STRATEGIC MANAGEMENT

Assignment # 2
Cola Wars Continue: Coke and Pepsi in 2006

Submitted by: Sheheryar Mahmood Amna Aslam Madeeha Tahir Class: MBA-IV (F) Submitted to: Sir Suhaib Hussain Date: 20.02.12

Overview:
From 1975 to the mid 1990s Coke and Pepsi achieved annual average revenue growth of around 10%. Late 1990s: US per capita CSD consumption declined slightly before it reached a plateau. 2004: Coke suffered several operational setbacks and Pepsi started to introduce alternative beverages. Both companies began to modify their bottling, pricing and brand strategies. 21st century: both companies were facing new challenges of whether their era of growth and profitability was coming to an end.

Economics of the US CSD industry:

In 1970: Americans consumed 23 gallons of CSDs annually. Over the next three decades consumption grew over an average of 3% per year. Reasons behind this growth were the increasing availability of CSDs, the introduction of diet and flavored varieties and declining real prices. Within the CSD segment, the cola segment maintained its dominance, with a market share of 60% in 2004.

Production and distribution of CSDs involved four major participants:

1. Concentrate Producers They blend the raw material ingredients, packaged the mixture and shipped it to the bottler. Manufacturing process involved little capital investment; a typical manufacturing plant cost $25 million to $50 million to build. Most significant costs: Advertising, promotion, market research and bottler support. They implement and finance marketing programs jointly with bottlers, but take lead in developing the plans. They also hired staff that was to work with bottlers. Among national concentrate producers, Coca-Coal and Pepsi-Cola claimed a combined 74.8% of the US CSD market in sales volume in 2004. 2. Bottlers They purchased the concentrate, added carbonated water and high fructose corn syrup, bottled/canned the resulting product and delivered it. Bottling process was capital intensive, involving high-speed production lines, which cost from $4million to $10 million each. In 2005, Cott completed construction of a 40 million case bottling plant at a cost of $40 million, but the cost of such a plant could range to as high as $75 million. Cost of sales breakup for a bottler (approximate): packaging 40-45%, concentrate 4045%, and sweeteners 5-10%. Gross profits usually topped 40%, whereas operating margins were usually 7-9%. US soft drink bottlers reduced from more than 2000 in 1970 to 300 in 2004.

Coke, later followed by Pepsi and Cadbury Schweppes, build a nationwide franchised bottling network. Franchised bottler had manufacturing and sales operation in an exclusive geographic territory. Under the contract that coke had with their bottlers, they had no obligation to assist the bottlers with marketing and advertising, but they still invested in order to ensure quality and match Pepsi. Bottlers had final say about decisions regarding retail price. 1971: Federal Trade Commission took action against eighth major concentrate makers, charging that exclusive territories prevented intraband competition. The concentrate makers argued that interbrand competition was strong enough and were granted exclusive territories in 1980.

3. Retail Channels Distribution break up of CSDs in 2004: supermarkets 32.9%, fountain outlets 23.4%, vending machines 14.5%, mass merchandisers 11.8% convenience stores and gas stations 7.9%. Main channel was supermarkets, from where annual sales reached $12.4 billion in 2004. Bottlers fought for shelf space and looked for new ways of attracting customers. Fountain outlets: Competition for national fountain accounts was intense, where companies frequently sacrificed profits. Local fountain accounts were more profitable as the bottlers handled them. However r margins were still less than bottle/can sales. Mass merchandisers, for e.g. Wal-Mart, usually had their own private label CSDs as well. In the vending channels, bottlers were in charge of buying, installing and servicing machines, and for negotiating contracts with the property owners. Historically, Coke has dominated fountain sales. Even in 2004, it continued to dominate with a 68% share against 22% for Pepsi. 4. Suppliers Concentrate producers required few inputs e.g. caffeine, citric acid, etc. Bottlers purchased two major inputs; packaging and sweeteners.

Evolution of the U.S. soft drink industry:

Early history: Coca-Cola was formulated in 1886 by a pharmacist, from whom, Asa Candler acquired the formula in 1891 and began the brand. It had its first bottling franchise in 1899, and 370 franchises by 1910. In 1919, Candler sold the company and in that year the company went public. During 1920s and 1930s coke introduced open-top coolers, automatic fountain dispensers and vending machines. Pepsi was invented in 1893 and by 1910 it had 270 bottlers. It declared bankruptcy in 1923, and again in 1932, but business began to stabilize then due to lower prices. 1938 Coke filed suit against Pepsi, but court ruled in favor of Pepsi.

