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Case Study of the Soft Drink Industry:
Length: 4504 words (12.9 double-spaced pages) Rating: Red (FREE) ---------------------------------Case Study of the Soft Drink Industry Incomplete Essay Table of Contents Introduction 3 Description 3 Segments 3 Caveats 4 Socio-Economic 4 Relevant Governmental or Environmental Factors, etc. 4 Economic Indicators Relevant for this Industry 4 Threat of New Entrants 5 Economies of Scale 5 Capital Requirements 6 Proprietary Product Differences 7 Absolute Cost Advantage 8 Learning Curve 8 Access to Inputs 8 Proprietary Low Cost Production 8 Brand Identity 9 Access to Distribution 9 Expected Retaliation 9 Conclusion 10 Suppliers 10 Supplier concentration 10 Presence of Substitute Inputs 11 Differentiation of Inputs 12
Importance of Volume to Supplier 13 Impact of Input on Cost or Differentiation 13 Threat of Backward or Forward Integration 13 Access to Capital 14 Access to Labor 14 Summary of Suppliers 14 Buyers 15 Buyer Concentration versus Industry Concentration 15 Buyer Volume 15 Buyer Switching Cost 15 Buyer Information 16 Threat of Backward Integration 16 Pull Through 16 Brand Identity of Buyers 17 Price Sensitivity 17 Impact on Quality and Performance 17 Substitute Products 18 Relative price/performance relationship of Substitutes 18 Buyer Propensity to Substitute 18 Rivalry 18 Industry Growth Rate 20 Fixed Costs 21 Product Differentiation 21 Brand Identity 21 Informational Complexity 22 Corporate Stakes 22 Conclusion 23 Critical Success Factors 23 Prognosis 24 Bibliography 26 Appendix 27 Key Industry Ratios 27 Introduction Description The soft drink industry is concentrated with the three major players, Coca-Cola Co., PepsiCo Inc., and Cadbury Schweppes Plc., making up 90 percent of the $52 billion dollar a year domestic soft drink market (Santa, 1996). The soft drink market is a relatively mature market with annual growth of 4-5% causing intense rivalry among brands for market share and growth (Crouch, Steve). This paper will explore Porter's Five Forces to determine whether or not this is an attractive industry and what barriers to entry (if any) exist. In addition, we will discuss several critical success factors and the future of the industry. Segments The soft drink industry has two major segments, the flavor segment and the distribution segment. The flavor segment is divided into 6 categories and is listed in table 1 by market share. The distribution segment is divided in to
7 segments: Supermarkets 31.9%, fountain operators 26.8%, vending machines 11.5%, convenience stores 11.4%, delis and drug stores 7.9%, club stores 7.3%, and restaurants 3.2%. Table 1: Market Share 1990 1991 1992 1993 1994
Cola Lemon-Lime Pepper 5.6 Root Orange Other 2.7 2.8 2.3 7.8
11.7 11.8 12 12.1 6.2 6.9 7.3 7.6 2.3 2.3 2.6 7.2 7.9 2.7 2.3 8.6 2.7 2.3 9.2
Source: Industry Surveys, 1995 The only limitations on access to information were: 1. Financial information has not yet been made available for 1996. 2. The majority of the information targets the end consumer and not the sales volume from the major soft drink producers to local distributors. 3. There was no data available to determine over capacity. Socio-Economic Relevant Governmental or Environmental Factors, etc. The Federal Government regulates the soft drink industry, like any industry where the public ingests the products. The regulations vary from ensuring clean, safe products to regulating what those products can contain. For example, the government has only approved four sweeteners that can be used in the making of a soft drink (Crouch, Steve). The soft drink industry currently has had very little impact on the environment. One environmental issue of concern is that the use of plastics adversely affects the environment due to the unusually long
time it takes for it to degrade. To combat this, the major competitors have lead in the recycling effort which starting with aluminum and now plastics. The only other adverse environmental impact is the plastic straps that hold the cans together in 6-packs. These straps have been blamed for the deaths of fish and mammals in both fresh and salt water. Economic Indicators Relevant for this Industry The general growth of the economy has had a slight positive influence on the growth of the industry. The general growth in volume for the industry, 4-5 percent, has been barely keeping up with inflation and growths on margins have been even less, only 2-3 percent (Crouch, Steve). Threat of New Entrants Economies of Scale Size is a crucial factor