1. Why is the soft drink industry so profitable?

An industry analysis through Porter’s Five Forces reveals that market forces are favorable for profitability. Defining the industry: Both concentrate producers (CP) and bottlers are profitable. These two parts of the industry are extremely interdependent, sharing costs in procurement, production, marketing and distribution. Many of their functions overlap; for instance, CPs do some bottling, and bottlers conduct many promotional activities. The industry is already vertically integrated to some extent. They also deal with similar suppliers and buyers. Entry into the industry would involve developing operations in either or both disciplines. Beverage substitutes would threaten both CPs and their associated bottlers. Because of operational overlap and similarities in their market environment, we can include both CPs and bottlers in our definition of the soft drink industry. In 1993, CPs earned 29% pretax profits on their sales, while bottlers earned 9% profits on their sales, for a total industry profitability of 14% (Exhibit 1). This industry as a whole generates positive economic profits. Rivalry: Revenues are extremely concentrated in this industry, with Coke and Pepsi, together with their associated bottlers, commanding 73% of the case market in 1994. Adding in the next tier of soft drink companies, the top six controlled 89% of the market. In fact, one could characterize the soft drink market as an oligopoly, or even a duopoly between Coke and Pepsi, resulting in positive economic profits. To be sure, there was tough competition between Coke and Pepsi for market share, and this occasionally hampered profitability. For example, price wars resulted in weak brand loyalty and eroded margins for both companies in the 1980s. The Pepsi Challenge, meanwhile, affected market share without hampering per case profitability, as Pepsi was able to compete on attributes other than price. Substitutes: Through the early 1960s, soft drinks were synonymous with “colas” in the mind of consumers. Over time, however, other beverages, from bottled water to teas, became more popular, especially in the 1980s and 1990s. Coke and Pepsi responded by expanding their offerings, through alliances (e.g. Coke and Nestea), acquisitions (e.g. Coke and Minute Maid), and internal product innovation (e.g. Pepsi creating Orange Slice), capturing the value of increasingly popular substitutes internally. Proliferation in the number of brands did threaten the profitability of bottlers through 1986, as they more frequent line set-ups, increased capital investment, and development of special management skills for more complex manufacturing operations and distribution. Bottlers were able to overcome these operational challenges through consolidation to achieve economies of scale. Overall, because of the CPs efforts in diversification, however, substitutes became less of a threat. Power of Suppliers: The inputs for Coke and Pepsi’s products were primarily sugar and packaging. Sugar could be purchased from many sources on the open market, and if sugar became too expensive, the firms could easily switch to corn syrup, as they did in the early 1980s. So suppliers of nutritive sweeteners did not have much bargaining power against Coke, Pepsi, or their bottlers. NutraSweet, meanwhile, had recently come off patent in 1992, and the soft drink industry gained another supplier, Holland Sweetener, which reduced Searle’s bargaining power and lowering the price of aspartame.


The stores counted on soft drinks to generate consumer traffic. Furthermore. But due to their tremendous degree of fragmentation (the biggest chain made up 6% of food retail sales. so they needed Coke and Pepsi products. If Mobil or Seven-Eleven were to negotiate on behalf of its stations. resulting in somewhat lower profitability. they could negotiate more effectively due to their scale and the magnitude of their contracts. While these stores did carry both Coke and Pepsi products. who was generally limited on thirst quenching alternatives. the mass merchandiser channel was relatively less profitable for soft drink makers. In the plastic bottle business. vending. had much more bargaining power. Property owners were paid a sales commission on Coke and Pepsi products sold through machines on their property. however. The customer in this case was the consumer. consumers expected to pay less through this channel. was the most profitable channel for the soft drink industry. as an avenue to build brand recognition and loyalty. Their only power was control over premium shelf space. can suppliers had very little supplier power. fast food chains made 75% gross margin on fountain drinks. where Coke and Pepsi bottlers could sell directly to consumers through machines owned by bottlers. Coke and Pepsi were able to negotiate extremely favorable agreements. The final channel to consider is convenience stores and gas stations. Furthermore. while Coke and Pepsi gained only 5% margins. Coke and Pepsi found these channels important. so they invested in the fountain equipment and cups that were used to serve their products at these outlets. and the largest chains controlled up to 25% of a region). the principal customer for soft drink makers. Coke and Pepsi effectively further reduced the supplier of can makers by negotiating on behalf of their bottlers. Profitability at these locations was so abysmal for Coke and Pepsi that they considered this channel “paid sampling. so they could negotiate for optimal pricing. As a result. convenience and gas. National mass merchandising chains such as Wal-Mart. Supermarkets. This power did give them some control over soft drink profitability. With more than two companies vying for these contracts. thereby reducing the number of major contracts available to two. Vending. fountain.With an abundant supply of inexpensive aluminum in the early 1990s and several can companies competing for contracts with bottlers. which could be allocated to Coke or Pepsi products. it would be able to exert significant buyer power in transactions with 2 . these stores did not have much bargaining power. For this reason. was fountain sales. meanwhile. so prices were lower. Essentially there were no buyers to bargain with at these locations. The least profitable channel for soft drinks. so their incentives were properly aligned with those of the soft drink makers. were a highly fragmented industry. on the other hand. so direct negotiation by the CPs was again effective at reducing supplier power. Power of buyers: The soft drink industry sold to consumers through five principal channels: food stores. and mass merchandisers (primary part of “Other” in “Cola Wars…” case). and prices remained high.” This was because buyers at major fast food chains only needed to stock the products of one manufacturer. however. again there were more suppliers than major contracts.