Cola wars begin: 1950 Pepsi CEO made hi motto Beat Coke. They sold concentrate at 20% lower price than coke, but later increased their prices, promising to spend on advertising. 1960s; Coke launched Fanta, Sprite and low calorie cola tab, whereas Pepsi launches Team, Mountain Dew, and Diet Pepsi. Pepsi doubled its market share between 1950 and 1970. 1974: Pepsi Challenge they tried to demonstrate that consumers preferred Pepsi. 1980s: Coke doubled its advertising expenditure. In response, Pepsi did the same. Coke introduced 11 new products, and Pepsi introduced 13 new products. 1982: Coke introduced diet coke, which was a huge success. Cola wars had weakened small independent bottlers, which led to Cokes plan to refranchise bottling operations. 1986: Coca-Cola Enterprises was made, a bottling subsidiary. 1999: Pepsi Bottling Group went public.

Adapting to the times: U.S. sales volume grew at a rate of 1% or less during 1998 to 2004. Worldwide annual per capita consumption declined from 125 to 119 8-ounce servings. Coca-Cola struggled due to internal difficulties, execution failures, its reliance on traditional CSD oriented model. During Goizuetas 16 year tenure Cokes share price rose by 3500%, while Pepsi lagged behind. Middle of the following decade Coke appeared to stumble, while Pepsi was flying high. 1997 to 2004: Pepsi shareholders enjoyed return of 46%, while Coke shareholder -26%.

Quest for alternatives: 2005: Pepsi treated Diet Pepsi as their flagship brand & Coca-Cola zero was launched. New federal nutrition guidelines identified CSDs as the largest source of obesity causing sugars, schools in US started banning sale of soft drinks on their premises, and suits were filed on causing harm against childrens health. Both Pepsi and Coke introduced purified water products.

Evolving structures and strategies: Early in the 21 century, Coke & Pepsi, and CCE & PBG were key elements of cola wars. In 1999 CCE increased retail prices, and PBG followed. Coke tried adjusting relations with CCE and they ended up agreeing on incidence pricing.

Cokes stepped up marketing and innovation: In 2001, they launched a new Fridge pack and focused on packaging innovation. In 2004, introduced a 1.5 liter bottle In 2005, coke launched a major advertising campaign The Coke Side of Life. As a result, it increased costs for bottlers.

To reduce costs for bottlers, more often than not, Coke and Pepsi took charge of producing certain beverages, and then sold to bottlers. Bottlers distributed these finished products as well as their own manufactured products. In other cases, the company paid half or more of the cost of additional equipment necessary. Internationalizing the Cola Wars: U.S. growth reached a plateau and so Coke and Pepsi looked abroad for new growth. U.S. remaining the largest markets, the next largest were Mexico, Brazil, Germany, China and UK. Coke flourished in the market with roughly 9 million outlets in more than 200 countries in 2004. 70% of its sales were from outside U.S. It had world market share of 51.4%. Pepsi entered Europe soon after WW II, moving later into Middle East & Soviet bloc.in the 1970s and 1980s it had put little emphasis on international market. Both companies faced obstacles: antitrust regulation, price controls, advertising restrictions, foreign exchange controls, lack of infrastructure, cultural differences, political instability and local competition.

QUESTIONS: Question # 1: Why has the carbonated soft drinks (CSD) concentrate industry been so profitable for Coke and Pepsi for decades? Please, present an analysis of industry attractiveness (of the concentrate producers) based on the five forces. An analysis of industry attractiveness: Five Force Analysis: 1. Threat of substitutes Through the early 1960s, soft drinks were synonymous with colas in the mind of consumers. Overtime, however, during 1980s and 1990s carbonated soft drinks have seen the emergence of many new substitutes. Coke and Pepsi responded by expanding their offerings, through alliances, acquisitions, and internal product innovation, capturing the value of increasingly popular substitutes internally. The threat of substitutes is reduced by the expansion of products portfolio. The switching cost is not high at all, as where they bought soft drinks, they could easily buy substitute drinks, and however some of these drinks may have a higher price. 2. Bargaining power of buyers Number of buyers: The buyers for the soft drink industry are members of a large network of bottlers and distributors that represent the major soft drink companies. Distributors purchase the finished, packaged product from the soft drink companies while bottlers purchase the major ingredients. With the consolidation that has occurred within the industry, there is little difference between the two. Distributors are assigned to represent a specific geographic area and are responsible for distributing the product to the retailers who sell the products to the end consumer.

