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The Success of Coca-cola in The Soft Drink Market

  • Category: Business
  • Subcategory: Marketing
  • Topic: Brand
  • Pages: 5
  • Words: 2393
  • Published: 12 February 2019
  • Downloads: 23
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In the years between 1975 and 1993, the Coca Cola Company posted an average return on equity of 30.5%. Similarly, PepsiCo Inc. recorded an average return on equity of 21.2%. Although these figures likely include the return form non-soft drink operations (it’s difficult to tell from the available information in the Yoffee and Foley case), it is clear that the soft drink industry is extremely profitable–profitable, that is, for concentrate producers such as Coke and Pepsi.

For other members of the soft drink supply chain, the soft drink industry is not nearly as attractive. Pretax profit for a typical bottler, by way of example, is less than one-third of that of a standard concentrate producer. This discrepancy between the profitability of concentrate producers and that of bottling companies results from the competitive structure of the two separate industries. Concentrate Providers: A Structural Analysis Using a basic structural analysis of the market for soft-drink concentrate, it is easy to see why the industry is so profitable. First, there are few direct competitors within this market: Coke and Pepsi make up 72% of the entire market, with only a handful of additional providers making up the remaining 28%. Furthermore, competition among these companies is limited by strong brand recognition, especially for Coke and Pepsi. Because the major players can rely on their strong, differentiated brands, they are able to price their products substantially above long-term average costs1.

Secondly, the basic cost structure of the industry – low fixed costs relative to high variable costs – helps concentrate producers avoid descending into stiff price competition2. The tendency for competing on price is further limited by Coke and Pepsi’s near-century of competition – a history that has allowed them to learn how to avoid destroying profits in mutually damaging price wars.

Third, concentrate providers have a strong strategic advantage vis–vis their suppliers. Because the concentrate producers purchase undifferentiated raw materials from a large host of supplier firms, they are able to avoid losing a significant portion of the value they create in upstream market transactions. The upshot of this strategic advantage is that the average concentrate provider spends only about 17% on direct costs of producing concentrate. This allows Coke and Pepsi to invest in other aspects of the business – brand recognition, retailer relations, and market research – that will help perpetuate these strategic asymmetries and allow concentrate providers to continue capturing the lion’s share of the value created by the entire soft drink industry. 1 Smaller brands charge substantially less than do Coke and Pepsi. Indeed, profitability for each producer is in direct proportion to the strength of their relative brands. A comparison of net profitability for Dr. Pepper, Seven-Up, and Royal Crown in Exhibit 2 shows that profitability for Royal Crown – a company with substantially less brand recognition than Dr. Pepper or Seven-Up – has historically lagged behind that of Dr. Pepper and Seven-Up. 2 The typical concentrate production plant costs $5-$10 million and could supply the entire country. This

compares to $3.2 billion capital investment required for bottlers to serve a commensurate demand. Likewise, concentrate providers have a strong strategic advantage vis–vis their customers. The large number of undifferentiated bottling companies allows concentrate providers to shop around for the highest prices for concentrate, locking in the most favorable returns in long-term contracts. This allows concentrate providers to avoid losing a significant proportion of the value they create in their downstream market transactions.

Finally, although producing the physical soft drink concentrate is a trivial industrial exercise, the importance of brand recognition has created high barriers to entry. In fact, Saloner, Shepard, and Podolny specifically cite Coke and Pepsi as having a “promotional advantage of incumbency from cumulative investment.” This brand recognition helps Coke and Pepsi perpetuate all of these strategic advantages by increasing the long-term barriers to entry in the concentrate market, thus preserving Coke and Pepsi’s ability to expropriate the vast majority of the value created along the entire value chain. It is interesting to note that the concentrate providers have managed to isolate the one aspect of the soft drink market that can provide ongoing positive returns. Although we are used to thinking of soft drink production as being composed of several industries along a multi-step value chain, the only reason it appears this way is because Coke and Pepsi have been very adept at outsourcing virtually all aspects of the business that do not provide long-term positive returns. In fact, it is likely that the only reason why Coke and Pepsi continue to manufacture soft drink concentrate is that it is easier to promote the brand if they can lay claim to producing the “essence of the product.” In pure economic terms, however, the concentrate is simply yet another commodity input, whereas the brand is the essence of the product. Bottlers: A Structural Analysis By contrast, the soft-drink bottling industry exhibits all the signs of long-term unprofitability. Bottlers face stiff competition in a highly fragmented competitive landscape: in 1994, there were between 80 and 85 bottlers nationwide, each of which produced an undifferentiated commodity. Moreover, as of 1994, there are few – if any – barriers to entry.

