THE CSD INDUSTRY

Background

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 The Dynamics of the bottled water industry in the USA

The bottled water industry in the USA was given a huge push by the entry of the CSD manufacturers
in 1998 when Pepsi entered the fray with Aquafina and Coke followed suit with Dasani in 1999.The
bottled water industry was a relatively untapped segment at this point in time and both players saw
enormous growth in their respective products’ sales. The cost of manufacturing bottled or mineral
water was minuscule in comparison to the prices they charged and this factor allowed the
manufacturers to survive and even prosper in the following years.

The market’s continuous changes were addressed by the manufacturers in a bid to maintain their
market share, sometimes at the cost of profitability. Since no brand offered any distinct and clear cut
differentiation with respect to the product, competition and pricing was much more vicious in this
industry. Some stark differences between the CSD industry and bottled water industry were that
people were always conscious about the price they paid for water, indicating that price sensitivity
was more important than brand loyalty.

Annual change in volume of consumption of beverages in 2000-2004

40

35

30

25

20

15

10

-5

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 Growth of consumption of various liquids in the USA for the past 30 years
(In gallons/capita)

Growth is calculated on a year-over-year basis by grouping the entities as follows:

Groups

Alcoholic- Wines, beer and distilled spirits

Non alcoholic-Carbonated soft drinks, milk, coffee, tea, juices, sports drinks and powdered drinks

Bottled water, which was virtually an unknown entity in terms of market share, saw steady growth
throughout the last 30 years and has carved a niche for itself, stealing from other segments due to
its universal acceptability and appeal.

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 Porter’s Five Forces Analysis

Threat of new
entrants (LOW)

Bargaining power of Intra-Industry Bargaining power of

suppliers (LOW) rivalry (HIGH) buyers (HIGH)

Substitute products
and services(HIGH)

Threat of new entry

New entrants into the carbonated soft drink (CSD) industry face a high entry barrier.

One of the factors for this is the capital expenditure required for a new entrant is very high. A new
company needs to set up its own bottling network for packaging. Every existing company has its own
group of franchisees for bottling and packaging. New entrants cannot use existing bottling
companies due to the various franchise agreements between concentrate producers and the
bottlers.

Hence, the closely knit framework between bottlers and concentrate manufacturers make it very
difficult for a new entrant without a reasonably extensive bottling network to break in to the
market.

The superpowers in the CSD industry enjoy high brand loyalty. Unconfirmed reports of
contamination in soft drinks and similar bad publicity led to customers shunning even established
brands. This makes it very difficult for new entrants to capture an appreciable market share.

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Bargaining Power of Buyers

In the CSD industry, bargaining power of buyers is generally high, the major reason being very low
switching costs. The availability of alternate products of equal quality means companies are always
under pressure to constantly innovate and improve upon their existing products.

Health concerns of buyers, especially in the last decade, have forced companies to innovate and
bring out low-calorie, low-fat drinks like Diet Pepsi and Coca Cola Zero. This also resulted in CSD
companies diversifying their portfolio of offerings by producing/acquiring substitute products,
thereby retaining their market share. A perfect example of this would be the decline in the market
share and consumption of regular CSDs in the years 2004 and 2005. This decline was compensated
by the increase in consumption of soft drinks with the "diet" label. In the period between 2000 and
2004, the market share of Diet Coke rose from 8.7 to 9.7 percent to compensate for the marked
decline in Coke Classic's market share from 20.4 to 17.9 percent.

The illustration here shows the

shift in the dynamics of the
American soft drink industry in
the period between the year
2000-04. As customers became
increasingly health-conscious,
the market share of
Carbonated Soft Drinks
(CSDs) went down by a
significant amount. This was
matched by a simultaneous
increase of market share in the
non-CSD segment.

