Strategic Management MBA 6300

Cola Wars Continue: Coke and Pepsi in 2010

Carlson School of Management Brandon Sather

Introduction: For the better part of the last 30 years, the rivalry between the two biggest players in the $74 billion dollar carbonated soft drink (CSD) industry has been has been waged without winners or losers. Coca-Cola and Pepsi the two largest companies in the CSD industry both maintained average annual revenue growth of over 10% due to ever-growing consumption for CSDs. The relationship remained cordial between the two companies for many years, but has recently changed as demand for CSDs has begun to decrease. As demands for non-CSD products decrease and awareness of potential health issues arising from CSDs increases, the demand for the traditional products for Coke and Pepsi have faltered, causing both companies to look at their operations and strategies. There are two separate operations at play in the CSD market; concentrate makers and bottlers. Typically these producers blend raw material ingredients, package these concentrates in plastic containers, and ship the containers to the bottlers. The concentrate producers are responsible for advertising promotions, market research and bottler support. Additionally, the concentrate makers negotiate directly with the bottlers major suppliers. The concentrate manufacturing process involves relatively smaller amounts of capital investment. The bottlers purchase concentrate from the concentrate producers, and add carbonated water and sweetener before bottling, or canning, the product and delivering it to customers. It is the bottlers who are responsible for negotiating shelf-space with local retail outlets and setting up point-of-purchases or end-of-aisle displays. The bottlers maintained rights to specific territories in the United States, and there are over one hundred each for both Coke and Pepsi. The bottlers main costs were typically the concentrate, packaging, labor, and overhead. In recent years, both Coke and Pepsi have spent significant funds to acquire or reacquire bottlers, and bring the whole process back in house. Historically, both of these firms have been very profitable. Much of the reason for this is that even though the two companies have been fierce rivals for decades, they have still operated the industry in similar fashion to an oligopoly. Rarely have there been battles surrounding prices. Coke has a history of attaching a greater value to the product, and deriving greater customer utility. Pepsi, on the other hand, has been a differentiator in the market, and looked for segments of the CSD market that were not being satisfied by Coke products. It made little sense for Pepsi to start a price war with a company that had significantly larger market share, and historically loyal customers. However, Pepsi did attempt to do this in the 1980s with the onset of the Pepsi Challenge, and eventually they were met with lowered prices from Coke. If one of these firms were to lower their prices, then the other would match and both would be left with smaller margins on the same market share. This is the reason why most of their efforts have been directed at getting market share through different avenues. This trend is likely to change as markets demand shifts begin to create demand for a variety of non-CSD beverages. Brief History of the Firms: Coca-Cola was founded in 1886 by pharmacist John Pemberton in Atlanta Georgia. The original distribution channel for Coca-Cola was drug store soda fountains and Coke was advertised as a potion for mental and physical disorder. The company was sold to Asa Candler in 1891 and Candler began selling bottling franchises in 1899. By 1910 there were 370 such franchises across the United States. Candler sold the firm in 1919 to a group of investors who took it public later that year. During the 1920s and 1930s Coke was responsible for developing some new distribution channels, including open-top coolers for use in grocery stores, automatic fountain dispensers, and vending machines. It was around this time that Coke initiated the lifestyle advertising for Coke, which emphasized Cokes role in the life of a consumer. During WWII Coke began developing their international business buy promising that every man in uniform gets a bottle of Coca-Cola for five cents wherever he is and whatever it costs the company. This helped Coke win exemptions from sugar rations during the war for overseas bottling plants and Coke was able to build 64 of these operations overseas. Pepsi was invented in 1893 by pharmacist Caleb Bradham of New Bern, North Carolina. In similar fashion to Coke, Pepsi began using the franchise bottling model and in 1910 has a network of 270 such bottlers. However, Pepsi struggled and was forced to declare bankruptcy in 1923 and 1932, but business increased in during the Great Depression when Pepsi old twice as much product for the same price that Coke charged. By 1950 Pepsi had grown to the second-largest CSD brand, owning 10% of the market compared to 47% for Coke.