In recent years, the national companies have been purchasing independent bottlers in an effort to consolidate the business and gain some distribution economies of scale. Major distributors: Food stores, convenience and gas, fountain, vending, and mass merchandisers. Supermarkets counted on soft drinks to generate consumer traffic, so they needed Coke and Pepsi products. Hence they did not have much bargaining power other than their control over the premium on shelf space. National mass merchandising chains such as Wal-Mart, on the other hand, had much more bargaining power. While these stores did carry both Coke and Pepsi products, they could negotiate more effectively due to their scale and the magnitude of their contracts Where vending machines are concerned, there were no buyers to bargain with at these locations, where Coke and Pepsi bottlers could sell directly to consumers through machines owned by bottlers. Property owners were paid a sales commission on Coke and Pepsi products sold through machines on their property. So the only buyers with dominant power were fast food outlets. They accounted for less than 20% of total soft drink sales. Buyers switching cost: Independent bottlers have contractual agreements to represent that company within a certain area. Switching costs would include establishing new relationships with other companies to represent and the legal costs associated with distributors being released from the contract. Degree of substitution: Buyer tendency to substitute is low due to the contractual relationships between the soft drink companies and the distributors. Possibility of backward integration: It is doubtful that local distributors will move into the actual production process of soft drinks. Distributors specialize in the transportation and promotion of the product that they rely on the carbonated beverage companies produce. However, major retailers; for example Wal-Mart and Harris Teeter have begun distributing their own private label brands of soft drinks. Wal-Mart now offers Sam's Choice and Harris Teeter offers President's Choice at a significantly lower price. These private label competitors will not provide the variety of packaging alternatives, which make the national leaders so successful. For example, Pepsi offers 12-ounce cans, 20 ounce bottles, 1 liter bottles, six packs, twelve packs, cases and "The Cube" 24 can boxes. 3. Threat of new entrants Capital requirements: The concentrate manufacturing process involved little capital investment in machinery, overhead or labor. A typical plant cost $25 to $50 million to build, and one plant could serve the entire U.S. Access to Inputs: All the inputs within the soft drink industry are commodity items. These include cane, beet, corn syrup, honey, concentrated fruit juice, plastic, glass, and aluminum. Access to these inputs is not a barrier to enter the industry.

Access to Distribution: Distribution is a critical success factor within the industry. Without the network, the product cannot get to the final consumer. The most successful soft drink producers are aggressively expanding their distribution channels and consolidating the independent bottling and distribution centers. From 1978 to the present, the number of CocaCola bottlers decreased from 370 to 120. In addition, 31.9% of the soft drink business is in supermarkets, where acquiring shelf space is very difficult. This is a high barrier to entry. Learning curve: The shift in the manufacturing of soft drinks is gravitating toward automation due to speed and cost. However, industry technology is low and the manufacturing process is not difficult, therefore the learning curve will be short and will have a low barrier to entry. It would be nearly impossible for either a new concentrate producer to enter the industry. New CPs would need to overcome the tremendous marketing muscle and market presence of Coke, Pepsi, and a few others, who had established brand names that were as much as a century old. These companies had intimate relationships with their retail channels and would be able to defend their positions effectively through discounting or other tactics. So, although the CP industry is not very capital intensive, other barriers would prevent entry. 4. Bargaining power of suppliers Number of suppliers of input: The major inputs are sugar, water, various chemicals, aluminum cans, and plastic and glass bottles. There are many places to buy sugar and ingredients for soft drinks as these are commodity items, hence they did not have much bargaining power. There are five major suppliers of glass bottles, which is fairly enough. There are even more suppliers for plastic bottles. The aluminum can industry is even older and more established than the plastic industry. With an abundant supply of inexpensive aluminum in the early 1990s and several can companies competing for contracts with bottlers, can suppliers had very little supplier power. Degree of inputs substitution: In the case of sugar, if sugar became to expensive, firms can easily substitute it for corn syrup as they did in the early 1980s. Hence, again, suppliers do not have much bargaining power. Possibility of upward integration: There is little threat of backward integration into the supplier's industry. Conclusion: When you sum up the different aspects of the suppliers you come to the quick conclusion that the power is definitely in the hands of the soft drink industry. This makes the industry very attractive for investment and for the companies already in the industry from the supply aspect. This means that it is attractive to new entrants as well. 5. Rivalry among existing competitors Many competitors: Three main competitors: PepsiCo, Coca-Cola, and Dr. Pepper/Cadbury control the Soft Drink industry. Their combined total sales revenues account for 90 percent