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Bargaining Power of Suppliers

The CSD manufacturers rely on a number of suppliers like manufacturers of artificial sweetening
chemical manufacturers, caffeine and other flavouring additives along with raw materials for
packaging and bottling.(manufacturers of glass and plastic bottles and cans)

The bottlers are in charge of packaging, and, to a certain extent, advertising and promotion. The
generic nature of the suppliers’ products and the lack of need for product differentiation in this
category lead to the rise of many bottling companies and caused cut throat competition.

With the boom in sales of CSDs, the number of bottlers grew exponentially in the 1970’s until the
sector became too competitive for all the companies to coexist. Consolidation in the sector has seen
the survival of only one-tenth of the companies that existed three decades ago.

The concentrate manufacturers have always held the upper hand in the relationship with bottlers
because of the constant eminent threat of backward integration by the concentrate manufacturers,
leaving the suppliers in an extremely weak bargaining position.

Example: Pepsi establishing the Pepsi Bottling Group as its primary bottler.

This is evident from the statistics shown below.

Concentrate price rise v. retail price rise

0.3

0.2

0.1 CONCENTRATE PRICE

CHANGE
0
RETAIL PRICE CHANGE
-0.1

-0.2 1990 1992 1994 1996 1998

-0.3

High profitability and margins have helped the bottlers absorb a large extent of increasing retail
prices despite steep and constant increase in the concentrate prices which directly affected their
bottom line.

Although bottlers enjoy high profitability, concentrate manufacturers strangle their freedom by
granting contracts which guarantee exclusive geographic territories to bottlers thereby killing off
competition between rival bottlers marketing identical products. This was strengthened by the
congress passing The Soft Drink Interbrand Competition Act in 1980.

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Threat from Substitute Products

The CSD industry faces a high threat from substitute products in the form of non CSDs, fruit drinks,
energy drinks and hot beverages. Also, health concerns and accusations of contamination in the soft
drinks lead to a large shift in consumption to non CSDs. This was particularly marked in India and
Belgium in the aftermath of the contamination scare.

However the major players in the industry (namely Pepsi and Coca Cola) have successfully
neutralised these threats by wide spread diversification into all sectors of the non-alcoholic beverage
industry. When the demand for sports drinks and energy drinks were on the rise, Coca Cola launched
Powerade and Pepsi, Gatorade. The introduction of bottled water brands Aquafina (Pepsi) and
Dasani (Coca Cola) to meet the demands of customers when demand for CSDs waned is another
example. Thus, threat of substitutes is definitely high in the CSD industry but has been adequately
handled by the major players in the industry to prevent loss of market share.

Intra Industry Rivalry

The CSD industry saw a great in the earlier stages were intent on maintaining market share in their
flagship cola brands and this greatly influenced the initial franchise agreements they made with their
bottlers.

Both companies had agreements with slight variations regarding the establishment of retail prices
and division of costs but they tended to optimise these aspects and had a more or less similar
relationship with their vendors.

The industry leaders fought on several levels to gain market leadership using provocative ad
campaigns, the legendary blindfold taste tests and promotional campaigns which offered gifts to
customers in exchange for product purchases.

During from 2001 to 2004, Coke found itself in the midst of many crises, among them complaints of
contamination in its products. This coupled with a dwindling market share and growth rate, forced
Coke to spend more on advertising campaigns during the period from 2003-04, as is evident below.

300000

250000

200000

150000 Advt. Spending in 2003

Advt. Spending in 2004
100000

50000

0
Pepsi Coke Dew Sprite

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Whenever one of them hit a trough, the other tried to capitalize on it through various means, be it
marketing campaigns or proliferation into hitherto unexplored market segments. An amazing range
of products to cater to every section of the market and the industry’s continuing ability to recover
from various pitfalls only shows that intense rivalry has brought about constructive changes in this
sector, instead of unimaginative and self-destructive cost-cutting techniques.

More than anybody else, companies within the industry realise they cannot afford to take a breather
lest they will be left behind. All these factors have given the industry the iconic status it finds itself in
today.