Coke and Pepsi are respected household names. Through other markets. an industry analysis by Porter’s Five Forces reveals that the soft drink industry in 1994 was favorable for positive economic profitability. making it impossible for new bottlers to get started in any region where an existing bottler operated. New CPs would need to overcome the tremendous marketing muscle and market presence of Coke. branded products. Bottlers have significantly less added value. the industry enjoyed substantial profitability because of limited buyer power. via the Soft Drink Interbrand Competition Act of 1980. In conclusion. giving their products an aura of value that cannot be easily replicated. would require substantial capital investment. they accounted for less than 20% of total soft drink sales. The fundamental difference between CPs and bottlers is added value. Also hard to replicate are Coke and Pepsi’s sophisticated strategic and operational management practices. Why is the profitability so different? In some ways. they do not have branded products or unique formulas. existing bottlers had exclusive territories in which to distribute their products. The company even left a billion-person market (India) to avoid revealing this information. ratified this strategy. Barriers to Entry: It would be nearly impossible for either a new CP or a new bottler to enter the industry. Coke has protected its recipe for over a hundred years as a trade secret. Their added value stems from their relationships with CPs and with their 3 . where bottlers’ profits were relatively high.40 per case. Through their DSD practices. as evidenced in companies’ financial outcomes. these companies had intimate relationships with their retail channels and would be able to defend their positions effectively through discounting or other tactics. however. With this high profitability. Regulatory approval of intrabrand exclusive territories. The CPs negotiate on behalf of their suppliers. and has gone to great lengths to prevent others from learning its cola formula. Although these outlets captured most of the soft drink profitability in their channel. although the CP industry is not very capital intensive. such as aspartame. other barriers would prevent entry. in 1993. another source of added value. it seems likely that Coke and Pepsi bottlers negotiated directly with convenience store and gas station owners. CPs pass along any negotiated savings directly to their bottlers. Compare the economics of the concentrate business to the bottling business. Even in the case of materials. Further complicating entry into this market. and they are ultimately dependent on the same customers. who had established brand names that were as much as a century old. at $0.Coke and Pepsi. Unlike their CP counterparts. Apparently. So. Pepsi. Yet the industries are quite different in terms of profitability. and a few others. this was not the nature of the relationship between soft drink producers and this channel. Entering bottling. 2. though. which included every significant market in the US. which would deter entry. meanwhile. that are incorporated directly into concentrates. The biggest source of added value for CPs is their proprietary. As a result of extended histories and successful advertising efforts. the economics of the concentrate business and the bottling business should be inextricably linked. So the only buyers with dominant power were fast food outlets.