in reducing operating expenses and being able to make strategic capital outlays. By consolidating the fragmented bottling side of the industry, operating expenses may be spread over a larger sales base, which reduces the per case cost of production. In addition, larger corporate coffers allow for capital investment in automated high speed bottling lines that increase efficiency (Industry Surveys, 1995). This trend is supported by the decline in the number of production workers employed by the industry at higher wages and fewer hours. This in conjunction with the increased value of shipments over the period shows the increase in efficiency and the economies gained by consolidation (See table 2). Table 2 General Statistics: Year Companies Workers Hours Wages Value of Shipments 1982 1626 42.4 85.2 7.84 16807.5 1983 41.5 85.1 8.24 17320.8 1984 39.8 81.7 8.51 18052 1985 1414 37.2 77.8 9.1 19358.2 1986 1335 35.5 73.5 9.77 20686.8 1987 1190 35.4 71.5 10.45 22006 1988 1135 35.2 71.8 10.78 23310.3 1989 1027 33.4 67.7 10.98 23002.1 1990 941 32 65.7 11.48 23847.5 1991 31.9 66.8 11.85 25191.1 1992 29.8 61.6 12.46 26260.4 1993 28.6 59.3 12.93 27224.4 1994 27.4 56.9 13.39 28188.5 1995 26.2 54.5 13.86 29152.5 1996 25 52.1 14.32 30116.5 Source: Manufacturing USA, 4th Ed. Further evidence of economies is supported by the increased return on assets from 1992-1995, as shown in table 3. Coke and Pepsi clearly show increased return on assets as the asset base increases. However, Cadbury/Schweppes does not show conclusive evidence from 95 to 96. Table 3 CADBURY/SCHWEPPES 93 94 95 96 ASSETS 2963100
NET INCOME 195600 236800 261900 300000 Sales/Income 5.80% 6.36% 6.50% 6.28% Income/Assets 6.60% 7.25% 7.48% COKE ASSETS 11051934 12021000 13873000 13073860 13963000 16181000 18018000
NET INCOME 1664382 2176000 2554000 2986000 Sales/Income 12.73% 15.58% 15.78% 16.57% Income/Assets 15.06% 18.10% 18.41% 19.85% PEPSI ASSETS 20951200 23705800 24792000 21970000 25021000 28472400 30421000 25432000 SALES
NET INCOME 374300 1588000 1752000 1606000 Sales/Income 1.70% 6.35% 6.15% 5.28% Income/Assets 1.79% 6.70% 7.07% 6.31% Source: Compact Disclosure Capital Requirements The requirements within this industry are very high. Production and distribution systems are extensive and necessary to compete with the industry leaders. Table 4 shows the average capital expenditures by the three industry leaders. Table 4 Dec-95 Dec-94 Jan-94 Jan-93 Receivables 1624333 1385767 1226633 1077912 Inventories 867666.7 803666.7 777366.7 716673.7 Plant & Equip 5986333 5795367 5246600 4642058 Total Assets 15022667 14055500 12997900 11655411 Source: Compact Disclosure The magnitude of these expenditures causes this to be a high barrier to entry. Proprietary Product Differences Each firm has brands that are unique in packaging and image, however any of the product differences that may develop are easily duplicated. However, secret formulas do create a difference or good will that cannot be duplicated. The best example of this is the "New Coke" fiasco of 1985. Coke reformulated its product due to test marketing results that showed New Coke beat Pepsi 47% to 43% and New Coke was preferred over old Coke by a 10% margin. However, Coke executives did not take into account the good will created by the old Coke name
and formula. The introduction of New Coke as a replacement of Coke was met by outrage and unrelenting protest by the public. Three months from the initial launch of New Coke, management apologized to the public and reissued the old Coke formula. Test marking shows that there is only a small difference in actual product taste (52% Pepsi, 48% Coke), but the good will created by a brand can have significant proprietary differences (Dess, 1993). This is a high barrier to entry. Absolute Cost Advantage Brands do have secret formulas, which makes them unique and new entry into the industry difficult. New products must remain outside of patented zones but these differences can be slight. This leads to the conclusion that the absolute cost advantage is a low barrier within this industry. 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. 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. Proprietary Low Cost Production The process of manufacturing soft drinks is not a proprietary process. The methods used in the process are relatively standard within the industry and the knowledge needed to begin production can easily be acquired. This is not a barrier to entry. Brand Identity This is a very strong force within the industry. It takes a long time to develop a brand that has recognition and customer loyalty. "Brand loyalty is indeed the HOLY GRAIL to American consumer product companies." (Industry Surveys, 1995) A well recognized brand will foster customer loyalty and creates the opportunity for real market share growth, price flexibility, and above average profitability (Industry Surveys, 1995). Therefore this is a high barrier to entry. 