactured by firms for their own internal needs, with the remainder being purchased on the quality specifications needed in their products. About half the food service market segment is private label and the government market segment is considered brand label.
Bargaining power of suppliers
Durum wheat is the only wheat that can be used for pasta due to its high protein percentage, which is higher than any other type of wheat. Poorquality durum results in pasta noodles that break easily, causing problems in packaging. North Dakota, eastern Montana, northwestern Minnesota, southern Alberta and southern Saskatchewan are the primary production regions due to cool nights and warm, but not hot, summers that are ideal for durum wheat. Although durum wheat is also grown in Arizona and California, the northern Great Plains states are expected to remain production leaders in the future.
One major problem in 1999 and 2000 was the poor quality of the durum wheat. The poor quality was caused by scab disease problems in early-planted durum and sprout damage from rain and frost at harvest. The poor quality caused millers to remove more screenings (which became mill feed and was used as an ingredient in feed rations) from the durum wheat. Thus, more durum wheat was needed to manufacture a unit of pasta, which increased costs. Consequently, millers imported durum wheat from Canada and other regions rather than using North Dakota wheat.
Rivalry between firms
This industry has undergone change as large pasta firms, which had produced both private label and brand label, have exited private-label production to focus strictly on their core brands. Some retailers prefer private label because of higher margins and greater control of merchandising. Although there is no direct evidence, retailers and pasta manufacturers believe that consumers prefer “Italian” brand names and regard imported Italian pasta as higher quality. Thus, some firms are beginning to develop domestic pasta with an Italian brand name. The perceived quality of a brand is related to its image as well as product characteristics such as shorter cooking time, ease of cleaning (e.g., less stickiness inside a pan), and innovative products that are easy to prepare and convenient to use by consumers.
Through lower-cost technology, new entrants in the pasta industry have focused on innovative products and manufactured them as private-label products for other firms that have brands. Thus, private-label brands are becoming more competitive because they have higher quality product attributes and are priced competitively. Price competition among retail brands lowered the average price of retail-brand pasta by the end of the 1990s. Thus, the price differential between private-label pasta and brand label-pasta declined, slowing private-label pasta growth.
Barriers to entry or threat of new entrants
Thirteen major companies milled durum wheat in the United States in 1991 when DGP was organized, but there have been significant changes since then. Well-known firms have exited durum milling (such as Pillsbury and Cargill) and new firms have entered (such as American Italian Pasta Co. and Dakota Growers Pasta). By 2001, Italgrani USA, Harvest States Cooperatives and Miller Milling Company comprised about 60 percent of total U.S. durum milling capacity. Durum milling plants have traditionally been located near durum wheat production or in regions with favorable rail transportation access to North Dakota. Milling capacity increases kept pace with consumption in the early 1990s but outgrew consumption by 1995. Capacity then began to decline as older and higher cost plants began to be shut down (Figure 1). By the late 1990s, capacity was concentrated in Minnesota and North Dakota, and in Midwestern states such as Missouri that are on a direct rail line to eastern North Dakota.
There are currently 141 pasta plants that manufacture dry pasta in the United States, but 67 of those plants accounted for the majority of pasta sales in 2000. The industry changed with the entry of vertically integrated firms, such as American Italian Pasta Company (AIPC), which had little market share in 1991 but had the largest production capacity by 1998. The main U.S. pasta manufacturers, with about 55 percent market share, are: Hershey Foods, AIPC, Borden Food Holdings Co., DGP, Philadelphia Macaroni Co., A. Zerega Sons Inc., and Gooch Foods (owned by Archer Daniels Midland).
Another 25 percent of market share is owned by companies that produce pasta for their internal needs, such as Kraft Foods, General Foods Inc., American Home Foods Products, Con Agra Inc., Pillsbury, Campbell Soup Co. and Stouffers Corporation. In 2000, Barilla, an Italian pasta manufacturer, built a plant in Iowa.
Pasta imports increased in the 1990s but leveled off when a trade ruling found that several Italian pasta companies were importing U.S. durum wheat and selling pasta to the United States at prices below their marginal costs (i.e., dumping pasta). Imports in 2000 represented another 13 percent, while total domestic capacity was estimated at 3.8 billion pounds per year.
General conclusions about competition
The change in durum milling capacity and geographic location, coupled with imports had increased durum wheat and semolina flour price volatility in the late 1990s. The Minneapolis Grain Exchange established a durum futures contract in February 1998, but it is not widely used due to lack of liquidity. Durum wheat prices rose because of increased demand for pasta and lower production yields in North Dakota due to disease problems. In addition, the increase in milling capacity in the late 1990s has helped increase demand for durum wheat, which increased durum prices. As durum and semolina flour prices rose and pasta demand began to plateau, pasta manufacturers found it more difficult to pass along higher input costs and their margins began to decline (i.e., pasta prices declined). By 1999, durum milling capacity was greater than pasta demand.
