Betting on organic tea
One bottled-tea company converts its entire product line to greener tea.
by Samuel Fromartz, FORTUNE Small Business contributor

(FORTUNE Small Business) - At the R&D facility of Honest Tea, brewmeister Michael Petrone passes around samples of a new organic tea. Petrone, just 24, joined the company as an intern last year and rose quickly to a full-time job as development and production coordinator, responsible for creating new flavors. He doesn't wear a white lab coat and only recently completed his bachelor's degree in food science.

In fact, calling this an R&D facility is a stretch; the space is just a cramped kitchen in the corner of Honest Tea's nondescript Bethesda, Md., headquarters. Yet the spartan offices mask the company's success - in a highly competitive market it has rocketed to $9.5 million in annual revenue in just seven years and broke even in 2005, thanks in part to a radical decision it made a few years ago to switch its entire line to organic teas.

"I think we've got it!" says Honest Tea co-founder Seth Goldman, 40, as he sips Petrone's latest concoction. The tea blend has no sweetener, but it's light--refreshing, even. The label reads Just Black Tea, a play on the purity of the brew, made from organic plants grown without chemical pesticides or fertilizers. (It's also certified as a "fair trade" product, a distinction important to customers concerned about the livelihood of workers who handpick the leaves in places such as China, India, South Africa, and Sri Lanka.) Goldman and Petrone refined Just Black Tea, along with a green tea version, right up until production began in February; it appears on store shelves this spring, Honest Tea's 24th flavor.

Although organic foods and beverages account for just 2% of the $460 billion in U.S. food sales each year, they have become the market's fastest-growing segment: Sales have risen at a double-digit rate for the past few years--and 19% in 2005 alone, according to industry tracker A.C. Nielsen.

Organic food might have started as the venue of back-to-the-landers, farmers trying to sell wilted vegetables in health-food stores, and artisans making tofu by hand, but it has come a long way since. Today even big players such as Kraft (Research) (owner of Boca Burger), Heinz (Research) (with a line of organic ketchup), and Kellogg (with its Kashi cereals) offer organic products.

Nearly 60% of Americans say they take health into account when buying food, and about 30% of Americans say they buy organic food regularly. (That percentage has held steady since 1999, but more organic food is sold every year, suggesting that the core customers are increasing their purchases.)

The market got a boost when the USDA rolled out the "organic" seal with great fanfare in 2002. "That was huge," Goldman says. "You see the organic seal on milk, fruits, meat, and all of a sudden it's a symbol that has equity to it." That symbol is on every bottle of Honest Tea.

Goldman was first to the organic bottled-tea market, where Honest Tea now accounts for 64% of all sales. Its revenues are puny by the standards of the $47-billion-a-year carbonated soft drink industry, but Goldman considers that a blessing. He isn't battling for a share of the sugary soda market, which requires huge marketing budgets and is shrinking by about 2% a year. Sales of all bottled tea have grown tenfold over the past decade, and increased about 20% in 2005 alone, a year in which Honest Tea's sales jumped 67%.

Not surprisingly, Goldman's biggest retail account is Austin-based Whole Foods Market (Research), the $4.7-billion-a-year supermarket chain that specializes in natural and organic products. But he has also made inroads into some nonorganic chains--Honest Tea is on the shelves at Target (Research)--and he is now trying to ramp up sales through regional beer distributors.

"He's hit a kind of tipping point," says Gary Hirshberg, CEO of yogurt company Stonyfield Farm, which is owned by the French food conglomerate Groupe Danone (Research). (Stonyfield invested $900,000 in Honest Tea in 2002 for a 10% stake in the privately held company.) "There's just a certain amount of dues paying you've got to do. I don't mean just paying slotting fees or kissing distributors' feet, but a learning curve over a long time."

But while the organic niche might seem, in hindsight, like a no-brainer, it took brains and guts to get it right. Honest Tea had to find sources for organic ingredients, offer customers a brew both tasty and pure, and create an identity that clearly stood apart from the Liptons and Cokes of the world--none of which proved easy.