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 Coca-Cola bottlers decreased from 370 to 120 (Industry Surveys, 1995). In addition, 31.9% of the soft drink business is in supermarkets, where acquiring shelf space is very difficult (Santa, 1996). This is a high barrier to entry. Expected Retaliation Market share within the industry is critical; therefore any attempt to take market share from the leaders will result in significant retaliation. The soft drink industry is a moderately mature market with slow single digit growth (Industry Surveys, 1995). Projected growth rates are 4-5% in sales volume and 23% in margin (Crouch, Steve). Therefore, growth in market share is obtained by stealing share from rivals causing retaliation to be high in defense of current market position. This is a high barrier to entry. Conclusion To be successful on a large scale, the high capital requirements for manufacturing, distribution, and marketing are high barriers to entry. Therefore the threat of new entrants is low making this an attractive industry. Suppliers Supplier concentration Supplier concentration is low due to the fact that the main ingredients are sugar (cane and beet), water, various chemicals, and aluminum cans, plastic and glass bottles. There are many places to get sugar and ingredients for soft drinks because they are commodity items. The containers (aluminum cans, bottles etc.) make up 36 percent of all the inputs that the industry uses. Other supplies like sugars, syrups and extracts account for 23 percent of the inputs (Manufacturing USA). There are five major suppliers of glass bottles. Altrista Corp., Anchor Glass Container, Glassware of Chile, Owens Illinois, and Vistro Sa are the major makers of glass bottles (Compact Disclosure). This is a fair amount of suppliers considering that only five percent of soft drink sales are in glass bottles. There are even more suppliers of plastic bottles. This is good because 43% of all sales are from plastic bottles (Prince, 1996). All this makes the concentration for glass and plastic suppliers moderate. The aluminum can industry is even older and more established than the plastic industry. Reynolds Metal Products, American National Can Company and Metal Container Corp. are the main suppliers of aluminum cans. 50.6% of total soft drink sales are packaged in aluminum cans (Prince, 1996). Since the aluminum industry is older and more established, these are likely to be the only manufacturers for a while. Even though the concentration of aluminum producers are low there are only three major players in the industry, Coke, Pepsi, and Cadbury. These three account for nearly 90% of domestic soft drink sales (Dawson, 1996). This makes the balance of power slightly favor the suppliers of aluminum cans, even though the
number of producers and buyers are equal (3). Syrups and extracts account for 16.7% of input costs to the soft drink industry (Manufacturing USA, Fourth Ed.). Even though these are a small percentage of inputs, all the major soft drink companies own companies that produce flavoring extracts and syrups (Industry Surveys, 1995). This is probably due to the fact that they all have "secret formulas" and this is how they protect the secret. Coke, Pepsi, and Dr. Pepper all have "secret formulas". This makes the concentration of suppliers for extracts very low but they are owned by the soft drink industry. This backward integration by the major players makes the power question moot. Suppliers do have limited power over the soft drink industry. The concentration of suppliers remains relatively low, which would seem to give the supplier power. The shear mass and volume that the industry buys negates that effect and balances, if not tips it back toward the soft drink industry. Presence of Substitute Inputs There is not a lot of variety in inputs. The biggest substitute input was when the industry switched from aluminum cans to plastic bottles. This made the glass industry almost shake out completely. The next big substitute input was for sugar. Since people were demanding more and more ways to lose weight and consume fewer calories, the diet soft drink exploded in sales. This demand made the soft drink