In direct contrast to Coke and Pepsi’s strategic advantage vis–vis their upstream providers, bottlers face a far less hospitable environment in their market for raw materials. Not only are there only a handful of concentrate providers, but two producers – Coke and Pepsi – together make up almost 60% of the market for soft drink concentrate. This is aggravated by the extent to which the bottling company’s customers have acquired an increasing amount of market power. WalMart’s huge size relative to other retailers and its effective use of its own soft drink brand has put increasing pressure on the prices that bottlers can charge to their retail customers. This pressure is compounded by the basic cost structure of the bottling industry in which high fixed costs relative to variable costs increase the incentives for short-term pricing below average total costs. The upshot of all of these factors is an industry that earns zero long-term economic profits.

Historical Relationship Between Bottlers and Concentrate Producers Coke and Pepsi have long relied on exclusive bottling franchises as the primary method of bottling and distributing their products. As of as of the early 1980s, Coke and Pepsi owned only 20%-30% of their bottling companies; the rest were either privately- or publicly-owned franchises. The historical relationships between concentrate providers and bottlers evolved as a result of the underlying economics of the soft drink business. Using the analysis of Stuckey and White, the industry displays the characteristics of one beset by vertical market failure. In this case, however, the advantages of these market dynamics accrue to the concentrate providers. Because there are many buyers (bottlers) and few sellers (concentrate providers), sellers dominate the market. (This is illustrated in the diagram below.)

Given that the majority of the value within the value chain resides in brand recognition associated with concentrate production, Coke and Pepsi clearly benefit from outsourcing bottling and distribution. Nonetheless, concentrate providers clearly need to assure that their brands are not compromised by the manner in which bottlers and distributors market and sell their products. Franchise arrangements have allowed concentrate prducers to control their brands without diluting their own capital and management resources.

The specific terms of these franchise agreements demonstrate the extent to which concentrate providers have managed to take advantage of the market dynamics and assert control over the entire soft drink value chain. Concentrate producers used their own sales and marketing organizations to promote soft drink sales. They also set production standards to control soft drink quality. They also have gone so far as to mandate the DSD (direct store door) delivery, effectively redistributing value within the supply chain from the bottlers to the retailers. The nature of this relationship, however, is not entirely expropriatory. Coke and Pepsi clearly recognized the extent to which the strategic asymmetries surrounding the bottling industry could very well lead to negative long-term economic profits and sup-par bottling and distribution of soft drink products. In order to promote long-term health of the bottling industry, Coke and Pepsi lobbied extensively for the 1980 Soft Drink Interbrand Competition Act–federal regulation that preserved the right of concentrate producers to grant exclusive territories. In essence, this legislation, promoted the strategic advantage of the bottlers vis–vis retail stores, transferring value from retail stores back to bottlers. Vertical Integration: Reasons and Rhetoric Given the benefits provided by the franchise system, it is difficult to see why Coke and Pepsi would want to vertically integrate into bottling. Yet this is exactly what they began to do, starting in the mid-1980s. According to Yoffie and Foley, Coke and Pepsi almost doubled their reliance on company-owned bottlers between 1980 and 1993. The “analyst’s reasons” for such expansion, however, make little economic sense.

Weakened bottlers needed capital infusion and thus sought buyers. While it is perhaps correct that the profitability of the bottling industry was declining through the late seventies and early eighties, this can only be seen as an effect of the franchise agreements – agreements put in place and enforced by the concentrate providers. Indeed, if concentrate providers were really concerned about the long-term viability of the bottling industry, they could have simply improved the terms of the franchise agreements. In essence, then, this purported cause simply begs the question: why did the concentrate providers allow the bottling companies to reach such a weakened state that they had no choice but to look for buyers?