Like many organic entrepreneurs, Goldman started out with a solid grasp of his ideals but less knowledge of how to navigate a P&L statement. After college he worked at a nonprofit and then enrolled in the Yale School of Management, hoping to learn how to pursue both principles and profits. His eureka moment came in 1997, after a jog with a friend in New York City's Central Park. They went to a corner bodega and found shelf after shelf of bottled water and sugary sodas, but nothing in between.

Goldman e-mailed one of his professors at Yale, Barry Nalebuff, saying it might be time to launch a less sweet beverage, though he was unsure what that might be. Nalebuff, coincidentally, had been studying the tea trade in India and had come up with a company name, Honest Tea, but had no product. They partnered to launch the business in 1998, raising $500,000 from family and friends, a figure that has since grown to $8 million in financing from angel investors and industry players such as Stonyfield Farm. Nalebuff, who still teaches business strategy at Yale and consults with other companies, is Honest Tea's chairman. "It's deeply satisfying to be making a real product," he says.

In the beginning, the pair worked out flavors and tested them at trade shows. "I was hauling around duffel bags of bottled tea, while my friends were jetting around the country working for dot-coms," Goldman says. Nalebuff emphasized that the product should be made with real tea, not the syrups or concentrates other producers use, a demand that made some manufacturers balk, as tea leaves are difficult to handle in assembly lines.

After visiting a dozen potential partners, Goldman and Nalebuff finally found a plant willing to make tea the way they wanted it (they now use Castle Copackers in New Kensington, Pa.). The company soon had five flavors and a deal with Whole Foods, and the brand quickly became the chain's top-selling bottled tea.

Goldman constantly searched for ways to differentiate his product in a market dominated by drinks such as AriZona Iced Tea, Snapple, SoBe, and Tazo (a startup acquired by Starbucks in 1999). Using real tea leaves and reducing the sugar helped, but the natural next step was to seek out organic ingredients.

What does it take to go organic? The term is regulated under federal law by the U.S. Department of Agriculture, which has published a 500-plus-page rule book governing everything from the proper method of making compost to the way a "processor" such as Honest Tea must formulate its product.

Under those rules, 95% of the ingredients of a product by weight, excluding water and salt, must be organic in order to use the word on the label. The remaining 5% may come from a limited number of approved nonorganic ingredients, such as citric acid, which helps prevent the growth of bacteria. (Although some of Honest Tea's flavors are 100% organic, others range from 96% to 99%.)

Goldman began by launching just one organic flavor and started looking for tea raised according to those precepts. He quickly realized that he would have problems finding a consistent, high-quality supply. Although organic milk and produce had been growing in popularity in Europe and the U.S. throughout the 1990s, tea plantations in India and China (where most of the world's supply is grown) hadn't made the switch. Early on, Goldman says, "the only thing that we could reliably source was organic sugar," because it was used in higher-volume organic products such as soy milk and yogurt.

In the mid-1990s, however, media reports about pesticides in tea started appearing in Europe, particularly Germany. Among the detected residues was DDT, banned in the U.S. since 1972. With tea subject to as many as 125 pests, common nerve-toxin pesticides such as organophosphates also showed up. Although producers argued that the levels were not harmful, German tea consumption fell by a fifth. Demand also declined in India and China, as younger consumers switched to soda. "Many smaller estate holders were really struggling," says Anupa Mueller, founder of wholesale tea importer Eco-Prima in Ossining, N.Y.

To address the glut in supply, tea growers began to switch to organic production. Mueller's brother-in-law was one of the first to go organic, converting his family's 1,500-acre Makaibari estate in Darjeeling, a premier tea-growing region in northern India. After the pesticide reports appeared, 20 of the 75 tea estates in Darjeeling followed suit, along with others in China and Sri Lanka. (Goldman uses Makaibari tea from Mueller's brother-in-law for the Peach Oo-la-long flavor.)