History of Dakota Growers Pasta
The 1,084 members of DGP are durum wheat producers who operate in the states of North Dakota, Minnesota and Montana. Dakota Growers Pasta’s state-of-the-art durum wheat mill and pasta production facility in Carrington, N. D., was completed in 1994. The cooperative has gone through many changes since its inception (Table 2). The company uses its semolina in its own pasta production process. The vertically integrated facility consists of a grain elevator, a mill, four pasta production lines, two of which manufactured short goods (such as macaroni) and two of which produced long goods (such as spaghetti), and a warehouse to store the finished goods.
The cost savings from integration provide a competitive advantage relative to other firms. Dakota Growers Pasta has become successful in a very short period of time and it became the third largest pasta manufacturer in the United States (Table 1). Members have received patronage refunds in every year since 1996. In addition, a threefor- two equity stock split was declared in July 1997. The company has remained profitable during its brief history by increasing the value that members received for their durum wheat relative to non-members in North Dakota who did not invest in DGP.
Because the plant had lower costs relative to others in the industry, it increased its market share and, hence, net income. Qualified cash patronage refunds and non-qualified retained patronage refunds per share since 1995 are shown in (Figure 3).
In the beginning, DGP focused mainly on the private-label business because that was the quickest way to enter this industry. During the plant’s first two years, it produced, among other things, pasta for other companies that were short on inventory due to unexpected demand or because of a shortage of durum wheat (this was called co-packing). However, DGP’s sales increased to where co-packing was less than 1 percent of sales. The retail private-label and ingredient market segments comprised the bulk of DGP’s sales. Branded pasta products represent an important market segment for the company. Approximately 60 percent of its business is retail (primarily private label), followed by 20 percent in food service, and 20 percent in the ingredient market. The majority of DGP sales are under private label although it has its own label, Dakota Growers, as well as Pasta Sanita and Zia Briosa.
Dakota Growers Pasta had grown so fast that the Carrington plant was already running at maximum capacity by 1997. The firm would not be able to sustain any new growth without additional capacity. In 1997, DGP acquired Primo Piatto, which owned two pasta plants in Minneapolis, Minn. The plants produced 200 million pounds of pasta per year.
Dakota Growers Pasta continued to meet customer demand for additional pasta products. In 2000, DGP began a certified organic pasta product line. In addition, the cooperative entered into an agreement with the second largest Italian pasta manufacturer, Gruppo Euricom, to serve as its exclusive distributer of private-label and brandlabel retail products and food service products in North America. Finally, DGP’s main brand, Dakota Growers, underwent an image change as the brand began to penetrate more markets outside North Dakota and Minnesota.
The members of Dakota Growers Pasta also voted to change its bylaws to enable Canadian producers or associations to become members and to purchase stock in DGP. The rationale is that as members retire, some may want to transfer their shares to other members. However, under current import restrictions, Canadian members are not allowed to deliver Canadian-produced durum wheat to DGP’s U.S. facilities. In addition, the poor quality of North Dakota-grown durum wheat in 1999 and 2000 increased DGP’s procurement costs, because many of the co-op’s members’ wheat crops were of poor quality, forcing DGP to purchase high-quality durum wheat from other sources.
In 2001, DGP signed an agreement with Semolina Specialties, a producerowned cooperative in Crosby, N. D. Semolina Specialties produces hard-tomake pasta specialty products and flavored pasta products. Under that agreement, DGP sold the pasta equipment from one of its two plants in Minneapolis to Semolina Specialties in exchange for $50,000 worth of preferred stock and $1 million in cash. The equipment from the Minneapolis plant (which was then closed) was installed in the Crosby plant. Dakota Growers Pasta also was to supply 35 million pounds of semolina flour and assume marketing of the Semolina Specialties pasta products.
In 2001, first and second quarter earnings were lower than in previous years due to the higher costs of procuring high-quality durum wheat, as well as to increased energy and other input costs. The inability to pass along price increases due to excess capacity within the pasta industry has also hurt earnings. The cooperative anticipates a return to profitability later in the year.
The value of marketing rights or growers agreements changes in response to a cooperative’s own profitability and the industry conditions in which that cooperative operates. In the case of DGP, the value of its stock reflects the cooperative’s profitability due to its competitive advantage from vertical integration and use of producer equity. Increases in industry capacity, entry and exit of durum millers and pasta manufacturers, slower growth in pasta consumption, increased use of private-label brands, and poorquality durum wheat changed industry conditions and caused greater rivalry among competitors. This increased rivalry caused changes in DGP’s stock price, as can be seen in Figure 2.
Authors’ note: This article is based on an extensive case study that will be published in the Case Research Journal later this year. We would also like to thank Tim Dodd, chief executive officer of Dakota Growers Pasta, and his staff for cooperating with us in this case study. We would also like to thank Tom Stafford and USDA Rural Business Cooperative Service for assisting us with this cooperative