COLA WARS CONTINUE: COKE AND PEPSI IN 2010
Binda Riccardo (829968) Datta Lucille (832610) Favero Marco (832363) Grimani Carlotta (829888) Mortandello Elisa (832356) Simioni Giulia (832353) Taglia Linda (832397)
Binda Riccardo – Datta Lucille - Favero Marco -Grimani Carlotta - Mortandello Elisa - Simioni Giulia - Taglia Linda
1. Why, historically, has the soft drink industry been so profitable? Evidence shows that CSD industry has been for decades a profitable industry, nevertheless what really matter for us is to understand the reasons behind the success of this business. In order to grasp why historically CSD business was so attractive, we have to analyse the industry landscape i.e. its structure and its main features. Researches and studies made in the past, in fact, demonstrate that there is a strong relationship among firm profitability and the sector in which it operates. The opportunities and threats of the specific environment shape and affect company performance understood as profitability, efficiency and innovation. In the following we will analyse the CSD industry in the period from 1970 to 1990 through the “5 Forces” model. This framework explores the main forces affecting an industry which are rivalry, new entrants threat, substitute products, suppliers and buyers' power. Remember that there is a negative relationship between these forces and the profitability of the industry (e.g. when rivalry increases the business is no longer so attractive as before). We start our analysis considering RIVALRY. Industry concentration as well as continuous growth and product diversification contribute to smooth competition with existing competitors. The CSD business consists mainly of two dominant companies Pepsi and Coke which hold the majority of the market shares, and other few small firms (see EXHIBIT 2). This means that it is easier to reach natural collusion and is more difficult to compete on prices. The two giants can fix price threshold (coordinated price changes) and threat small companies. The Cola war in fact aims to strengthen and enhance advertising, marketing, distribution network and product diversification instead of focusing on prices. Concerning growth we can say that in the period under observation the US and world consumption of CSD grew by 3% yearly (see EXHIBIT 1). On the other hand one factor that contributes to foster rivalry is the presence of high barriers to leaving the market. These barriers arise for two main reasons: 1) the bottlers face huge fixed costs as manufacturing plants need great investment, so they cannot exit the market before recovering these costs 2) bottlers are bound by binding contracts to concentrate producers, it is difficult to escape from these relationship (even if margins and gains of the bottlers are low). If the rivalry issue is quite strong, on the other hand the threat done by NEW ENTRANTS is very low. Coke and Pepsi are protected by strong entry barriers which makes it very difficult for new companies to penetrate the business. Institutional barriers consist in legal protections such as trademarks and patents. Structural barriers in CSD industry derive from the fact that the two “giants” 1) exploit economies of scale 2) have the exclusivity of the distribution network 3)incur huge expenses and efforts in marketing and advertising their product (this is not possible for new entrants which have little capital to invest) 4) have the ability to establish lasting and strong relationship with their suppliers and bottlers. Coke and Pepsi have the opportunity to rise also strategic barriers through 1) loyalty of customers and deep brand recognition 2) triggering a strong response to new entrants with price war and launch of new products. Lets consider now another industry force. Despite the wide range of beverages offered by the market as alternative to CSDs (tea, coffee, wine, bottled water, juices,..) and the very low switching costs, the threat of SUBSTITUTES in the period that we analyse is quite weak. The reason why consumers prefer CSDs to other products is that they are perceived as unique (we will see that this is no longer true from late 1990 as buyers will change their tastes toward healthier drinks and their propensity to buy CSD will drop). Moreover substitutes cannot compete with soft drinks producers like Coke and Pepsi as they have well established businesses and brand, customers are loyal, they invest in vigorous advertising campaigns and their products are affordable for everybody. The last piece of the puzzle is to understand whether SUPPLIERS AND BUYERS have POWER in the industry. Suppliers' power is very weak as there is few concentration, the raw material supplied is easily available in the market and has a low cost (concentrate producers can obtain it from different sources and switching costs are null), lot of substitutes are available (for example the packing can be made of plastic, can, glass) and most important the suppliers are dependent from soft drink industry which is the major buyer of their goods. The buyers' power is in the hands of 1) final consumers: they have no switching costs but they are brand-loyal and their demand is price inelastic 2) retailers: they have significant switching 1
Binda Riccardo – Datta Lucille - Favero Marco -Grimani Carlotta - Mortandello Elisa - Simioni Giulia - Taglia Linda
costs as the major brands attract customers into their stores, nevertheless they have moderate purchasing power as they buy in bulk and have good information about prices (so they are able to evaluate potential substitutes), moreover they can influence final consumer's decisions for example using marketing and advertising tricks. Analysing the 5 forces in an overall perspective we can notice that only rivalry and buyers' power can be potential threats for the industry, conversely new entrants, substitutes and suppliers' power are not so strong to undermine the attractiveness of CSD business. We can conclude saying that the structure of soft drink industry fosters high profitability. 