khlhk,

Cola Wars Continue: Coke and Pepsi in 2010

BMGT493H

Jillian ChavisJoshua FinifterAalap Trivedi

Virginia Williamson

10/17/2011

Cola Wars Continue 2

Question 1

Barriers to Entry

Historically, the cola industry has been so profitable due to the advantages created by

Porter’s five forces. The first reason for this profitability was high barriers to entering the

carbonated soft drink (CSD) industry. Barriers to entering the CSD industry began almost as

soon as the industry itself, as courts barred imitations and counterfeit versions of Coca-Cola such

as Coca-Kola, Koca-Nola, and Cold-Cola, under trademark infringement. In 1916, courts barred

153 of these imitations, demonstrating the prevalence of the desire to enter the CSD industry, as

well as the extreme difficulty to do so. (5) This barrier to entry allowed Coca-Cola to dominate

and almost single-handedly develop the CSD industry, and almost excluded Pepsi-Cola from the

industry, until Pepsi-Cola won the 1941 trademark infringement suit that Coca-Cola had filed

against it.

Historically, the second significant barrier to entry was brand loyalty, created largely by

Robert Woodruff who began leading Coca-Cola in 1923. Woodruff’s goal was to place a Coke

“in arm’s reach of desire,” so he pushed for new channels through which to make Coke

available, including open-top coolers in grocery stores, automatic fountain dispensers, and

vending machines. Woodruff coupled this mass availability of Coke with an advertising

campaign that emphasized the role of Coke in a consumer’s life, the combination of which

developed brand loyalty through increasing both the availability of and the desire for Coke.

Woodruff further developed brand loyalty, increasing the barrier to entering the CSD industry,

through associating Coke with the United States military during World War II, promising that

“every man in uniform gets a bottle of Coca-Cola for five cents wherever he is and whatever it

costs the company.” (6) Coca-Cola’s efforts to increase brand loyalty were so successful early


on that in order to gain market share and develop brand loyalty of its own, Pepsi-Cola had to rely

very heavily on price differentiation and sold its 12-ounce bottle for five cents, the same price

that Coca-Cola charged for its 6.5-ounce bottle. (6) Since 1950, when Coca-Cola and Pepsi-Cola

shared 57% of the U.S. soft drink market, loyalty to these brands has remained high and often

increased, as evidenced by their combined U.S. market shares by volume which reached 54.5%

in 1970, 63.7% in 1980, 73.5% in 1990, and 75.5% in 2000. (Exhibit 2)

The third significant historical barrier to entering the CSD industry was the successful

vertical integration of nationwide franchise bottling networks of Coca-Cola and Pepsi-Cola,

beginning in 1980. Coca-Cola recognized that most of the family-owned bottlers that it used no

longer had the resources to remain competitive in the industry and began buying up the poorly-

managed bottlers, reinvigorating them with capital, and selling them to better-performing

bottlers. In 1985 Coca-Cola bought two of its largest bottlers for $2.4 billion and in 1986 created

an independent bottling subsidiary called Coca-Cola Enterprises, which allowed the company to

consolidate its territories into larger geographic regions, placed it in a better position to

negotiation with suppliers and retailers, and merged redundancy. (8-9) In the late 1980s, Pepsi-

Cola followed Coca-Cola’s lead, first attempting to operate its bottlers for a decade before

shifting to a bottling subsidiary, Pepsi Bottling Group, which went public in 1999. By 2009

Coca-Cola Enterprises handled about 75% of Coca-Cola’s North American bottle and can

volume and Pepsi Bottling Group produced 56% of PepsiCo’s total volume. (9) Further, this

vertical integration created the additional barrier to entry of increased dependence on the Pepsi

and Coke bottling networks for product distribution. Franchise agreements since 1987 had

allowed bottlers to handle non-competing brands of other concentrate producers, but this


consolidation of bottling networks limited the flexibility of bottlers to handle alternative brands,

and thus heightened the barriers to entering the CSD industry.

The final significant historical barrier to entry was economies of scale. Large bottling

and canning production facilities can cost hundreds of millions of dollars, so the established

production lines of major brands like Coca-Cola and PepsiCo allowed them to continuously

introduce new products within their brands, as well as new container types in which to sell them.

In the 1980s Coke introduced 11 new products including Caffeine-Free Coke in 1983 and Cherry

Coke two years later and Pepsi followed suit and introduced 13 new products during the same

period. (8) By the end of the 1980s, both Coke and Pepsi offered more than 10 major brands in

at least 17 container types, squeezing existing concentrate producers out of the market and

creating a significant barrier to entry because Coke and Pepsi were creating new products before

other potential rivals could create them to compete and because Coke and Pepsi had such

efficient economies of scale that it would be difficult for competitors to be able to profit from

entering the industry.