Many bottlers were small and unable to handle the corporate goals in a particular market. Once again, this does not address the question of why the concentrate providers would need to purchase these bottling companies to address this issue. Indeed, if the franchise arrangements were working well at the time – and all evidence seems to point to their dramatic success – it would have been a better strategy to encourage the larger bottling franchises to take over the small franchises. Given the financial resources of the major concentrate providers, this seems like a fairly simple task, at least relative to pursuing a policy of vertical integration. Many bottlers were located near a company-owned bottler. It is difficult to see exactly why this would help encourage a change in strategy of the major concentrate providers. Presumably, there had been franchises located near company-owned bottlers in the 1940s, 1950s, 1960s, and 1970s, but it wasn’t until the 1980s that Coke and Pepsi began buying up independent franchises in earnest. Many bottlers were under-investing. The major concentrate providers had long encouraged bottling companies to increase their investment in various areas of the business. For example, Coke and Pepsi’s push to have bottlers implement DSD is an investment in their relationship with the various retailers. If the major concentrate providers really wanted to encourage investment on the part of the bottlers, they could have easily done so through modified franchise agreements. This would have achieved the same ends, while keeping the balance sheet as trim as possible. Understanding the Push for Vertical Integration According to Stuckey and White, there are only four ways a company can benefit from vertical integration:

  1. Capturing market power of those in adjacent stages in the industry chain
  2. Increasing entry barriers and obtaining the opportunity to price discriminate
  3. Promoting the formation of a “mature market”>
  4. Addressing vertical market failure3

Unfortunately, none of these rationales provides a very satisfactory explanation of why Coke and Pepsi began buying up their bottling franchises in the 80s and 90s. Indeed, the first three reasons to vertically integrate have little to do with the reality of the soft drink industry. If Coke and Pepsi indeed pursued a rational policy, the only possible explanation is that the two companies saw a potential change in the nature of the vertical market failure they were facing. As the economies of scale in the bottling industry grew and the minimum 3 Ironically, this is the exact market dynamic that had long benefited the major concentrate providers and provided an incentive for disaggregating concentrate manufacturing and bottling. efficient scale of bottling increased, more and more bottling companies were destined to go out of business. For example, between 1960 and 1983, the average bottling plantvolume increased from approximately 400,000 cases to 3.5 million cases. It is possible that Coke and Pepsi foresaw a time when there would be only a handful of bottling companies – a situation in which their market power would be seriously compromised. In essence, then, perhaps Coke and Pepsi feared a transformation from one in which there were few sellers and many buyers to one in which there were few sellers and few buyers. Perhaps both companies were attempting to promote their long-term strategic advantage by locking in a set of relationships before the bottling industry began to consolidate in earnest. This would accomplish two objectives. First, both companies would assure themselves bottling capacity long into the future. Second, they would do so before they had to pay for the long-term benefit of this strategic advantage. In other words, the price of these acquisitions would rise disproportionately if Coke and Pepsi waited for significant consolidation to occur within the industry.

If this were indeed the reasoning behind Coke and Pepsi’s rationale, pursuing a policy of vertical integration would be justified in economic terms. Perhaps, however, it is more likely that concentrate producers were merely working to meet a set of irrational expectations of the investor community. If Wall Street analysts sincerely believe the purported explanations set forth by Yoffie and Foley, it could make sense from a short-term shareholder value perspective to vertically integrate into bottling. Regardless of which explanation better fits the circumstances, it is clear that Coke and Pepsi would only obtain true long-term value from these acquisitions if the bottling industry were to further consolidate to the point that concentrate producers would no longer be able to profit from the strategic asymmetries of the market. As of the date of the HBS case study, this had not yet occurred and it was difficult to foresee whether or not vertical integration would ever provide long-term value to the major players within the soft drink industry.

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