industry find an alternative to sugar to sweeten their product. This substitute turned out to be Nutrasweet non-sugar sweetener. This was found to reduce the calories and retain the taste of their respective products. Other sweeteners, like molasses, do not work because they change the flavor of the product. Most of these substitute inputs had already taken place so they become less relevant to the industry as time marched on. Substitute inputs usually do not become important until the customer or market changes dramatically. This happens when new studies come out from the government about how harmful something is. This was the case when scientists came out with the study that stated that saccharin was harmful to rats. The industry had to respond by reducing its use of saccharin and look for a substitute. At this time, the industry found Nutrasweet to be a reasonable substitute for saccharin, which was used more heavily in diet drinks. All in all, there are a lot of substitutes for packaging but not for sweeteners because these sweeteners must have government approval (Crouch, Steve). This makes suppliers have power over the industry as seen in the almost overnight empire of Nutrasweet. This will most likely change drastically when Aspirtain (Nutrasweet) loses its patent in a few years. Differentiation of Inputs Sugar is commonly available while Nutrasweet is patented. There is no differentiation for sugar and only one choice in Nutrasweet. As far as the other chemicals and inputs, they are commodity items, and it does not matter who supplies them. This makes suppliers have little power over the soft drink industry. Importance of Volume to Supplier
The soft drink industry buys a large portion of the Nutrasweet market but their percentage of purchases are falling as other products begin to use it. Sugar is bought but not in the volume that the grocery store or other industries do. The aluminum can, plastic bottles and glass bottles (less now) are all pretty much dependent on the soft drink industry for their livelihood. This makes the supplier have pretty much no power over the industry. Impact of Input on Cost or Differentiation Since the inputs are basic elements there is no differentiation and therefore no impact on the final product for using different inputs. If the price of the input changed, it would dramatically change the price of the product as the aluminum cartel did in 1994. Since the major inputs are commodity items, the prices can change dramatically due to environmental forces. If the sugar industry suffers a loss due to weather or because of political unrest (like in Cuba), then the prices go up and the soft drink industry is usually left absorbing them. The soft drink industry can not, in all cases, simply pass along the price increase. Customers and distributors are more price sensitive than ever. This makes the supplier have a fair amount of bargaining power over the industry. Threat of Backward or Forward Integration With the current climate of "sticking to the core of the company," there is little threat of backward integration into the supplier's industry. This is after the fact that they already have integrated into the extracts to protect their secrets. The integration into the extract-producing segment of the suppliers will be the extent of the backward integration. The suppliers do not have the capital required to forward integrate into the soft drink industry. This makes the industry attractive for investment. Access to Capital The soft drink industry is very profitable and therefore looked upon favorably by financial institutions. This includes the stock market, direct investors (bondholders), and banks. Currently the operating margins for the industry have grown from 17.9% in 1992 to 19.5% in 1996. The projected operating margins are projected to grow to 20.5% from 1997 to 2001 (Value Line 1996). The profit margins and demand are increasing for the soft drink industry (Industry Surveys, 1995). What this means is that capital is available for expansion or upgrading, if additional capital is required. This is favorable to the industry. Access to Labor The industry is not highly technical except for chemical engineering. This means that the demands for skilled labor are not very high. Which means that the soft drink industry will not have trouble finding labor. There are no established labor unions. The average labor cost is no more than in any other industry. The average hourly wage is $11.85 per hour, which just about the same as all manufacturing firms of $11.49 (Manufacturing USA).