Buyer Power

The buyers in the CSD industry are the various retail outlets for CSDs, including

supermarkets, fountain outlets, vending machines, mass merchandisers, convenience stores, gas

stations, and other outlets. Overall, there is a moderate amount of buyer power in this industry,

because the buyers have significant power because they determine the shelf space and visibility

of the industry’s products, but their power is also limited by the significant sales of CSDs of $12

billion annually, or about 4% of total store sales in the U.S. Buyer power is also limited by the

fact that CSDs are a big traffic draw for many of these outlets. (4) The balance of power creates

a moderate buyer power relationship.


Supplier Power

Supplier power is low for this industry because the factors of production for both the

concentrate aspect of the industry and the bottling aspect of the industry are basic commodities

like caramel coloring, natural flavors, and caffeine for concentrate and packaging and sweeteners

for bottling, none of which require specialized suppliers. Further, Coke and Pepsi are among the

metal can industry’s largest customers, and it is often the case that two or three can

manufacturers compete for a single contract with the companies, giving Coke and Pepsi a large

advantage, and therefore creating a situation of low supplier power. (2) This lowers expenses

and therefore increases profits for CSD producers.

Substitutes

Historically, the threat of substitutes to the CSD industry has been low to moderate.

There are many substitutes, including alcoholic beverages, coffee and tea, sports drinks, and

several other beverages, as well as non-cola CSDs such as lemon/lime and root beer, but the

availability and variety of CSDs make the CSD industry nearly impervious to this threat. (2)

Since 1970, beer and milk have both remained around 20 to 25 gallons per capita, coffee has

significantly declined in per capita consumption, from 35.7 gallons in 1970 to 15.8 gallons in

2009, and tap water/hybrids/all others has decreased from 68 gallons per capita in 1970 to 31.8 in

2009. Contrarily, the U.S. consumption of CSDs in gallons per capita has increased steadily

from 22.7 in 1970 to 53 in 2000, and has only trended slightly downward since, dropping to 46

gallons per capita in 2009. The percentage of CSD consumption as a share of total beverage

consumption has followed a similar trend, beginning at 12.4% in 1970 and peaking at 29% in

2000, and has also only dipped slightly to 25.2% in 2009. (Exhibit 1) This data suggests that

even though several alternative beverage options exist, consumers do not view them as


substitutes to CSDs, lessening the threat of substitutes and allowing the industry to remain

profitable. Finally, the threat of substitutes is low because the CSD industry has already

introduced several products, such as diet versions and flavor variations of classic products,

creating its own substitutes for those classic products and absorbing the subsequent profits.

Rivals

Rivalry is extremely high in the CSD industry and has been a contributing factor to the

profitability of the industry. The two primary CSD companies, Coke and Pepsi, have been

engaged in “cola wars” for over a century, which has led to innovation in the industry ranging

from new lines of products and vertical integration to marketing campaigns and novel packaging.

Additionally, several rivals exist beyond Coke and Pepsi, including Dr. Pepper Snapple Group,

which has seen a significant increase in U.S. soft drink market share by volume, from 11% in

1970 to 16.4% in 2009 (Exhibit 2), as well as emerging private labels and generic labels,

specifically at discount retailer locations such as Wal-Mart and Target. (4) High rivalry has

driven innovation and led to the historical profitability of the CSD industry.

Question 2

While the concentrate and bottling businesses work together to develop, make, blend,

package and deliver the products to retail outlets and consumers, the economics of the businesses

vary greatly. Concentrate producers are responsible for blending raw material ingredients,

packaging the blended mixture, and shipping it to the bottler. (2) The process itself is relatively

inexpensive and little capital investment is needed with regard to machinery overhead and labor.

A typical plant could costs between $50-100 million and covers a distribution area as large as the

United States. (2)


Contrastingly, the bottling practice is very capital-intensive. The bottler must purchase

the concentrate, add carbonated water and high-fructose corn syrup, package the product in a

bottle or can and deliver the final product to customer accounts. (2) The process involves a

number of high-speed mass production lines, and each product type, canned or bottled, and size

requires its own line, each of which ranges from $4 million to $10 million. (3) A large plant that

was equipped to handle the multiple variations in sizes and products that Pepsi and Coke produce

cost hundreds of millions of dollars. Bottlers have further expenses that stem largely from

concentrate and syrup costs, packaging, labor and overhead. This, in addition to other invested

capital in trucks and distribution networks, causes the bottling industry to have gross profits over

40% routinely, but operating margins of only 8%, which varies greatly from the 32% margin

concentrate producers enjoy (Exhibit 4). Contrasting the majority expenses of bottlers, the

majority of the expenses for concentrate producers includes advertising, promotion, market

research and bottler support.