2. Economics of the concentrate business compared to bottling business: why profitability is so different? Concentrate producers and bottlers are the two main figures which represents the Carbonated Soft Drink (CSD) Industry. Coca-Cola and Pepsi “claimed a combined 72% of the U.S. CDS market’s sales volume in 2009”: they’re among the most important concentrate producers in the world. Concentrate producers mix raw material ingredients and package the mixture in plastic canisters then they ship them to the bottlers. The latter in fact are the ones who purchase concentrate and add carbonated water and sugar to it, they bottle and can the product and deliver it to retailers and consumers in general. Economics of these two players are quite different and this leads to some meaningful differences in their profitability. First of all there is a discrepancy in the investment in capital: while the concentrate producers invest only few in capital and in machinery, bottlers operate in a very capital intensive industry, usually fighting against expensive investments as for example in even more efficient production lines (high speed production lines). The costs beard by them are different: bottlers should pay a lot of money for packaging, labor, general overhead and invested capitals (i.e. trucks, distribution networks) while concentrate producers ‘ costs are about advertising the brand, promotions, market research and support. Analyzing this aspect it is easy to understand that the responsibility differ between the two figures: the concentrates producers are responsible for brand promotion and investment in trademark, their risks are greater since the bottler’s business depends by theirs: if the brand is not well advertised and appreciated by people, bottlers cannot aim at gaining the consensus of consumers and sell products. This is one important factor that causes difference in profitability. But there is a more important one: the business model in which they operate. Concentrate producers work with the franchising principle, they negotiate with the retailers and they are the FRANCHISOR. Bottlers instead, are the FRANCHISEE and they pay the concentrate producers to enter the bottling network. The former can decide what price to impose, adjusting it with inflation, the latter should depend on them paying the price imposed. This difference is very significant for determining profitability difference: concentrate producers still have higher returns. In the history there have been two important contracts between bottlers and main concentrate producers as Coca-Cola and Pepsi: the Master Bottler Contract (1987, between Coca Cola and its bottlers) and the Pepsi ‘s Master Bottling Agreement (between Pepsi and its bottlers): both aimed at letting great concentrates set the price for bottlers. Another important aspect which should be underlined is the fact that there still be greater competition among bottlers than concentrates producers since the former are present in a much higher number in the market. Less competition for the concentrate producers make it less difficult to them to increase profit. Looking at some statistical data1 it can be noticed that the concentrate producers’ gross profit (expressed as percentage of net sales) is 78% compared with the one of bottlers which is 42%. The most 1
Source : Compiled from estimates provided by beverage industry source, October 2010.
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Binda Riccardo – Datta Lucille - Favero Marco -Grimani Carlotta - Mortandello Elisa - Simioni Giulia - Taglia Linda
expensive expenses for concentrate producers are the general and administrative ones (25%) while for bottlers, as said before, the selling and delivery ones (18%). The operating income differs a lot between the two players: the concentrate producers’ one is 32% (as percentage of net sale) while the bottlers’ one is 8%. It is clear also from this specific analysis that concentrate producers earn more than bottlers but anyway another thing is sure: no one of the two could live without the other. 3. How has the competition between Coke and Pepsi affected the industry’s profits? The two companies experienced their own distinct ups and downs; Coke suffered several operational setbacks while Pepsi charted a new, aggressive course in alternative beverages and snack acquisitions. Talking about the goals of Coke and Pepsi might be a good way to interpret the competition along this Coke War. On one side, Pepsi: modernized plants and improved store delivery services, built bottles with larger size, very popular among families. Furthermore, during Great Depression, the price of its 12-oz bottle was a nickel (w.r.t. 6.5-oz bottle of Coke). Pepsi also redesigned a new logo, which cost over $1billion (2008) as a new market strategy. On the other side, instead, Coke: had independent franchised bottlers, which obtained greater flexibility and the advertisement of its brand (between 1981 and 1984).Coke also switched to high-fructose corn syrup (a lower-priced alternative of sugar). As well as Pepsi, in 1985, Coke changed the 99-year-old- Coca-Cola formula (big fail: they switch again back with: Coca Cola Classic); later on, the new name was: Coca-Cola (2009). Both Coke and Pepsi strategies had (and currently have) the goal of earning more than other competitors (like Dottor Pepper’s for example).The competition between this two important firms also reached the diversification point, as a corporate growth strategy in which a firm could expand its operation by moving into a different industry. First the products have been diversified and launched into the CSD’ market: Coke with Fanta (1960), Sprite (1961), Diet Coke (1982), Caffeine-Free Coke (1983), Cherry Coke (1985) while on the other side Pepsi counted with: Teem (1960), Mountain Dew (1964), Diet Pepsi (1964), LemonLime Slice (1984), Caffeine-Free Pepsi-Cola (1987), tea Lipton (2004). Despite some success with diet drinks, Coke and Pepsi realized that growth would involve «noncarbs» and also bottled water, so they tried to diversify also into non-CSD’ market: they both moved into the bottled-water segment of the market with Aquafina (by Pepsi in 1998) and Dasani (by Coke in 1999). The last chance to diversify was with the energy sports drinks: PowerAde (by Coke) and Gatorade (by Pepsi). This is because, energy sport drinks commanded premium prices and were usually chosen for immediate, single-serve consumption. Furthermore the average case price is was of $34.32 compared to CSD’s $8.99! However, declining CSD sales, declining cola sales (volume of beverage was down from 81% in 2000), and the rapid emergence of non-carbonated drinks appeared to be changing the game in the cola wars: this is the new side of “Cola Wars”. However, along this “Cola War” they (Coke and Pepsi) had been largely criticized for their environmental and health policies. This damaged a lot their images and also their industry’s profits. Anyway they also tried to expand to foreign countries in order to increase and internationalize their distribution as a way for increasing profits. The diversification process has increased for sure the shareholder value. On one hand, there is the answer to the “better-off test” because the diversification produced opportunities for synergies and 3
Binda Riccardo – Datta Lucille - Favero Marco -Grimani Carlotta - Mortandello Elisa - Simioni Giulia - Taglia Linda
then the overall company was better off (in this case, Pepsi is a clear example). On the other hand, there is the answer to “the best-alternative test” made of the contracts, licenses and joint-ventures side of the diversification (Coke has been dominant in this part).
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