Soft Drink Industry – E299

While the soft drink industry was very profitable in the 1980’s and 1990’s, the profitability varied
between concentrate producers and their contracted bottlers. After a period of consolidation, one of the
two main cola producers opted to vertically integrate. We will explore the profitability of the soft drink
industry as well as evaluate the concentrate producers’ decision to vertically integrate.
Why is the soft drink industry so profitable? The soft drink market grew by 172% between 1970
and 1993 largely from an increase of soft drink consumption per capita of 115%. Brand awareness of the
two main concentrate producers, Coca-Cola and Pepsi, were fueled by millions of advertising dollars
during the “Cola Wars” and yet, the soda industry remained very profitable, at least for the concentrate
producers. We will discuss the sources of this profitability within Porter’s Five Forces framework. While
there were several Substitutes for soft drinks, few other threats to profitability were presented by
Suppliers or Buyers. Also, the cola space had significant barriers to Entry and though the Rivalry
between producers was fierce, it was a “battle without blood” as the CEO of PepsiCo Roger Enrico
described. Soft drink Substitutes, like juices and water, were readily in the US and around the world and
were in the same price range. During soda’s rapid growth phase, these substitutes seemed not to threaten
their profitability, but in the early 1990’s, New Age beverage sales grew twice as fast as cola sales and
competed for shelf space; Coca-Cola and Pepsi responded by trying to become “total beverage
companies,” partnering with Nestea and Lipton. In terms of Entry, while there were no barriers to coming
up with a new formulation for a soda per se, bottlers were locked into exclusive cola contracts so if one
wished to enter the cola market specifically, a small bottling plant would require $20 to $30 million on
top of the advertising dollars required to compete with the brands of Coca-Cola and Pepsi. While the
glass, can, and plastic packaging suppliers were highly concentrated and bottlers were more fragmented,
since the concentrate producers negotiated the packaging contracts, the Suppliers were not able to assert
as much power to reduce the bottlers’ profitability. Other costs included sugar, a commodity, and while
Nutrasweet was able to affect profitability for some time, the creation of the Holland Sweetener company
later reduced the cost of aspartame. On the other side of the equation, the Buyers of soft drinks, food
stores, fountain sales, vending machines, and other stores were able to affect prices to varying degrees.
While many of the buyers were fragmented, large supermarket chains (with their private labels) and fast
food corporations were able to affect the price of soft drinks, reducing profitability.
Finally, the Rivalry between Coca-Cola and Pepsi, while intense, existed in a highly concentrated
market with the two main players owning over 70% of the market in 1992. The Rivalry also took place in
a market with increasing demand, smooth sales (as opposed to lumpy), little excess capacity, and
depending on the stage of the industry, low fixed costs (high for bottlers). Coca-Cola also shrewdly used
advertising and promotion in their warfare, opting not to cut prices to increase market share. On the other
hand, low switching costs between brands and relatively homogeneous products (as evidenced by the
“Pepsi Challenge”) may have eroded profits. That this near-duopoly may have protected profits is
indicated by the price discounting and decreased margins (for bottlers) in the mid-1980’s when diet Coke
and several cola brand extensions were introduced; consumers began to purchase what was on sale
instead staying loyal, displaying the homogeneity of the products and low switching costs. As the growth
of the soft drink industry slowed and the brand rivalry heated up, the profits began to erode. The
remaining profits were not equally shared among bottlers and concentrate producers.
Compare the economics of the concentrate business to the bottling business. Why is the
profitability so different? While the overall soft drink industry was very profitable, the concentrate
producers were able to gain an increasing share of those profits. In 1986, concentrate producers sustained
73% gross margins, 18% net income as a percent of sales, and 10 cents net income on 25 cents of assets
for each case of soda. This was twice the margin percentage but one third the net income of the bottlers
who received on average 40% gross margin, 9% net income, and 35 cents net income on 95 cents of
assets per soda case. By 1993, the concentrate producers’ margins had increased (to 29%, 23 cents per
case) while the bottlers’ income decreased (9%, 27 cents per case) even as their assets grew (to 2.81 per
case, largely due to goodwill increases possibly from acquisitions during the consolidation of the bottling
companies). During this period, the concentrate producers were able to increase their case price from 55
cents to 66 cents (through contractual agreements) even as the bottlers’ average price to buyers decreased
from $3.80 to $2.99. The concentrate producers were able to do this because of their superior sustainable
competitive advantage, greater Added Value, and their better positioning in the Value Net.