The economics of concentrate producers and bottlers also differ in their ability to build

relationships and negotiate. The concentrate producers usually lead the relationship building and

negotiation process with large businesses such as Wal-Mart, whereas the bottlers champion the

smaller regional accounts. (2-3) Concentrate producers also employed a number of bottlers by

supporting sales efforts and suggesting operational improvements. Additionally, concentrate

producers assumed the role of negotiating directly with their bottler’s major supplies. The

concentrate producers have more influence, provide in many ways for bottlers and, therefore, can

reap many of those economic benefits.


In terms of the supply chain, bottlers are more dependent on the concentrate producers.

For this reason, the concentrate producers have, to a large degree, been able to influence the

bottling industry. The number of U.S. soft drink bottlers has decreased tremendously as large

corporations like Coke and Pepsi consolidate bottlers in subsidiary companies to build a

nationwide franchised bottling network. (3) While this solidified and entitled certain bottlers, it

limited many others. The bottlers that were franchised benefited by Coke and Pepsi investing

deeply in their success, as quality and marketing costs were necessary at all levels to ensure the

brand image. At the same time, by entering into these agreements, the bottlers subject themselves

to terms and conditions given. For example, Pepsi required its leading bottler to purchase raw

materials from Pepsi on terms determined by Pepsi. (3) Lastly, bottlers were not required to

handle all the non-cola brands of the concentrate producer, however they were prohibited from

carrying directly competing brands. (3) Again, the economics and profitability of the bottlers are

affected by the dependence on the concentrate producers and large brands.

Question 3

The rivalry between Coke and Pepsi has played a substantial role in both companies’

profits. As the competition increased, and as each company made a move, the other company

took resultant steps that increased profits. As a result, because Coke and Pepsi hold such a

dominant share of the industry, the industry’s profits have increased but it has largely benefited

only these two companies. Market share in the soft drink market over the decades beginning in

1970 has seen increases for Coca-Cola and Pepsi at the expense of the other competitors.

(Exhibit 2) Roger Enrico, former CEO of Pepsi, went as far as to say that the Coca-Cola forced

Pepsi to be “sharper” and “original”. While rivalry was intense between the two companies, it


was nevertheless characterized as a “carefully waged” struggle and a battle “without blood”. (1)

In fact, Pepsi and Coke would realize annual revenue growth of 10%, as the CSD industry grew

worldwide. From 1975, sales have consistently grown over the time period, and more

importantly, net profit as a percentage of sales has increased across the decades, from 9% for

Coca-Cola Company and 4.6% for PepsiCo, Inc. in 1975 to 22% for Coke and 13.8% for Pepsi

in 2009. (Exhibit 3a)

The move and counter move relationship between Coke and Pepsi compelled each

company to take steps to remain competitive. Following Pepsi’s entrance into the fast food

industry with the Taco Bell, KFC, and Pizza Hut acquisition, Coca-Cola managed to convince

market competitors such as Burger King to switch to their product. Coke retention of Burger

King and McDonald’s would be significant since each represented tremendous sales accounts.

This battle over the control of retail channels directly contributed to profit margins in the bottling

industry and spurred each company to take appropriate steps to not only retain market share but

expand, as demonstrated by Quiznos’ and Subway’s switch to Pepsi and Coke, respectively. (4)

The growth and expansion put a squeeze on other smaller concentrate producers and the profits

of the industry can be characterized by the shuffling of brands. While profits were increasing,

other brands were pushed aside. Phillip Morris entered the market in 1978 with the acquisition

of Seven-Up only to incur substantial losses and eventually leave the industry in 1985. (8)

Furthermore, as both companies sought to acquire market share and revenue, the rivalry

induced a greater degree of innovative practices to branch out in the market, create lower prices,

and packaging. In addition to its flagship cola brand, Coca-Cola added Fanta (1960), Sprite

(1961), and Tab (1964). Pepsi, quickly responding, developed Teem (1960), Mountain Dew, and

Diet Pepsi (1964). Perhaps the most influential of these additions was Diet Coke (1982) – the


nation’s third largest CSD. (6) The flood of new brands took up shelf space and made entrance

by other competitors very difficult. The industry was monopolized by two companies. The new

flavor introductions were accompanied non-returnable glass bottles and 12-ounce metal cans. In

addition, both Pepsi and Coca-Cola would also try their hand in the non-CSD market. Product

innovation, though, was closely followed by changes within the relationships between bottlers

and concentrate producers. Coke, in response to eroding market share and successful Pepsi

marketing campaign (Pepsi Challenge), began restructuring contracts with bottlers to obtain

greater flexibility in pricing concentrate and syrups. (7) Finally, as the cola wars truly began to

increase in competitiveness, Coca-Cola in 1980 found a lower priced substitute for sugar in high

fructose corn syrup. A move emulated by Pepsi, both of these companies would reap benefits

from the shift in ingredients. (7) Again, the unsubtle shifts in each of these corporation’s

strategies were in direct response to each other and in the process, made both innovative and in

some cases as a result, more efficient.

