1

Cola Wars Continue: Coke and Pepsi in 2010 Business Case

17/10/2011

Table of contents:

1. Executive Summary 2. Why, historically, has the soft drink industry been so profitable? 3. Compare the economics of the concentrate business to that of the bottling business. Why is the profitability so different? 4. How has the competition between Coke and Pepsi affected the industrys profits? 5. How can Coke and Pepsi sustain their profits in the wake of flattening demand and the growing popularity of non-CSDs? 6. References

01bgfbfghfhfggregterrgert1

1. Executive Summary
The soft drinks especially the carbonated ones (CSDs) are popular drinks constituting very attractive and profitable business for more than a century. This business is capital intensive and was and still dominated for long period by few giants who has patent right of the secret formula and who gained very high brand recognition over long years especially the well known Coca Cola and Pepsi. The competition between the giants was very aggressive like a war battle without blood for all that long history causing the industry profitability to fluctuating up and down and affecting the bottlers dramatically. The rivalry in this industry was fatal for small concentrate producers as well as small bottlers and lead to merging and acquisitions that left the industry controlled by big players of huge firms. Since the year 2000, the industry is facing a big challenge with the increase if the popularity of the non-CSD drinks especially with the multiple issued warnings by the healthy organizations against the carbonated soft drinks and their healthy implications. The following analysis answers some of the most challenging questions that might illustrate the business future and the necessary actions that might be taken to save this historically successful industry.

2. Why, historically, has the soft drink industry been so profitable

With huge market size in US and worldwide, with few giants existing in the market for more than a century mainly Coca and Pepsi which control more than 70% total of market share and constituting almost a kind of duopoly market in this industry, with low product price, with perfect setup of the business, with vertical integration pattern and with the huge marketing campaigns that created strong brand names with unbelievable customer loyalty, with all of these mentioned reasons, we could argue that the soft drink industry has been, historically, very profitable For more clarification of our argument, lets use the Michael Porters five economic forces, external assessment tool to analyze the soft drink industry over long decades:

1.1. Potential Entrants

Over long decades it was very difficult for new entrants to invade the market of CSDs. Due to the nature of the business, the new entrants could be concentrate producers (CPs) or bottlers. For new entrant CPs, it was and still so difficult for the following reasons: The concentrate formula is a secret highly protected by patent and trade mark protection rights. Many counterfeiters tried to enter the market but were easily pursued by Coca Cola and stopped. Only Pepsi was able to invent its own formula and could compete with Coca. There are few major concentrate producers constituting high economics of scale. Coca Cola and Pepsi are the two major players with 72% of market share. The low cost of concentrate production and consequently the very high profit margin was in the favour of funding huge marketing campaigns by these major players and resulted over decades in creating huge customer base with very high loyalty to these brands. New entrants would not be able to compete with these strong brand names

For new entrant bottlers, it was and still so difficult for the following reasons: The bottling industry requires huge capital investment with noticeable low profit margin. The franchise agreement set up by concentrators gives exclusivity for the bottlers in their territories and consequently create barriers for any new entrants in that territories The setup of bottling industry is not encouraging for new entrants because it creates limitation to produce any other products of different shape or size and also the franchise agreement prevent dealing with other competitor products which shape the business to be one customer business.

1.2. Industry Competitors (Rivalry)

There are very few giants in the market of soft drinks. Mainly Coca Cola and Pepsi have seized the biggest market share of almost 72% for long years in addition to other few players seizing the rest of the market share. Actually it looks as duopoly market between Pepsi and Coca. The competition between these 2 big players was very healthy and played a major factor to creating the success for both companies. No other company was able to effectively compete with these two companies which make this business very profitable for more than a century

1.3. Substitutes
The soft drink, Coca Cola that was invented in 1886 suffered from very little competition of other substitutes existed by that time. Over decades many substitutes became popular and constitute a real threat to Coca Cola, Pepsi and other minor soft drink manufacturers. Examples of other threaten non-CSD substitutes are beer, milk, bottled water, coffee, juices, tea and sports drinks. By the year 2000, the increasing warnings issued from health institutions against the CSDs affected the popularity of these drinks and constitute a real threat to this industry. The giants had adopted very intelligent strategy to reduce the threat of substitutes by diversifying their offering portfolio. That was done through creating many internal substitutes of

different tastes and compositions and through the acquisition of other popular substitute brands. The reservation of greater shelf space in buyers outlets also reduced the threat of other substitutions. The bottlers had merged together forming fewer but bigger organizations to face the huge capital investment required to adapt with the new strategy adopted by their suppliers. The adopted strategy was successfully able to eliminate the threat of other substitutes.

1.4. Suppliers
The raw materials required by concentrate producers are mainly sugar and packaging which are basic commodities; this makes the bargaining power of suppliers very weak and has no effect. In case of bottlers, the CPs are their main supplier with very high bargaining power over pricing as they are the sole supplier of the concentrate but the bottlers are part of the industry production chain and there supplier high bargaining power will has no effect on the overall business.

1.5. Buyers
The buyers of soft drinks are mainly the fountains, chain stores and other food stores and supermarkets of smaller size. The bargaining power of these buyers depends on their size and their ability to providing shelf space. The more shelf space the buyers can offer the more bargaining power they have to get lower prices. Fountains: Due their huge purchases, they are the buyers of the highest bargaining power and they are able to negotiate prices to get the lowest price Chain stores: They can provide greater shelf space and hence they have also high bargaining power and can get very low prices for their purchases Other food stores & supermarkets: because they are on their own, these are the buyers of the lowest bargaining power due to their inability to providing big shelf space or making big purchase requests.