CHANGE IN MARKET SHARE OF VARIOUS COMPANIES OVER THE YEARS

50
45
40
Pepsi
35
30
Coke
25
20
Others-
15 Dr.Pepper's/Schweppes/Cott
10
5
0
1966 1975 1985 1995 2004

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 Kendall Square Research Corporation

a. Revenue Recognition Junctures

The KSR Corporation followed a system of revenue recognition that, in our view, can be
considered “unorthodox”. Before we analyze our opinions on whether the junctures were right or
not, let us first see the method of revenue recognition that KSRC followed during 1991-92 period.

The company recognized a sale the moment a customer placed an order. The customer’s
pay back capacity was not probed at all. It was assumed that the customer (mainly scientists funded
by governmental grants) will eventually get the money and pay back.

One of the KSRC customers had paid only for half of what was delivered. The rest was
considered as a loan against future grants that the customer could possibly receive in future, but
KSRC considered the entire shipment as sales revenue.

There is also a case of the company upgrading the customers’ existing product even before
they have been granted the funds for the aforementioned operation, from government agency and
as a result KSRC is waiting for government funding, thereby increasing its accounts receivable.

There were few transactions where a sale was recognized as per the customer’s requirement
and then more processors were delivered to the customer for his use. KSRC’s balance sheet entry on
this peculiar transaction was titled-Inventory Pending Customers’ decision. Customers’ decision to
keep the additional items or to apply for grants to buy them or to make arrangements to pay for
loan of that additional equipment depended a lot on government’s support for additional allotment
of funds and invariably affected KSRC to get paid for what it delivered. But to categorise a delivered
product as inventory is the risk that the management took in reliability of its accounting reports that
were placed before its stake holders.

What happened was that, KSRC in the process of ramping up its sales had adopted an
unreliable method of accounting.

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Consonance with the Fundamental Accounting Principles

The practice of recognizing revenue only when cash is received at hand is the most
simple, and reliable method. Yet, revenue can be recognized far before that also. In this case, KSRC
choose to recognize revenue as soon as a customer placed an order.

This method is NOT in conformity with the Conservatism concept of Accounting. The
accounting principles were designed so as to keep in check the extent to how early revenue could be
recognized. This observation is supported by the excerpt from the Harvard Business Review Article
which says: “Everyone in an organization may be thrilled when a large contract has been signed and
sure that the value of the organization has been enhanced, but until the products and services
promised under the contract have been delivered to customers or the criteria of the percentage of
completion process have been met, no revenue will be reported.”1

Yet, this practice is not frowned upon by many accountants. They justify that for a
new company, recognizing revenue as soon as the order is placed, helps the company project a
healthy figure in order to attract initial investments. This might be vital for the company, so using
this method for the initial period is reasonable.

This practice has led to the revenues recognized by KSRC to fall short of cash collected by
significant amounts. The accounts receivable (A.R) in the year ended December 26, 1992 is 16 times
the A.R in the year ended December 28,1991, amounting to $13,328,000.Experts agree that KSRC
must have an agreement with customers requiring to pay the bill in full , within a period of 3-6
months after receiving the grant. This was a common practice in research-intensive, supercomputer
industry. This would have ensured that company’s best interests were protected.

b. Two transactions that we feel have impacted the balance sheet and income statements are:

1. Accounts Receivable for the year ended December 26, 1992:

28-Dec-91 26-Dec-92

Sales Revenue 904 20,729

Cash Received from Customers 527 8,533

Accounts Receivable 804 13,328

A/c Receivable from Customers 377 12,196

Loss from Operations 22,505 13,048

(Value in thousands)

The Accounts receivable is cash that has not yet been received. This forms 64%
of the total revenue which is a very significant amount! Even if we neglect that portion of cash that
are to be received from other sources, the major portion that is to be received from customers

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forms 58.8% of the total revenue. Thus its impact on the balance sheet is that it projects a
larger than life profit, a considerate amount of which are not at all realizable in the near future.