Summary of Suppliers 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. Buyers Buyer Concentration versus Industry Concentration The buyers for the soft drink industry are members of a large network of bottlers and distributors that represent the major soft drink companies at the local level. 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, for example a town or a county. In turn, these distributors 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 (Thompson and Strickland, 1993). Buyer Volume The contractual agreements, which are present in this industry, dictate that the major soft drink companies will sell their products to the distributors. Therefore, buyer volume is not a factor for this industry. Buyer 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. Buyer Information Distributors are very informed about the product that they are distributing. Information flows freely between the soft drink Companies and the local distributors and down to the retailers. There are many co-operative promotions where distributors and soft drink companies collaborate on price and advertising campaigns (Crouch, Steve). For example, major soft drink firms will send a regular report out to its distributors describing upcoming promotional events where the cost will be shared between the two companies. For promotions that fall outside of this report, the distributors will have to coordinate that sponsorship with the soft drink company. Threat 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 (PepsiCo 1995 Annual Report). For example, Pepsi offers 12-ounce cans, 20 ounce bottles, 1 liter bottles, six packs, twelve packs, cases and "The Cube" 24 can boxes. Pull Through Pull through is not a factor from the independent bottler's perspective. These bottlers have a franchise agreement to represent a major carbonated beverage company on the local level. These distributors are legally bound to represent these companies and therefore cannot choose not to promote certain types of beverages. Brand Identity of Buyers Brand identity of buyers is not relevant to the distributors because of the contractual relationship that exists where distributors represent the soft drink companies. The distributors have an exclusive contractual agreement to represent that soft drink brand. Price Sensitivity Distributors are not highly price sensitive buyers. Independent bottlers are on a national contract so all distributors pay the same price for the same products. Price to Total Purchases Soft drinks are the single product that the distributors are concerned with so price is very important to them. Soft drink companies rely on these distributors to represent them on the local level, so it is important to maintain a healthy relationship. Impact on Quality and Performance All three of the leading carbonated beverage producers, Coca-Cola, PepsiCo, and Cadbury Schweppes believe that their buyers (distributors) are an important step in taking their products to the end consumer. The service, which their distributors provide to the retailers, makes a difference to the retailers who sell the product to the end consumer. The actions of that distributor reflect on the soft drink company so if the distributor does not provide the level of service that retailer or restaurant desires, it may harm the company's image.
Substitute Products Relative price/performance relationship of Substitutes The carbonated beverage industry provides a non-alcoholic means of satisfying an individuals desire to quench their thirst. Traditionally, coffee and tea would be considered substitute products. In recent years, carbonated beverages have seen the emergence of many new substitute products that wish to reduce soft drink's market share. The soft drink market has been traditionally competitive, without the added friction from "ready to drink tea, shelf stable juice, sports drinks and still-water" competitors also. (Gleason, 1996) Leaders in these emerging segments include Quaker Oats, with their Snapple and Gatorade products, Perrier, and Arizona Iced Teas. "In other words, Pepsi isn't Coke's biggest competition, Tap water is." (Gleason, 1996). Generally speaking, soft drinks are less expensive to the consumer than these substitute products. Buyer Propensity to Substitute Buyer propensity to substitute is low due to the contractual relationships between the soft drink companies and the distributors. Rivalry Degree of Concentration and Balance among 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. As far as balance among competitors is concerned, PepsiCo is a much larger company than Coke and Dr. Pepper/Cadbury combined. The reason being that PepsiCo also owns companies in the snack and food industries (Frito-Lay, Pizza Hut, Taco Bell, and KFC). With a work force of 480,000 people, PepsiCo is the world's third largest employer behind General Motors and Wal-Mart. This has not lead to a more profitable soft drink business, nor has it helped PepsiCo use its size to steal market share from Coke or Dr. Pepper/Cadbury. Diversity among Competitors Though Coca-Cola dominates the industry in sales volume and market share, it does not dominate when it comes to innovative marketing and business strategy efforts. For instance, PepsiCo generates 71 percent of its revenues from the U.S., while Coca-Cola derives 71 percent of its from international markets. Similarly, PepsiCo only gets 41 percent of its total revenues from soft drinks.
