Cola Wars Continue (Prof.

David Yofffie, HBS)

Case Discussion: July 20, 2011

Major Themes

Underlying economics of an industry: Relationship to profits Different stages of the value chain in an industry: Incentives for vertical integration How globalization can impact industry structure

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Opening Questions

In such a profitable industry (see Exhibit 4), why have so few firms successfully entered this business over the last century? Why havent other great marketing companies, such as P&G (see Exhibit 9), been successful in launching competitive products?
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What are the barriers to entry?

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First-mover Advantages

Brand equity: Cumulative spend on Ad. Brand identity over a long period. Part of American culture / World culture. Limited shelf space, vending slots, and fountains: Much more costly than moving into open channels. The franchise system: Bottling is very capital intensive, and bottlers have exclusive arrangements for colas ( 60% of CSD demand). It cost roughly $4 billion to $7.5 billion [100 plants X $40m-$75m per plant] to build national distribution (p. 3). Scale economies in advertising: Coke and Pepsi get much more bang for the buck for their core brands than smaller brands do. (From Exhibit 8 )

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Question

Werent there substitutes available? What did they cost? Why didnt they have much of an effect on the price?

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Substitution
Many substitutes: Water Coffee Fruit juice, etc Most of the substitutes are free, or much less costly per ml than CSDs. How do the soft drink companies get away with charging $1.00 for a product when the healthy substitute (tap water) is free?
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Substitutes

Not always conveniently available. In many cases, soft drinks are an impulse buy. Lifestyle choices: Coke and Pepsi have made their drinks represent a choice about how you live, not just how you quench your thirst. Addiction (especially to Coke): Half the consumption of Coke is reportedly consumed by people that drink an average of 8 cans per day! Americans drink more soft drinks than any other beverage by a huge margin (Exhibit 1); and in some foreign countries, drinking Coke or Pepsi is a status symbol
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Suppliers

Do suppliers have any real power vis--vis the concentrate manufacturer? Who are they?
What really goes into regular concentrate for CocaCola?
Not sugar (added by the bottler) Not water (added by the bottler) ITS A SECRET! NO ONE KNOWS? How much do you think the ingredients cost?

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Buyers: Bottlers

Bottlers have had very little power in the last 25 years, even when they were independent. Why?
High switching costs Franchise agreements locked bottlers into exclusive deals

Concentrate is 40% to 45% (p. 3) of COGS to the bottler, but CPs offer significant benefits:
o o

. buying power for cans, sugar, etc. .marketing, brand development, and product development

Competitors are very concentrated and large, relative to the bottling network: Historically, Coke had 800 bottlers.
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Buyers: Final Customers

Fragmented: Customers number in the billions! Price-sensitive, but susceptible to advertising No switching costs, but substitutes not always available

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Rivalry

How can companies make so much money in the middle of a war?

Who has won the cola wars? Who has lost? Why? What have been the weapons of war?
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Rivalry: Structural Characteristics

Two players, with a long history of interaction, dominate almost 75% of the market. The terms are clear and well defined; both have carefully avoided downward spiral seen in other competitive contexts. High degree of perceived differentiation
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Rivalry: Tools of War

War is measured one from the beginning: Prices on concentrate have not been affected since the early 1970s (Exhibit 5). Competition is focused largely on:

Shelf space Lifestyle-based advertising and brand name Selective discounting on the downstream products (not on the upstream product) DSD

BUT NOT ON CONCENTRATE PRICES

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Rivalry
Why doesnt the war escalate out of control? How do Coke and Pepsi keep the war within bounds?

Opportunity for gaining advantage is very short-term Both are capable of quickly imitating each other on almost every dimension Efforts to escalate are simply met by imitation (Michael Jackson & Bill Cosby, FridgePack & FridgeMate; Kinley & Aquafina) War is just to keep fizz and froth alive rather than to fight it out
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Who has been winning the war?

(Exhibit 2)

1950: Coke 47%, Pepsi 10% 1970: Coke 35%, Pepsi 20% 1980: Coke 36%, Pepsi 28% 1990: Coke 41%, Pepsi 32% 2000: Coke 44%, Pepsi 31.4, Cadbury Schweppes 14.7% 2006: Coke 43.1%, Pepsi 31.7%, Cadbury Schweppes 14.5% Initially (through the 1960s), Coke was the winner:
Extensive bottling franchise Brand name

Then Pepsi gained significant share

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Pepsi Strategy

Selective discounts in distribution outlets Targeted growing take-home market (i.e., contestable locationssupermarkets) Targeted younger consumers (Pepsi Generation) Motivated its bottlers (bottler size; concentrate pricing) Competed on package size and advertising, not price. Coke was focused on overseas markets, while Pepsi focused on the US grocery channel
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Who wins since Pepsi Challenge?

Both Coke and Pepsi! Increased share of total CSD market
[Although Cokes cola share has actually declined; see Exhibit 2]

Expanded primary demand for CSDs

[In the last five years, cola share declined, but CSD VOLUME has soared].

Rising tide has lifted both boats!

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Who has been losing?

Smaller Brands Historically, they could piggyback on Coke and Pepsis bottler systems Historically, little head-to-head competition (classic niche/focus strategies)
1990s and after: Coke and Pepsi proliferate product Force head-to-head competition Coke and Pepsi fill shelf space, push small brands off the shelf Industry is consolidating; smaller brands sell to Cadbury
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Summary, so far

Constrained competition High BTE Locked-in buyers Secret ingredients (low cost, hard to imitate) Lots of substitutes, but advertising and widespread distribution limit their impact

In sum, a great business!