This principle of revenue recognition is not so good a trend that may backfire if
prolonged for a long term. Now that the trend of the company is showing a promising trend (from
the quarterly statements of ’92), we suggest that it is best for the company to change its revenue
recognition principle to more realistic grounds.

2. The conversion of the outstanding convertible debt to common shares was the second most
important transaction that positively affected the balance sheet. The conversion was effected in the
beginning of the second quarter of 1992. As a result, the company’s interest expense was
dramatically brought down in the following quarters.

I Quarter II Quarter III Quarter IV Quarter

March 28, '92 June 27, '92 September 26, '92 December 26, '92

Interest Expense 323 61 40 25

Net Income(loss) (4,532) (4,946) (3,250) 6

(Value in thousands)

(From page 8 of the given material, under the sub head titled “Quarterly Results”)

These convertible subordinated notes decreased the firm’s liabilities as they were to be
converted into equity. The interest amount payable by the firm annually also decreased due to this
transaction. This increased the liquidity ratios of the firm. As there was an increase in the Owner’s
equity and decrease in the liabilities, the balance sheet looked more “healthy”. Also the increase in
the liquidity ratios would have impressed more possible investors.

The important effect of this move is that the company can now go for more loans as its
liability is reduced. The profit made during the fourth quarter is because of increased sales revenue
during the fourth quarter. But, if there wasn’t a reduction in interest expense, KSRC wouldn’t have
realised profit in the fourth quarter.

When a yearly is made, the significance of this may be lost as the interest expense of ’92 is
still higher than that of ’91. But, if we view the quarterly results of ’92, we can observe clearly that
the there is a notable reduction in the interest expense in the second Quarter due to this
transaction.

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 For the year ended December 28, 1991, the Debt Ratio which is the ratio between the total

debt and the total assets is found to be 0.5191 The Debt Ratio for the ensuing year ’92 is
0.1705 because of this conversion of convertible subordinate debts into equities. This has
helped the balance sheet put on a happy face.

3. There is research and development costs amounting to a larger portion of the the costs and
expenses

Part of the income statement.

December
December 29,1990 December 28,1991 26,1992

Total Research & Development

cost $10,575 15,786 14,113

Gross Profit -na- $572 11,540

-
Software Development cost -na- na- 3,506*

(Value in thousands)

*-included in total R&D cost

Such massive R&D costs have made the company incur loss. If sufficient funds are at hand
then the company has the liberty to develop upgrades for their primary product. There is a reduction
of R&D costs for the year ended Dec 26’92 by 11%. Further, software license fees had not been
incurred for the previous year.

This transaction has made affected the income statement to a very large extent. The company
also has R&D tax credit forwards which expire through 2007 of $ 2,900,000 available to offset future
income tax liabilities.

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4. Inventory entry in the Balance Sheet:

Inventory Transactions December 28,1991 December 26,1992

Raw materials and manufactured assemblies $1,337 4,808

Work-in progress 1,906 1,272

Finished Goods 1,073 2,859

Total inventory $4,316 $8,939

(Value in thousands)

The method of inventory control used by KSRC is first-in and first-out (FIFO) method. The items
stated in the inventory are stated at lower of cost or market price. This practice is not in conformal
with the standard accounting principles, which is to rate every item at its cost price.

Suppose that the market price is lower, and then a value of item represented by Inventory
entry is much lower than what was paid for it. This would in turn imply a reduced COG, thereby
affecting both balance sheet entry and the Income Statement.

Now, out of the four transactions listed above, the group feels the two transactions that
have had maximum impact on the balance sheet and income statement are the first two
transactions because

• The sales revenue being recognized before the cash has been received has resulted in an
increase of values for the ‘accounts receivable’ section. This influenced KSRC to look for cash
sources from convertible subordinated debts and such, to cover their operating expenses.

• Conversion of debts to equity enabled the company to achieve profitability during the fourth
Quarter of 1992.This increases the shareholders trust in Kendall Square Research
Corporation.

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