of the entire domestic market. This market dominance makes the industry a fiercely competitive and dynamic business environment to operate in. The single market leader is Coca-Cola with a 42 percent market share and over $18 billion in sales worldwide. PepsiCo maintains a 31 percent market share with $10.5 billion in sales worldwide. The smallest of the three leaders is Dr. Pepper/Cadbury, which holds roughly 16 percent of the market. Coke's consistent dominance of both Pepsi and Dr. Pepper/Cadbury has caused Coke to become a household name when referring to soft drinks. Low industry growth: From 1975 to the mid 1990s Coke and Pepsi achieved annual average revenue growth of around 10%. Growth figures for the soft drink industry have been very steady since 1993. U.S. sales volume grew at a rate of 1% or less in the years 1998 to 2004. Globally too, the demand remained flat.

Question # 2: Compare the economics of the concentrate business to that of the bottling business: why is profitability so different? (You can also perform a five forces analysis here). Concentrate business has added more value as they are the initiator and have the formula as compared to bottlers, which dont add distinct value as concentrate business do. Concentrate producers and bottlers both are ultimately dependent on the same customers, yet the industries differ in terms of profitability. The basic difference is the added value. Concentrate producers add value through their brand name, unique formula, and sophisticated strategic and operational management practices. Bottlers have a lesser added value comparatively; it comes from their relationships with concentrate producers and customers. Through long-term relations with customers, they are able to serve them more effectively. The other major source of profitability is their relationship with concentrate producers, which grant them exclusive territories preventing intrabrand competition, creating an oligopoly at the bottlers level. This reduces rivalry and allows profits. Also, they pass along some of their supply savings to their bottlers. There was a time when at the same time while concentrate producers profitability went up, the bottlers become less profitable. One reason for this could be that a product line expansion for new beverages helped CPs but hurt bottlers. While concentrate producers were able to charge more for their products, bottlers faced price pressure, resulting in lower revenues per case. In a struggle to secure limited shelf space with more products and slower overall growth, bottlers were probably forced to give up more margin on their products. Concentrate producers, meanwhile, could continue increasing the prices for their concentrates with the consumer price index. Coke had negotiated this flexibility into its Master Bottling Contact in 1986, and Pepsi had worked price increases based on the CPI into its bottling contracts. So, while the bottlers faced increasing price pressure in a slowing market, concentrate producers could

continue raising their prices. Despite improvements in per case costs, bottlers could not improve their profitability as a percent of total sales. As a result, through the period of 1986 to 1993, bottlers did not gain any of the profitability gains enjoyed by CPs. For example, Pepsi negotiated concentrate prices with its bottling association and usually based price increases on the consumer price index (CPI). As a result, even as the inflation adjusted retail prices were declining, the concentrate prices were regularly increasing. In 2004, while the concentrate producer had a pretax profit of 30%, the bottler had a pretax profit of 9%. Rivalry among existing competitors: Geographically exclusivity bounds the competition among Bottlers so its difficult to limit profitability through lower prices. Threat of Substitutes: There are less substitute for concentrated business as their prices can not be lowered.

Question # 3: Can companies affect the industry structure of their markets? Companies do affect the industrys structure of their markets. If two or three companies grow that big as to capture 70% to 80% share of the entire market, then that would make its a consolidated industry as opposed to a fragmented one. Such was the case with the CSD industry: PepsiCo, Coca-Cola, and Dr. Pepper/Cadbury control the Soft Drink industry. Their combined total sales revenues account for 90 percent of the entire domestic market. If a company manages to finds a better way of doing things which would increases its productivity/performance, irrespective to whatever market it operates, the other companies would start adopting those practices as well to increase their performances. Thus the whole market structure would change.

Illustration: Looking at Pakistans Telecom industry, when Mobilinks monopoly was wrecked as other cellular operator entered Pakistani market, the call rate kept decreasing due to the fact that every operator was trying to give lower call rates than others to capture most of the market. It only took the first operator to start the chain to change the whole industrys structure from very high call rates to very low rates. Another example is of the CSD industry, where most practices followed by Coca-Cola were later adopted by Pepsi.