In addition to finding organic ingredients, Goldman had to be certified as an organic processor. When Honest Tea came out with its first organic flavor in 1999, First Nation Peppermint, made with organic mint grown in the U.S., he located a nearby nonprofit certifier called Pennsylvania Certified Organic. PCO is one of 56 domestic and 41 foreign entities accredited by the USDA to certify products. Certifiers, which may be for-profit companies or state agencies, charge on a sliding scale. (Honest Tea pays PCO 0.1% of sales, or about $11,000 a year based on 2005 revenues.) There are no restrictions on which certifier a company must use, as long as it is USDA-accredited.

Staffers from PCO visit Honest Tea's plants each year to make sure the company is manufacturing to organic specifications. This means organic and nonorganic products cannot be manufactured at the same time. Factories flush out the lines with hot water and a sanitizing agent approved by the organic regulations before any organic product is made. Organic regulations also limit the pest-control methods manufacturers can use in their plants, barring chemical pesticides, for example.

The certifier checks all Honest Tea's paperwork regularly to make sure its ingredients are certified. Like processors, organic farms must be visited by USDA-accredited inspectors every year--even the ones in Darjeeling. Once a tea estate is certified, it must send copies of its certification documents with every export shipment.

After its first stab at a fully organic tea, Goldman decided to convert the rest of the Honest Tea line; each flavor required separate certification by PCO to ensure that it met organic requirements. Although a ton of organic tea can cost $5,000, compared with $3,500 for a conventional shipment, cost was never the major issue, because tea leaves make up less than 4 cents of a bottle's $1.29 total cost. The biggest expense, at 18 cents, is the cost of the 16-ounce plastic bottle.

That isn't always the case. Otter Creek Brewing, a beer company in Middlebury, Vt., ran into pricing issues with a line of organic beer. Organic hops were unavailable domestically, and organic barley cost about twice as much as conventionally grown hops. At first Otter Creek accepted lower margins on the beer, but as organic food grew more popular, the company found that it could charge a premium for the product, raising the retail price from $6.99 for a six-pack to $8.49.

Goldman also faced the challenge of converting his existing varieties to organic production. For the company's most popular flavor, Moroccan Mint, he replaced the refined mint oils with organic peppermint and spearmint leaves and bought organic Chinese green tea. Although he was nervous about tinkering with the top seller, "the flavor actually improved," he says, and sales of the product posted double-digit gains after the switch. He also found that his production costs declined, because the new formula was cheaper to produce, even with the new ingredients. The tea in each organic batch of Moroccan Mint (about 5,000 gallons, or 20,000 16-ounce bottles) costs about $408 to make, 8% less than the ingredients cost before the change.

Other steps have not gone as smoothly. When the USDA rules took effect, they banned the use of malic acid, a stabilizer that kills bacteria. Honest Tea had to switch to citric acid, which required tweaking flavors to tone down the tartness and citrus flavor. In another glitch, supplies of an organic sweetener made from agave cactus dried up when the Mexican supplier's crop failed. Goldman was forced to make do with organic sugar until the market recovered.

Honest Tea also rolled out a flavor called Haarlem Honeybush, made with an organic herb supplied by a subsistence-farming community in South Africa. (Honest Tea shared a portion of its sales with the farmers.) But a few shipments of the herb arrived moldy, causing production snafus. Worse, the slightly floral herb was unfamiliar to Americans, so bottles sat on shelves, and Goldman eventually pulled it. "It was too much about the mission and not enough about what our customers wanted," he says.

Overall the switch to organic has paid off, not only in a consistent identity for the company but also in sharply rising sales. Goldman says the key to the beverage business is distribution, but he could never have persuaded distributors to sign deals with his company without a strongly defined brand and product line.

He has recently struck deals with regional beer distributors in Chicago and San Francisco, evidence of how organic food is spreading into mainstream grocery stores. With even beefy beer delivery men playing up the organic label, Goldman wonders if he should have emphasized it more. "The seal is the real selling point," he says.

Samuel Fromartz's book, Organic, Inc.: Natural Foods and How They Grew, is being published this month by Harcourt. His website is at fromartz.com.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.