Some large bottling companies had small advantages in terms of scale economies and
differentiation (some glass bottlers were still required for a diminishing market segment) but the
concentrate producers had much larger competitive advantages derived from their flavor formulas and
powerful brands. Because of these inimitable attributes, Coca-Cola and Pepsi were able to create
exclusive contracts with bottlers and negotiate prices with suppliers. The concentrate producers also
showed some foresight when lobbying Congress to enact the “Soft Drink Interbrand Competition Act”
which protected the contracts with bottlers.
In terms of Added Value, because the concentrate producers were so highly concentrated and
owned the formulation of the sodas, they controlled a larger share of economic value than the fragmented
bottler companies (in 1994, the top six concentrate producers held 89% of the market) which included
small bottlers, large public bottlers, diversified companies, and concentrate producer owned bottlers.
More importantly, concentrate producers showed that they could vertically integrate into bottling (mostly
Pepsi) reducing the economic value of the bottlers themselves; an attempt was also made to backward
integrate into can production but that was abandoned by 1990. Without the concentrate producers, the
bottlers would also have to organize significantly to negotiate prices with suppliers. Finally, if the bottlers
were entirely removed from the market, the concentrate producers would still be able to sell through the
fountain channel and to the restaurants and movie theatres in the “other” channel.
Because of the construction of contracts in perpetuity, the bottlers did not face as much
geographic competition within their brand but still absorbed the bulk of the brand rivalry over shelf space
in food stores that required additional promotions and discounts. Some large chains like Walmart exerted
additional price pressure through private label brands (maintained even though their profitability was
lower than carrying the major brands). Overall, the concentrate producers possessed control over more of
the economic value in the soft drink industry and were able to sustain higher profits. They were even able
to increase prices each year despite the fact that the industry growth slowed and competition increased.
Why have contracts between concentrate producers and bottlers taken the form they have in the
soft drink industry? Though bottlers may have benefited from the exclusive contracts in perpetuity, the
concentrate producers were able to create beneficial agreements because of the brand strength, proprietary
formulas, and their demonstration of ability to integrate into bottling. While the bottler assets required
little technical specificity and the profitability of bottlers was tied to their own performance, the
effectiveness of incentives for performance varied. Coca-Cola was able to successfully manage their
bottlers but Pepsi, unsatisfied with their franchisees’ performance domestically and abroad, eventually
acquired most of them.
The ownership of strong brands, proprietary formulas, sole access to the fountain channel (more
for Coca-Cola), and their partial backwards integration into bottling allowed concentrate producers to
construct certain benefits in their contracts with bottlers but it was their right to cancel contracts and
granting of exclusive contracts that created incentives for bottlers to perform well. The brand and formula
ownership afforded the concentrate producers significant competitive advantage; this allowed them to
create non-negotiable contracts that effectively fixed the real price of their product subject to ingredient
increases (1986 Coca-Cola Master Bottler Contract) as well as limit the bottler production to only their
cola. This also benefited the bottler in a way since the concentrate producers could not arbitrarily raise
prices. Their brand strength was not as apparent in new beverages and non-cola sodas; this was reflected
in the fact that the contracts allowed the franchisees to bottle competing non-cola soft drinks. The
movement towards vertical integration by both concentrate producers and the acquisition of bottlers by
Pepsi demonstrated their willingness to bottle on their own, a credible threat which further weakened the
bottlers’ bargaining position. Concentrate producers were also able to sell directly to the fountain channel
without the bottlers.
In order to provide incentives for quality and performance, the concentrate producers allowed
bottlers to have exclusive territories in perpetuity (long term internationally); this incentive had to be
strong to control the “freedom” given with respect to pricing, promotions, and packaging. Also, the
vending channel was left entirely to the bottler who derived 50% of their profits from this area. The
concentrate producers still had some control since they had the final say on packaging, put in 50% of the
local promotional and advertising dollars, and negotiated supply prices. Coca-cola was able to derive
many benefits from their contracts and only maintained equity positions in 11% of its bottlers. Pepsi, on
the other hand, felt that their bottlers were under performing and began acquiring them until they owned
56% outright and had equity positions in most of the remaining capacity in the early 1990s. That the
contracts included no performance provisions exposed a degree of bonded rationality that may have
limited the effectiveness of the agreements in Pepsi’s case. It may have been harder for Pepsi, without
specific contractual conditions, to convince their bottlers to participate in the “guerrilla” marketing and
promotions that they chose to employ against Coca-Cola. Also, as the underdog fighting the incumbent
Coca-Cola, it might have been harder for Pepsi to convince their bottlers to make the necessary
investments in equipment to handle greater volumes and new packaging since their demand was less
certain. Thus, even with the brand and formula strength of the concentrate producers, the lack of
contractual performance conditions left some room for error which may have caused more problems for
Pepsi than for Coca-Cola in their management of their bottler franchisees.