Porters Model for CSDs: When using the Porter model to analyze the CSD market, we see that the main reason for these two firms profitability is that all five market forces aided in providing beneficial market conditions. It is important to note the differences between the concentrate producers and their bottlers. As stated before, these have, until recently, been maintained as separate identities, and they operate very differently, although there is a lot of monetary support from the concentrate producers going to the bottlers. The central issue in Porters model is the rivalry between the companies in the industry. As stated earlier, the industry has operated as an oligopoly for decades, with each firm taking an occasional jab at the other. However, these jabs have been limited, as they were usually bad for both companies (i.e. the Pepsi Challenge creating lower margins for both firms in the 1980s). Besides each other, the two companies were not particularly worried about competition from other firms. There has not been a high threat of new entrants in this industry, and that threat remains low to this day. A new concentrate producer would have to invest very large sums of money in buildings and equipment to be able to compete with Coke or Pepsi, and would still not have the ability to create the same savings on manufacturing through economies of scale that both of these firms do. Additionally, a new firm would have to create its own proprietary bottling plants (which could cost upwards of $100 million) because Coke and Pepsi do now allow their bottlers to bottle any products that are in direct competition with one of their products. Additionally, any new entrants would be unable to leverage their suppliers, a major difference between the industry leaders. For both Coke and Pepsi, their suppliers maintain littler power over their respective firms. The largest ingredient for both companies is sugar/sweetener. Both firms showed that they are willing to go with the lowest priced option when they made the switch to high-fructose corn syrup, and with the onset of new natural sweeteners that would not only be more marketable to the changing customer demands but may also be cheaper, the highfructose corn syrup suppliers are in no position of leverage with Coke or Pepsi. Additionally, the firms maintain the advantage over their packaging suppliers, as there are only two or three large purchasers for the aluminum cans and plastic bottles, allowing the firms to negotiate in their favor. For the most part, the firms in the CSD industry have most of the power, but they do give up some power in certain areas. Industry wide, the distribution outlets of CSDs do not have much power of the likes of Coke and Pepsi. The retail distribution market is extremely fragmented across the country, and thus there are not enough locations of a single store to influence what the large CSD companies do. There is some power of buyers in the shelf space accommodations from large stores, such as Wal-Mart, Sams Club, and Costco because of the scale of their operations. Much of this power led to price reductions and less profitability in these distribution channels. Additionally, large restaurant chains held a significant amount of power over Coke and Pepsi, because these outlets typically only had one brand. This power is clearly shown through the contract battles with restaurants such as McDonalds, Burger King, and Subway. Industry-wide, the biggest threat to of these firms is the threat of substitutes. This explosion of different drink options is, in part, what has been causing the decline for CSDs and both firms must take this threat seriously. Thus far, both firms have hedged against this threat through acquisitions and new product offerings, and the more the firms diversify their product offerings the less they will be affect by the threat of substitutes. Analysis of the Firms: As the two largest firms in the CSD market, both Coke and Pepsi have developed some similar strengths as far as manufacturing capacity and distribution networks are concerned. In general, the advantages of improving these functions would be highly imitateable, and would not generate a sustained competitive advantage. However, the two firms are in distinctly different positions, and should be analyzed separately. Coke is the largest, and strongest, brand in the world. Coke has become synonymous with the American lifestyle, and as such Coke has developed a major strength in the branding of its products. They hold a significantly larger portion of the international market, generating 80% of their sales outside the U.S. Coke has also established very profitable contracts with the two largest restaurant chains (McDonalds and Subway) in the domestic market, and thus dominates the fountain soda portion of the CSD market. Cokes customers have proven to be very loyal, in fact opposing when Coke announced they would be changing their recipe. Coke has also consolidated the vast majority of their bottling operations domestically, allowing them to avoid some of the historical problems which arose from supporting independent bottling operations. Coke does have its limitations though. One of the weaknesses of Coke is that their product offerings are limited to beverages, meaning that any change in beverage demand could affect the firm significantly. Cokes customers are also particular about the

product, so changes to it may have a significant negative impact on consumers. Additionally, when compared to Pepsi, Coke has a smaller number of product offerings, meaning they may lose customers in more differentiated markets Pepsi, on the other hand, maintains a diversified portfolio, including operations in markets other than beverages. They have purchased large restaurant chains, and in doing so have created a buffer to a decline in the CSD markets by maintaining revenues from other industries. They have also maintained a larger product selection in the beverage industry than has Coke, and is able to serve more unique customer markets domestically. These products have helped them create the majority share of the non-carb beverage market, which is an increasing market due to the health concerns associated with sugar and high-fructose corn syrup. Even though Pepsi has more product offerings and controls portions of the U.S. market, they have not been as successful in foreign markets. Pepsi is far behind Coke in foreign markets, and has been unable to gain market share in countries where Coke is already an established brand. Pepsi has, so far, been unable to compete with Coke in respects to chain restaurant contracts. Current Conditions: From 1975 through the mid-1990s both Coke and Pepsi were able to achieve double digit annual revenue growth due to the fact that consumption for U.S. and world-wide was on a steady rise, and the industry environment was primed for profit. However, during the 1990s there was a shift in the industry as new challenges were presented. Americans were still drinking more CSDs than other beverages, but the increases were declining in comparison to the growth rates of the 1980s and early 1990s. The cause for this shift was the growing relationship between CSDs and health issues such as obesity. Federal guidelines were being put into place, and the government identified CSDs as the number one source for sugars in the American diet. The correlation between high sugar and obesity was becoming a major problem. By April of 2010 there were already 29 states that had distinct soda taxes, and there was a growing list of states considering using such measures. In response to these measures, both Coke and Pepsi began to expand their low/no sugar product alongside their offerings of low-carb products. Pepsi was introducing more new low-carb products than was Coke, with 77% of Pepsis new products in 2007 as non-carbs as compared to Cokes 56%. In response to the declining U.S. market demand for CSDs, both Pepsi and Coke looked for opportunities in other markets; including bottled water and international markets. While Coke was successful in affiliating its brand with American culture, Pepsi focused on non-carb markets abroad including juice. The rivalry between these two firms is likely to intensify as more substitutes hit the market, which is likely to set off a price-driven battle for market share. In this case, Coke may end up being the winner, as they have expanded globally much more than has Pepsi. Recommendations: In the case of both of these companies, they have been spending capital to reacquire bottling operations. I do not see this strategy creating increased market share for either firm. Consolidating bottling operations for CSD and non-CSD beverages may lead to cost savings for the firms, which can offset decreased demand, and could be an important factor in their continuing operations. However, these strategies can be imitated by other companies, so any competitive advantage gained by passing savings from bottling operations on to the customer in the form of lower prices will be matched soon by competitors, thus this advantage would not be a sustained competitive advantage. It makes even less sense for Pepsi to be the firm that starts down this path, as they are already competing with the superior brand image of Coke and Cokes historically loyal customers. The largest benefit of consolidating bottling operations would be the distribution channels for the product line; however I dont see it being a very profitable strategy when the new bottling plants may cost $50 or $100 million dollars. Consolidating bottling would make sense if the bottlers had some sort of advantage over the concentrate producers, but this is not the case as the concentrate producers hold all the power in that relationship. Furthermore, it would make sense to consolidate if it would create bargaining power, but the concentrate producers currently negotiate on behalf of the bottlers, so there is not much to be gained in the form of negotiating power through consolidation. Going forward I think that it will be very important for Coke to maintain its operations abroad, while at the same time addressing some deficiencies in the domestic market. It is clear that Cokes international brand has led to huge revenues; 80% of their total sales. It will be important for Coke to expand beyond the 200 countries it is currently in for two reasons. The first of which is that it will generate first-mover advantage for Coke itself, and it