The remaining 59 percent come from its snack and food business. Coke on the other hand gets all of its revenues from its soft drinks. Clearly both of the industry leaders have different strategies as far as revenue generation is concerned. However, as far as their product lines are concerned they are very similar and operate parallel to one another. Pepsi and Coca-Cola both have lemon-lime, citrus, root beer, and cola flavors. Dr. Pepper/Cadbury does not have as similar a product line to that of Pepsico and Coca-Cola. It manufactures Dr. Pepper (a unique spicy cola drink), ginger ale, tonic water, and carbonated water under its Schweppes and Canada Dry brands. Coke does have an answer to Dr. Pepper in its Mr. Pibb, but only holds a .4 percent market share compared to Dr. Peppers 6 percent market share. The relatively low level of diversity makes the soft drink industry unattractive for investment. Industry Growth Rate Although new product lines have come into the beverage industry over the past two to three years, the soft drink segment has held and grown its share steadily. The onslaught of the sport drink and bottled tea have proven to be a passing fad that has gained little if no long term market share from soft drinks. Growth figures for the soft drink industry have been very steady since 1993, and are projected to continue to be so into the last part of the twentieth century. As can be seen in Figure 1, volatility was somewhat prevalent in the 1980's but has since lessened and leveled off (Valueline, 1996). Figure 1 Year '87-'88 '88-'89 '89-'90 '90-'91 '91'92 '92-'93 '93-'94 '94-'95 Growth 5.7% 5.2% 3% 2.9% 4% 4.4% 4% 2%
Over the past ten years soft drinks have gained 5 percent of total beverage sales, putting them over the 25 percent share level for all beverage sales. As for new and emerging markets, both Coke and Pepsi are attacking the international environment. Coca-Cola generates 80 percent of its revenues abroad, and Pepsi is attempting but failing to put more emphasis there as well. "Pepsi is losing customers to Coke in every major foreign territory. The company has always struggled overseas, but in the past few months it has lost key strongholds in Russia and Venezuela to Coke" (Sellers, 1996). Because of the consistent growth of both the domestic and foreign markets, the soft drink industry is attractive for investment. Fixed Costs The S&P Industry Survey has shown the soft drink industry profit margin to be on a steady incline over the past fifteen years. Levels in 1980 were near 14%, while as of year-end 1995 were over 20% and expected to flatten a bit. This flattening effect may be an indication that fixed costs are on the rise due to expansion
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Firms in this industry acquire ingredients such as liquid beverage bases, syrup, sweeteners and other ingredients like caffeine, potassium and sodium from their various manufacturers and blend these ingredients into soft drink beverages. Along with water acquired from natural springs, and other sources, these beverages are bottled in glass or plastic or otherwise canned in aluminum for sale to grocery product wholesalers, retailers.
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. 2 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. Furthermore, Coke and Pepsi effectively further reduced the supplier of can makers by negotiating on behalf of their bottlers, thereby reducing the number of major contracts available to two. With more than two companies vying for these contracts, Coke and Pepsi were able to negotiate extremely favorable agreements. In the plastic bottle business, again there were more suppliers than major contracts, 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, convenience and gas, fountain, vending, and mass merchandisers (primary part of “Other” in “Cola Wars…” case). Supermarkets, the principal customer for soft drink makers, were a highly fragmented industry. The stores counted on soft drinks to generate consumer traffic, so they needed Coke and Pepsi products. But due to their tremendous degree of fragmentation (the biggest chain made up 6% of food retail sales, and the largest chains controlled up to 25% of a region), these stores did not have much bargaining power. Their only power was control over premium shelf space, which could be allocated to Coke or Pepsi products. This power did give them some control over soft drink profitability. Furthermore, consumers expected to pay less through this channel, so prices were lower, resulting in somewhat lower profitability. 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. For this reason, the mass merchandiser channel was relatively less profitable for soft drink makers. The least profitable channel for soft drinks, however, was fountain sales. Profitability at these