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BOTTLERS

How do the Economics of Bottlers differ from the economics of CPs? What was the logic of the franchise system? Why did Coke and Pepsi use exclusive (vs. non-exclusive) franchise agreements in the past?

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Bottling: Barriers to Entry

Exclusive franchises High capital investment in bottling and canning lines High investment in trucks, distribution centers Shelf space limited

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Open Question

If you could be a bottler for Coke or Pepsi, would you rather have NYC or Oklahoma City as your territory?

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Buyers: Fountain

Large fountain accounts, such as McDonalds, have significant power: Fountains usually carry only one brand, so they can easily play dominant players off against each other Coke and Pepsi are strongly motivated to get fountain accounts, in order to build brand awareness. They dont lower the price of concentrate; they simply give back money to the fountain in the form of promotions.
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Buyers: Vending

Highly profitable for the bottlerwhy? (Data in Exhibit 6 combine vending--the most profitable channel-- with fountain, the least profitable). Machines are in hard-to-reach places, allowing for high retail prices. In general, single-serve channels are always more profitable, explains why the growing convenience/gas channel is very profitable for bottlers BTE/capital costs are high for vending machine The bottler shares the profit with the owner of the real estate

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Buyers: Supermarkets

For the supermarket, it is a high turn productit draws in customer traffic. Not necessarily as price-sensitive as they are in other product categories Coke and Pepsi try to minimize supermarket power by offering more efficiencyi.e., product is delivered to the door, stocked for them. Compared with convenience stores, mass retailers, drug stores, etc supermarkets get some of the lowest prices (Exhibit 6) and bottler margins are generally lower because of the supermarkets buying power and the competition for shelf space.
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Suppliers
Do they have power?
CPs have significant power, But Suppliers, such as can makers, are intrinsically weak (commodities), and Coke and Pepsi negotiate the contracts on bottlers behalf Even for suppliers with potentially strong bargaining positions, like Searle (maker of NutraSweet), CPs negotiate on bottlers behalf
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Substitutes for Bottlers

NONE (except direct delivery to the fountain by the CP) Warehouse delivery reduces some of the function of the bottler

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Rivalry
Other brands share the rivalry problems with Coke and Pepsi But Geographic exclusivity limits the competition among bottlers. For CP producer, every sale (no matter how much it costs to deliver) is a profitable sale; for bottlers, the key is to find profitable sales (i.e., where sales and delivery do not eat all of their margin). If bottlers had non-exclusive territories, the tendency would be to expand geographically and go after the easy sales (vending, warehouses, etc.). But the CP wants exclusive franchises to force the bottler to saturate their territory: A bottler can only grow in this system if it increases saturation.
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Summary, so far
Bottling is clearly much less profitable; most bottlers lost money in the 1990s. The keys are rivalry and suppliers:

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BTEhigh Substitutionlimited Rivalrycan be fierce in certain markets where Coke and Pepsi are fighting SuppliersCoke and Pepsi appropriate most of the returns Buyersvary with the distribution channel
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Transition
Coke and Pepsi have created a very profitable industry that has lasted more than a century. What are the likely challenges to the stability of the industry structure in the coming decade? What are the potential drivers of structural change?

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Globalization Demographics/flattening demand Non-CSD beverages

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Non-CSD beverage
Coke and Pepsi are attacking these categories themselves, each trying to become a total beverage company.

Will this approach lead to brand dilution? Do CPs risk becoming a less profitable business if they do not extend the brand? No good answers yet to these questions: Pepsi, so far, has had more success and has been more aggressive with non-CSDs.
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Non-CSD beverage

The business model for non-CSDs is somewhat different from the classic CSD model (pp. 11-14) The supply chain and bottling requirements add complexity to the value chain, compared with the relatively simple CSD model.

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Non-CSD beverage
The basic principles of the business remain the same: Coke and Pepsi own the brand and control product development; Dedicated bottlers leverage economies of scope in distribution (selling to same outlet, same trucks). There are exceptionse.g., Gatorade is delivery through food wholesalers. As niche products, non-CSDs carried prices and margins that are higher for everyone in the value chain.
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The Implications of Bottled Water

Will Coke and Pepsi be able to repeat their success with CSD in the water segment, or will a new competitive dynamic emerge? (page 14)

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Bottled Water
Repeat of CSD New (less attractive) Industry Structure

Economies of scale in advertising Hard to create brand loyalty Barriers to entry in distribution Highly fragmented, competitive structure Similar economics of concentrate firm High price sensitivity Little differentiation (e.g., taste)

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Bottled Water

Unless Coke and Pepsi can generate brand loyalty and establish their brands, water is more likely to become a commodity-like product, where despite the scale and barriers in distribution, most of the profits will be extracted by the distribution channel (retailers) rather than by the concentrate companies or (especially) the bottlers.
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Summary of the Case

1. One of the clearest examples on how firms can create and exercise market power. 2. To really understand the opportunities for strategy, we have to look at the underlying economics of the firm and the industry, and its related (upstream and downstream) parts.
Without understanding the economics of the CP and bottler, we cannot understand the motivations and the likely success of moves like vertical integration.
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Summary
3. Coke and Pepsi did not just inherit this business; they created it. Part of their on-going success will be a function of their ability to structure not only their businesses, but the industry as a whole (In other words, industry structure is not always exogenous, it can be endogenous). 4. Coke and Pepsi are the classic case (no pun intended) of smart competitors: When they go to war, they kill the bystanders not themselves.
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Thank You