Coke had negotiated this flexibility into its Master Bottling Contact in 1986. so that they are unlikely to challenge their contracts. p. To further build “glass houses. bottlers faced price pressure. making it possible for their customers to purchase and sell more product.27. bottlers were probably forced to give up more margin on their products. is in top line revenues. and whose idiosyncratic needs are familiar to them. Bottlers’ principal ability is to use their capital resources effectively. while the bottlers faced increasing price pressure in a slowing market. bottlers did not gain any of the profitability gains enjoyed by CPs. During this period. Through DSD programs. Despite improvements in per case costs. CPs. however. CPs pass along some of their negotiated supply savings to their bottlers. Through long-term. Coke gives 2/3 of negotiated aspartame savings to its bottlers by contract. resulting in lower revenues per case.” as described by Nalebuff and Brandenberger (Co-opetition. They have repeatedly negotiated contracts with their customers. CP profits rose by 130% on a per case basis. mostly due to economies of scale developed through consolidation. While CPs were able to charge more for their products.2% CAGR in the period 1989 to 1993. as operational effectiveness is easily replicated. Exhibit 1 demonstrates these dramatic changes.35 to 0.3%. This. These per case revenue changes occurred during a period of slowing growth in the industry. from $0. Growth in per capita consumption of soft drinks slowed to a 1. however. for their bottlers. In this way. the differences in added value between CPs and bottlers resulted in a major shift in profitability within the industry.customers. from $0. and Pepsi does this in practice. While industry profitability increased by 11%. while case volume growth tapered to 2. bottlers could not improve their profitability as a percent of total sales. Such operational effectiveness is not a driver of added value. So. Why have contracts between CPs and bottlers taken the form they have in the soft drink industry? 4 . In an struggle to secure limited shelf space with more products and slower overall growth. which reduce rivalry and allow profits. Between 1986 and 1993. One possibility is that product line expansion in defense against new age beverages helped CPs but hurt bottlers. which grant them exclusive territories and share some cost savings. bottler profits actually dropped on a per case basis by 23%. as shown in Exhibit 2. creating oligopolies at the bottler level. and Pepsi had worked price increases based on the CPI into its bottling contracts. This practice keeps bottlers comfortable enough. As a result.23. was not the case. This would be expected if bottler’s per case costs increased due to the operational challenges and capital costs of producing and distributing broader product lines. 3. they lower their customers’ costs. cost of sales per case decreased for both CPs and bottlers by 27% during this period.10 to $0. could continue increasing the prices for their concentrates with the consumer price index. in depth relationships with their customers. 88). with whom they work on an ongoing basis. The real difference between the fortunes of CPs and bottlers through this period. they are able to serve customers effectively. then. Their other source of profitability is their contract relationships with CPs. Exclusive territories prevent intrabrand competition. CPs could continue raising their prices. meanwhile. through the period of 1986 to 1993. bottlers are able to grow the pie of the soft drink market.

The contracts also excluded bottlers from producing the flagship products of competitors. while the bottling industry has struggled to retain any profitability. PepsiCo might not have a core competency in food sales or a strong position in the industry. realizing that fast food chains were capturing most of the value of fountain sales. “don’t vertically integrate unless it is absolutely necessary to create or protect value. Pizza Hut. Coke could negotiate this more flexible pricing because its bottlers were dependent on it for business. First. only influenced by rising prices of sugar. Should concentrate producers vertically integrate into bottling? Given the data in Exhibit 1. by definition. entered the fast food business by purchasing Taco Bell. 4. These mergers allowed the firm to capture more value from its soft drink sales. and developing a chain of its own against such formidable competition would be extremely risky. and then to give general flexibility to the CP (Coke) in setting prices. from the bottler perspective. For example. Stuckey and White also point out that “high-surplus stages must. As Stuckey and White say. Pepsi. without the complications of vertical integration. as contracts were renegotiated. the contracts favored the CPs’ long-term strategies in important ways. which would only produce Coke products. Each bottler could only negotiate with one supplier for its premium product. But it is also beneficial to CPs. be protected by barriers to entry. Although beneficial to bottlers on the surface. (2) “Companies in adjacent stages of the industry 5 . Violation of this stipulation would result in termination of the contract. Historically. (1) “The market is too risky and unreliable. which would leave the bottler in a difficult position. Stuckey and White (p. territorial exclusivity is beneficial to bottlers. 78) indicate that a firm should “Integrate into those stages of the industry chain where the most economic surplus is available. This changed in 1978 and 1986. It could be prohibitively expensive to purchase McDonalds or Burger King. and KFC.” In the soft drink industry. contracts were designed hold syrup prices constant into perpetuity.” So it could be difficult for Coke to enter the fast food business. the concentrate market is highly stable and will be for a long time to come. irrespective of closeness to the customer or the absolute size of the value added. Coke would capture 49% of the dividends from CCE. first to accommodate for rises in the CPI.” We shall address each of these individually to formally refute the plausibility of vertical integration of CPs into bottling. who are also not subject to price wars within their own brand. but these mergers could also be problematic. the mergers might not be successful in the long run. as it prevents intrabrand competition. it would not be advisable to vertically integrate. ensures bargaining power over buyers and establishes barriers to entry. CPs generally miss out on the profits earned through fountain sales. This created monopoly status for the CPs. It further ensured that its bottlers would be captive to its monopoly status by buying major bottlers and then selling them into the CCE holding company. Because it might not be able to effectively transfer skills or share activities with its fast food businesses. So integration into this phase of the value chain would be difficult or impossible for Coke. indicating the CP business has grown more profitable over the last seven years.Contracts between CPs and bottlers were strategically constructed by the CPs.” On the contrary.