locations was so abysmal for Coke and Pepsi that they considered this channel “paid sampling.” This was because buyers at major fast food chains only needed to stock the products of one manufacturer, so they could negotiate for optimal pricing. Coke and Pepsi found these channels important, however, as an avenue to build brand recognition and loyalty, so they invested in the fountain equipment and cups that were used to serve their products at these outlets. As a result, while Coke and Pepsi gained only 5% margins, fast food chains made 75% gross margin on fountain drinks. Vending, meanwhile, was the most profitable channel for the soft drink industry. Essentially 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 their incentives were properly aligned with those of the soft drink makers, and prices remained high. The customer in this case was the consumer, who was generally limited on thirst quenching alternatives. The final channel to consider is convenience stores and gas stations. If Mobil or Seven-Eleven were to negotiate on behalf of its stations, it would be able to exert significant buyer power in transactions with 3 Coke and Pepsi. Apparently, though, this was not the nature of the relationship between soft drink producers and this channel, where bottlers’ profits were relatively high, at $0.40 per case, in 1993. With this high profitability, it seems likely that Coke and Pepsi bottlers negotiated directly with convenience store and gas station owners. So the only buyers with dominant power were fast food outlets. Although these outlets captured most of the soft drink profitability in their channel, they accounted for less than 20% of total soft drink sales. Through other markets, however, the industry enjoyed substantial profitability because of limited buyer power. Barriers to Entry: It would be nearly impossible for either a new CP or a new bottler 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. Through their DSD practices, 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. Entering bottling, meanwhile, would require substantial capital investment, which would deter entry. Further complicating entry into this market, existing bottlers had exclusive territories in which to distribute their products. Regulatory approval of intrabrand exclusive territories, via the Soft Drink Interbrand Competition Act of 1980, ratified this strategy, making it impossible for new bottlers to get started in any region where an existing bottler operated, which included every significant market in the US. In conclusion, an industry analysis by Porter’s Five Forces reveals that the soft drink industry in 1994 was favorable for positive economic profitability, as evidenced in companies’ financial outcomes. 2. Compare the economics of the concentrate business to the bottling business. Why is the profitability so different? In some ways, the economics of the concentrate business and the bottling business should be inextricably linked. The CPs negotiate on behalf of their suppliers, and they are ultimately dependent on the same customers. Even in the case of materials, such as aspartame, that are incorporated directly into
concentrates, CPs pass along any negotiated savings directly to their bottlers. Yet the industries are quite different in terms of profitability. The fundamental difference between CPs and bottlers is added value. The biggest source of added value for CPs is their proprietary, branded products. Coke has protected its recipe for over a hundred years as a trade secret, and has gone to great lengths to prevent others from learning its cola formula. The company even left a billion-person market (India) to avoid revealing this information. As a result of extended histories and successful advertising efforts, Coke and Pepsi are respected household names, giving their products an aura of value that cannot be easily replicated. Also hard to replicate are Coke and Pepsi’s sophisticated strategic and operational management practices, another source of added value. Bottlers have significantly less added value. Unlike their CP counterparts, they do not have branded products or unique formulas. Their added value stems from their relationships with CPs and with their 4 customers. They have repeatedly negotiated contracts with their customers, with whom they work on an ongoing basis, and whose idiosyncratic needs are familiar to them. Through long-term, in depth relationships with their customers, they are able to serve customers effectively. Through DSD programs, they lower their customers’ costs, making it possible for their customers to purchase and sell more product. In this way, bottlers are able to grow the pie of the soft drink market. Their other source of profitability is their contract relationships with CPs, which grant them exclusive territories and share some cost savings. Exclusive territories prevent intrabrand competition, creating oligopolies at the bottler level, which reduce rivalry and allow profits. To further build “glass houses,” as described by Nalebuff and Brandenberger (Coopetition, p. 88), for their bottlers, CPs pass along some of their negotiated supply savings to their bottlers. Coke gives 2/3 of negotiated aspartame savings to its bottlers by contract, and Pepsi does this in practice. This practice keeps bottlers comfortable enough, so that they are unlikely to challenge their contracts. Bottlers’ principal ability is to use their capital resources effectively. Such operational effectiveness is not a driver of added value, however, as operational effectiveness is easily replicated. Between 1986 and 1993, the differences in added value between CPs and bottlers resulted in a major shift in profitability within the industry. Exhibit 1 demonstrates these dramatic changes. While industry profitability increased by 11%, CP profits rose by 130% on a per case basis, from $0.10 to $0.23. During this period, bottler profits actually dropped on a per case basis by 23%, from $0.35 to 0.27. One possibility is that product line expansion in defense against new age beverages helped CPs but hurt bottlers. 