Question 4

Despite diminishing demand for CSDs, there is no doubt that Coke and Pepsi can sustain

their profits if they respond appropriately to the challenges disrupting their industry. The

barriers to entry in the beverage industry remain high, reducing the likelihood that a rival firm

could easily upset the industry’s duopolistic structure. Though consumer preferences have

shifted, Coke and Pepsi have advantages over potential rivals that put them in the best position to

adjust to the changes. Their brand equity, established infrastructures, economies of scale, and

relationships with suppliers and distributors will allow them to maintain dominance. To continue

to be as profitable as they have been historically, Coke and Pepsi must enter emerging markets,


bolster consumption of CSDs in existing international markets, and continue to introduce

increasingly popular non-CSDs domestically.

Coke and Pepsi must continue to reduce their dependence on the domestic market by

expanding into new markets in Asia and Eastern Europe. The firms should take advantage of

lowered trade barriers and use their marketing prowess to establish footholds in these regions as

early as possible. Coke, which already has a strong international presence, has an early

advantage in these markets because during World War II, the United States government helped

to set up 64 bottling plants overseas to supply American soldiers with Coca-Cola. (6) Because

Coke already has established facilities and potential consumers with knowledge of the brand in

some European and Asian countries, the entrance into nearby emerging markets is eased. Coke

can test the waters in these markets by shipping product from existing factories before expending

the capital to build new bottling plants in these countries. Pepsi currently derives nearly 50% of

its sales from the domestic market. (11) It will have to be particularly focused on its overseas

development given the flattening of domestic demand. Pepsi should start to strengthen the value

of the brand abroad with marketing efforts like the sponsorship of important local events.

China and India warrant particular attention from both companies because of their

growing middle classes. (11) Coke and Pepsi should focus on introducing both existing products

and new products tailored to the specific preferences of consumers in each area. In China, for

example, Coke has introduced Sprite Tea while Pepsi has developed products using Chinese

herbs to appeal to local taste. (11) In addition, the retail value of juice in China is expected to

grow 94% over the next year. This can be an opportunity for both companies to establish

themselves as leading tea producers in the country, a form of diversification that can help them

to weather the changes in the domestic market.


Efforts should also be made to increase consumption of CSDs in countries where Coke

and Pepsi already sell their products. The marketing campaigns that drove the extraordinary

success of the companies domestically can be adjusted and replicated in new markets that have

not been as affected by rising health concerns that have disrupted the U.S. market. Some of

Pepsi’s top international CSD markets are Asia, Middle East, and Africa. (11) A campaign

tailored to the people of these regions that focuses on CSD products as “lifestyle” enhancements

as Coca-Cola’s early U.S. advertising did, could increase international CSD consumption to

offset some of the domestic decrease in consumption. (6)

In North American markets where demand for CSDs has flattened, there has been a

corresponding increase in the consumption of other types of beverages. Sports drinks, ready-to-

drink teas, and energy drinks have become more popular over the past decade while the

consumption of CSDs has decreased. (Exhibit 9) Coke and Pepsi should continue to introduce

non-CSD products and shift their marketing campaigns to focus on their companies as beverage

producers rather than as makers of carbonated products. This should not be a challenge for

either company. Both firms are known for their product innovation, a factor which allowed them

to garner and maintain profitability despite shifts in consumer preferences away from their

flagship products and toward non-colas and diet CSDs in the 1960s. (6) Both Coke and Pepsi are

already leading producers of several of the non-CSD “megabrands” including the three highest

volume non-CSDs Gatorade, Aquafina, and Dasani. (Exhibit 7) The acquisition of other firms

has been central to the non-CSD diversification of both brands. Coke and Pepsi should continue

to acquire potential rivals before they have the scale and brand power to be true threats.

In addition to the growth in the consumption of non-CSD products, there has been a

substantial increase in consumption of diet CSDs. In 1999, diet sodas made up about 24% of the


CSD market. A decade later, these drinks captured nearly 30% of the market. The successful

launch of Coca-Cola Zero, which has experienced continued growth since its introduction in

2005, also suggests that the diet market has not been expended. (10) Coke and Pepsi can

maintain some of their profitability by introducing more diet CSD brands to remain in line with

consumer trends.

Overall, despite the flattening of domestic demand for CSDs and the growing popularity

of non-CSDs, Coke and Pepsi will be able to maintain their profits by focusing on their

international markets and expansion and by continuing to develop new products tailored to

consumer preferences and aligned with contemporary trends.

Documents

khlhk,