Should concentrate producers vertically integrate into bottling? The profitability of bottling
operations declined over time even as the income of the concentrate producers increased. Despite the
capital-intensive nature of the bottling industry, Pepsi still chose to vertically integrate into bottling while
Coca-Cola maintained their contractual relationships with their bottlers. We will examine the reasons for
and against vertical integration to see how the companies fared given their strategy choice.
The concentrate producers might have been inclined to vertically integrate in order to address a
market failure for the production of soft drinks, to gain power over an adjacent stage in production, or to
exploit market power by raising barriers to entry or creating an opportunity for price discrimination. Since
there were only a small number of concentrate producers and a large (though decreasing) number of
bottlers, there seemed to be no indication of market failure from buyer-seller relationships. While it is true
that the bottlers assets were “specified” for a given brand, this was more a result of the exclusive contracts
rather than a technology or input required by one company or the other; likewise, the bottlers were
geographically tied to the brands through the non-overlapping territories, giving concentrate producers
potentially less incentive to vertically integrate. As far as garnering increased market power from an
adjacent stage, it was the bottlers who lacked market power and the concentrate producers who already
held a dominant position. The concentrate producers might have considered vertically integrating into
fountain sales with their 75% soda margin and in fact, Pepsi moved to acquire fast food chains like Taco
Bell. Lastly, in terms of raising barriers to entry and creating price discrimination, the exclusive contracts
with bottlers already allowed them to satisfy both interests. New cola entrants without a bottling company
contract would have to invest capital of their own to enter the cola market and the bottler contracts
allowed the concentrate producers to sell to the fountain and other channels separately.
Because the independent bottlers were weakened during the “Cola Wars,” because many small
bottlers were located near other company owned bottlers, and because some bottlers were under investing
in their plants, Pepsi began acquiring most of their domestic franchisees to improve efficiency. These
reasons might not have been so convincing as there was no evidence of geographic specificity in cola
production, contractual incentives might have been constructed to spur operational investment, and
efficiency seemed to increase with plant size, not acquisition, since larger bottlers were able to capture
larger profits through economies of scale. Coca-Cola, perhaps because of their incumbency position and
greater emphasis on international growth (80% of profits), chose to maintain large, minority equity stakes
in large bottlers (CCE with its 50 million case capacity and international “anchor bottlers”).
While these factors do not seem to indicate a need for vertical integration, the fact that
concentrate producers either owned equity shares in bottler companies or owned them outright gave them
some control of the bottling process and indicated a credible threat of backward integration. The latter, in
conjunction with their franchisee contracts, might have been enough to effectively manage the bottler
companies’ performance without having to take on additional capital expenditures. Also, the
consolidation and acquisition of the bottling companies was an expensive proposition with a fair dose of
the “winner’s curse” as the acquisition cost of bottlers in 1986 was $5.00 per case versus the $2.50 per
case prices in 1980, though there was no increase in bottler profitability in the interim period. A quick
look at the profitability of Coca-Cola, Coca-Cola Enterprises (large bottler), and Pepsi in 1993 shows the
results of choosing or avoiding vertical integration. Coca-Cola was able to generate 15.6% net profit from
sales of $14 billion or $2.2 billion income on assets of $4.2 billion. CCE did not turn a net profit in this
period on assets of roughly $25 billion displaying the eroding profits of the capital-intensive business.
Pepsi with their vertical integration strategy might be expected to be somewhere in between and in fact
were with 6.4% net profit on $25 billion in sales or $1.6 billion income on $6.4 billion in assets. Given
the reasons above and the demonstrated profitability, concentrate producers should do whatever they can
do to improve bottler performance through contracts and limited equity positions in key bottlers before
resorting to full vertical integration.