3. Compare the economics of the concentrate business to that of the bottling business. Why is the profitability so different?
Although the relation between concentrator producers and bottlers is so dependent and sharing the same end customers, the profitability for both of them is so different for the following reasons: 1. The CPs profitability based on their highly recognition brand names and their ownership of the patent of their unique formula. As a result, the CPs are suppliers to the bottlers with high bargaining power so they can set the price that guarantee profits 2. The Bottlers dont have any patents and their profitability based on their contracts with CPs which gives them exclusivity in their territories to preventing intrabrand rivalry, the contract gives them the right to produce other non-CSD products and make the cost of marketing expenses shared between them and the CPs. The bottlers are suppliers with low bargaining power to their customers who are requesting big discounts for their shelf space which lowering the profit margin of bottlers 3. For CPs, the initial capital and the cost of goods sold are not high causing the operating income to reach 32% while the initial cost and the cost of goods sold for the bottlers are very high causing their operating income to be only 8%. see exhibit 1 below

Exhibit 1 Comparative Costs of a Typical U.S. Concentrate Producer and Bottler, 2009

Net sales cost of goods Sold Gross profit Direct marketing expense Selling & delivery expense General & admin expense Operating income

Concentrate Producer Bottler Dollars per Percent of net Dollars per Percent of net case sales case sales $0.98 100% $4.63 100% $0.22 22% $2.67 58% $0.76 78% $1.97 42% $0.21 $0.00 $0.24 $0.30 21% 0% 25% 32% $0.45 $0.85 $0.31 $0.36 10% 18% 6% 8%

4. The production of new CSD or non-CSD beverages by CPs for rivalry reasons is at very low cost for them while it requires new production line expansion by bottlers which is very costly. This results in increasing profitability for CPs while decreasing profitability for bottlers

4. How has the competition between Coke and Pepsi affected the industrys profits?
Although the competition between Coke and Pepsi had started since the very early years of the 20th century; it started to be more effective by the year 1950 and reached its peak to become a real war battle by the year 1980. Coke was the leader in the market with considerable market share much higher than Pepsi, so Pepsi was the leader of the competition with little response from Coke at the beginning but soon the war started. This war had affected the industry profits for both concentrator producers and bottlers while the effect of bottlers was much higher. The concentrate producers were always able to increase their profits by increasing the concentrate price while the bottlers especially the small size had to suffer from the war dramatically by decreasing their profits. The war forced bottlers to increasing their advertising and packaging proliferation, giving discounts for shelf space, injecting high capital for adaptation of plants with new products. The following historical analysis would help illustrating our judgment: 1950: Beat Coke strategy was adopted by Alfred Steele, the new CEO of Pepsi who was the x-CFO of Coca Cola. The strategy targeted the family consumption and focused on take-home sales through supermarkets. As a result Pepsis growth curve reached its peak by 1962 reaching 32000 supermarkets. No measured response by Coke against this strategy. 1960: New Cola and non-cola flavours and disposable glass bottles were introduced by both Coke and Pepsi. Non-CSD drinks approach was adopted by Coke through acquisitions and by Pepsi through merges. Focus on overseas markets was adopted by Coke while the Pepsis response was aggressive battle in US market 1963: New CEO of Pepsi, Donald Kendall adopted the Pepsi generation strategy targeting the young at heart, so Pepsi narrowed Cokes lead to a 2-to-1 margin. At the same time modernization of bottlers plants had started. By 1970 Pepsi bottlers had grown significantly so Coke counterparts by doing the same with their bottlers.

1974: Pepsi Challenge had started doing blind taste tests to prove better taste of Pepsi, so Pepsi gained a 1.4 point lead in food store and successfully decreased the market share of Coke. Coke had responded by retail price cut and serious of counter advertisements. 1980: New CEO for Coke, Roberto Goizueta had adopted cost reduction strategy by using high-fructose syrup instead of sugar and double advertising expenses between 1981 and 1984. Most of nonCSD business was sold while as a response, Pepsi doubled their marketing expenses in the same period. 1982: Coke introduced the Diet Coke achieving great success. 1985: Coke changed the 99 years formula, and introduced 11 new products and many packaging types while the battle for shelf space started affecting dramatically the small producers. 1990-2002: Early 1990, the bottlers of Pepsi and Coke adopted low price strategy in supermarkets to competing with big store brands which decreased their profitability in that period. During the period, many acquisitions of small concentrate producers as well as small bottlers forming bigger firms controlling the industry. Pepsi and Coke were stimulating the moves of each other.

5. How can Coke and Pepsi sustain their profits in the wake of flattening demand and the growing popularity of non-CSDs?
The following actions would help Coke and Pepsi to sustain their profits: 1. Integrate horizontally by diversifying their offering portfolio into non-CSD products. This can be done either by acquisition, merging or by internal inventions 2. Large Investment on R&D to developing their CSD products to meet the healthy requirements issued by the health organizations and to eliminate or at least reduce the bad side effects of these products 3. Give more attention to overseas huge markets in Asia and Africa emerging economies like India and China where per-capita consumption is still very small comparing to US market 4. Build on their global high brand recognition, low rivalry force and their high economics of scale to gain huge market share of the non-CSDs consumers as they already did with the CSDs consumers base. 5. Investing more on marketing campaigns and on social activities to acknowledge consumers by their new healthier products of both CSDs and non-CSDs 6. CPs has to Helping bottlers to achieve higher profit margins by reducing their concentrate prices and inject capital investment to modernize the bottlers plants, to adapting the new product lines or CPs have to continue the strategy they started by integrating vertically into bottling.

6. References
1. Article from syllabus: Cola Wars Continue: Coke and Pepsi in 2010. By: David B. Yoffie and Renee Kim, 9-711-462, REV: May 26, 2011-10-22

2. Book: Strategic management, by Hugh Macmillan and Mahen Tampoe, chapter 9, page 102.