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. This, however, was not the case; cost of sales per case decreased for both CPs and bottlers by 27% during this period, mostly due to economies of scale developed through consolidation. The real difference between the fortunes of CPs and bottlers through this period, then, is in top line revenues. While CPs were able to charge more for their products, bottlers faced price pressure, resulting in lower revenues per case. These per case revenue changes occurred during a period of slowing growth in the industry, as shown in Exhibit 2. Growth in per capita consumption of soft drinks slowed to a 1.2% CAGR in the period 1989 to 1993, while case volume growth tapered to 2.3%. In an 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. CPs, 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, CPs 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. 3. Why have contracts between CPs and bottlers taken the form they have in the soft drink industry? 5 Contracts between CPs and bottlers were strategically constructed by the CPs. Although beneficial to bottlers on the surface, the contracts favored the CPs’ long-term strategies in important ways. First, territorial exclusivity is beneficial to bottlers, as it prevents intrabrand competition, ensures bargaining power over buyers and establishes barriers to entry. But it is also beneficial to CPs, who are also not subject to price wars within their own brand. The contracts also excluded bottlers from producing the flagship products of competitors. This created monopoly status for the CPs, from the bottler perspective. Each bottler could only negotiate with one supplier for its premium product. Violation of this stipulation would result in termination of the contract, which would leave the bottler in a difficult position. Historically, contracts were designed hold syrup prices constant into perpetuity, only influenced by rising prices of sugar. This changed in 1978 and 1986, as contracts were renegotiated, first to accommodate for rises in the CPI, and then to give general flexibility to the CP (Coke) in setting prices. Coke could negotiate this more flexible pricing because its bottlers were dependent on it for business. 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, which would only produce Coke products. Coke would capture 49% of the dividends from CCE, without the complications of vertical integration. 4. Should concentrate producers vertically integrate into bottling? Given the data in Exhibit 1, indicating the CP business has grown more profitable over the last seven years, while the bottling industry has struggled to retain any profitability, it would not be advisable to vertically integrate. Stuckey and White (p. 78) indicate that a firm should “Integrate into those stages of the industry chain where the most economic surplus is available, irrespective of closeness to the customer or the absolute size of the value added.” In the soft drink industry, CPs generally miss out on the profits earned through fountain sales. Pepsi, realizing that fast food chains were capturing most of the value of fountain sales, entered the fast food business by purchasing Taco Bell, Pizza Hut, and KFC. These mergers allowed the firm to capture more value from its soft drink sales, but these mergers could also be problematic. For example, PepsiCo might not have a core competency in food sales or a strong position in the industry. Because it might not be able to effectively transfer skills or share activities with its fast food businesses, the mergers might not be successful in the long run. Stuckey and White also point out that “high-surplus stages must, by definition, be protected by
barriers to entry.” So it could be difficult for Coke to enter the fast food business. It could be prohibitively expensive to purchase McDonalds or Burger King, and developing a chain of its own against such formidable competition would be extremely risky. So integration into this phase of the value chain would be difficult or impossible for Coke. As Stuckey and White say, “don’t vertically integrate unless it is absolutely necessary to create or protect value.” We shall address each of these individually to formally refute the plausibility of vertical integration of CPs into bottling. (1) “The market is too risky and unreliable.” On the contrary, the concentrate market is highly stable and will be for a long time to come. (2) “Companies in adjacent stages of the industry 6 chain have more market power than companies in your stage.” The opposite is true, CPs already have more market power than bottlers, so they should not vertically integrate. (3) “Integration would create or exploit market power by raising barriers to entry or allowing price discrimination across customer segments.” In fact, CPs already have market power through efficient barriers to entry, and effectively price discriminate through various retail channels. (4) “The market is young and the company must forward integrate to develop a market, or the market is declining and independents are pulling out of adjacent stages.” The market is neither young nor declining. Having determined that a vertical integration strategy fails all four of Stuckey and White’s tests, CPs should not pursue vertical integration into bottling.