” The market is neither young nor declining. (4) “The market is young and the company must forward integrate to develop a market. Having determined that a vertical integration strategy fails all four of Stuckey and White’s tests. 6 . and effectively price discriminate through various retail channels.” In fact. (3) “Integration would create or exploit market power by raising barriers to entry or allowing price discrimination across customer segments. so they should not vertically integrate. or the market is declining and independents are pulling out of adjacent stages.” The opposite is true.chain have more market power than companies in your stage. CPs already have more market power than bottlers. CPs already have market power through efficient barriers to entry. CPs should not pursue vertical integration into bottling.

35 Percent of Total 100% 60% 40% 25% 3% 3% 9% Total Dollars per Case 4.05 n/a -7% 7% 1% 1% 1% 4% -16% -27% -3% -10% -9% 6% 11% 7 .08 Change in percent of total n/a -3% 3% 3% -1% 1% 0% % Change in dollars per case -21% -27% -13% -11% -50% 8% -23% Change in Change in % Change in dollars per percent of dollars per case total case -0.55 0.24 0.10 -0.Industry Profitability Analysis 1986 Concentrate Producer Dollars per Case Net Sales Cost of sales Gross profit Selling and delivery Advertising and marketing General and administrative Pretax profit 1993 Concentrate Producer Dollars per Case Net Sales Cost of sales Gross profit Selling and delivery Advertising and marketing General and administrative Pretax profit Change from 1986 to 1993 Concentrate Producer Bottler Total 0.02 0.05 -0.95 0.65 1.55 0.96 0.99 1.70 -0.50 0.11 -0.15 0.04 0.86 0.90 0.31 0.18 0.45 Percent of Total 100% 56% 44% 22% 8% 4% 10% Change in Dollars per Case Net Sales Cost of sales Gross profit Selling and delivery Advertising and marketing General and administrative Pretax profit Green Text indicates a change for the better Red Text indicates a change for the worse Black Text indicates no change 0.45 1.Exhibit 1 .13 Change in percent of total n/a -10% 10% 0% -3% 2% 11% % Change in dollars per case 20% -27% 38% 0% 8% 0% 130% Change in dollars per case -0.35 2.05 0.69 1.34 0.66 0.05 0.81 -0.01 -0.80 2.27 Percent of Total 100% 57% 43% 28% 2% 4% 9% Total Dollars per Case 3.10 Percent of Total 100% 27% 73% 2% 42% 11% 18% Bottler Dollars per Case 3.10 0.11 0.00 0.26 0.10 -0.05 0.20 -0.85 0.85 0.01 0.12 0.61 -0.17 0.80 1.00 0.05 0.65 -0.03 0.13 0.30 1.50 Percent of Total 100% 49% 51% 24% 8% 5% 14% 0.23 Percent of Total 100% 17% 83% 2% 39% 13% 29% Bottler Dollars per Case 2.40 0.15 0.01 0.01 0.30 0.

6 48.4% 4. Exhibit 1.3% .4% .8% .3% 3.5 40.Soft Drink Market Growth Tapered in late 1980s and early 1990s Data drawn from 1994 case "Cola Wars Continue…".1% .6 34.3% 3.9 1970-1975 1975-1981 1981-1985 1985-1989 1989-1993 .Exhibit 2 .2% 4.2% 8 .8 46.7 26.4% 1. Compound Annual Compound Annual Growth Growth Rate (Per Capita Consumption) Rate (Case Volume) Year 1970 1975 1981 1985 1989 1993 Period Cases (millions) 3090 3780 5180 6500 7680 8395 Gallons/ Capita 22.

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