will also prevent Pepsi from establishing operations in those countries. Pepsi receives a relatively small portion of their sales from international markets, so Coke should assume that they will be pressing for growth in these markets, and thus Coke should enter to these markets first. In these markets, Coke should acquire local bottling companies to both establish distribution markets, but to also gain insight into the tastes of local populations in order to develop a variety of successful products. The different products will also prevent Pepsi from coming in and differentiating the market. This is an issue that Coke must address on more than just the international market. Domestically, Coke has recently been behind the times in anticipating shifts in the non-alcoholic beverage market. Though it does have a history of releasing very profitable new beverages (Diet Coke, and Coke Zero) it has typically been second in releasing such drinks. Going forward, it will be important for Coke to be more responsive to customer demands in order to get first mover advantage. With the increasing health concerns associated with CSDs, Coke should focus a large amount of resources on non-carb drinks and juices. Pepsi currently holds the largest market share in these markets, but with the branding capacity of Coke, devoted product development and marketing operations could lead to large revenue increases by taking market share from Pepsi. Along the same lines, Coke must work to develop new products to counteract the decline in CSDs. Coke should focus on its tea brands, because tea is generally associated with health benefits which could lead to large revenue streams from health focused consumers. The firm should also increase its bottled water business. To do this, I think that the firm should look into merging with local water bottlers. There are significant costs associated with shipping water all over the country, and these costs may be significantly diminished if Coke could produce and bottle the water closer to the sales locations. Along the same lines, Coke should also push to expand the alternative water markets, namely Vitamin Water, and continue to experiment with natural sweeteners to appeal to the health conscious consumer. This will provide additional revenues as the revenues from CSDs decrease. As a company, Pepsi prides itself on being a differentiator and for their operations to continue being successful, this will have to continue. Going forward, it will be important for Pepsi to continue to build its brand globally. Pepsi may be behind Coke in the international markets, but with countries such as India and China still up for grabs, there is still a ton of revenue potential out there. It will be imperative that Pepsi establish itself in these countries before Coke does, as they have not had much success in taking market share from Coke in countries where Coke already has operations. Pepsi still relies on the U.S. market for more than 50% of its sales, and that may be a problem in a country that is beginning to associate their product with health. Pepsi should look to expand its restaurant franchise business globally. This will help them battle coke in fountain sales across the international markets, and should help build brand quit with customers. In the future, Pepsi should continue to offer a wider product range than Coke does. This will help Pepsi in a couple of ways. First, as a differentiator, it is important that Pepsi make products that find specific customer bases, so if Pepsi does not continue to pursue this strategy they may lose the advantage of being a differentiator. Additionally, if Pepsi is successful with these new products, it will force Coke to enter product markets that they may not be suited for, and may not be profitable in. Along the same lines of differentiation, I think Pepsi should also focus on developing complimentary products from their snack industries to go with their beverage industries. This may include furthering snacks that appeal to the health conscious consumer. Pepsi dominates the low-carb beverage industry, so it was make sense for them to leverage this consume base and attempt to gain market share for the snack industry (through Gatorade protein bars, or meal replacement foods). Not only will this create a new revenue stream for Pepsi, but it will also give Pepsi more of a buffer if the CSD market continues to drop.