COLA WARS CONTINUE:

COKE AND PEPSI IN 2010

Binda Riccardo (829968)

Datta Lucille (832610)
Favero Marco (832363)
Grimani Carlotta (829888)
Mortandello Elisa (832356)
Simioni Giulia (832353)
Taglia Linda (832397)
Binda Riccardo – Datta Lucille - Favero Marco -Grimani Carlotta - Mortandello Elisa - Simioni Giulia - Taglia Linda

1. Why, historically, has the soft drink industry been so profitable?

Evidence shows that CSD industry has been for decades a profitable industry, nevertheless what
really matter for us is to understand the reasons behind the success of this business. In order to
grasp why historically CSD business was so attractive, we have to analyse the industry landscape
i.e. its structure and its main features. Researches and studies made in the past, in fact, demonstrate
that there is a strong relationship among firm profitability and the sector in which it operates. The
opportunities and threats of the specific environment shape and affect company performance
understood as profitability, efficiency and innovation. In the following we will analyse the CSD
industry in the period from 1970 to 1990 through the “5 Forces” model. This framework explores
the main forces affecting an industry which are rivalry, new entrants threat, substitute products,
suppliers and buyers' power. Remember that there is a negative relationship between these forces
and the profitability of the industry (e.g. when rivalry increases the business is no longer so
attractive as before). We start our analysis considering RIVALRY. Industry concentration as well
as continuous growth and product diversification contribute to smooth competition with existing
competitors. The CSD business consists mainly of two dominant companies Pepsi and Coke which
hold the majority of the market shares, and other few small firms (see EXHIBIT 2). This means that
it is easier to reach natural collusion and is more difficult to compete on prices. The two giants can
fix price threshold (coordinated price changes) and threat small companies. The Cola war in fact
aims to strengthen and enhance advertising, marketing, distribution network and product
diversification instead of focusing on prices. Concerning growth we can say that in the period under
observation the US and world consumption of CSD grew by 3% yearly (see EXHIBIT 1). On the
other hand one factor that contributes to foster rivalry is the presence of high barriers to leaving the
market. These barriers arise for two main reasons: 1) the bottlers face huge fixed costs as
manufacturing plants need great investment, so they cannot exit the market before recovering these
costs 2) bottlers are bound by binding contracts to concentrate producers, it is difficult to escape
from these relationship (even if margins and gains of the bottlers are low). If the rivalry issue is
quite strong, on the other hand the threat done by NEW ENTRANTS is very low. Coke and Pepsi
are protected by strong entry barriers which makes it very difficult for new companies to penetrate
the business. Institutional barriers consist in legal protections such as trademarks and patents.
Structural barriers in CSD industry derive from the fact that the two “giants” 1) exploit economies
of scale 2) have the exclusivity of the distribution network 3)incur huge expenses and efforts in
marketing and advertising their product (this is not possible for new entrants which have little
capital to invest) 4) have the ability to establish lasting and strong relationship with their suppliers
and bottlers. Coke and Pepsi have the opportunity to rise also strategic barriers through 1) loyalty of
customers and deep brand recognition 2) triggering a strong response to new entrants with price war
and launch of new products. Lets consider now another industry force. Despite the wide range of
beverages offered by the market as alternative to CSDs (tea, coffee, wine, bottled water, juices,..)
and the very low switching costs, the threat of SUBSTITUTES in the period that we analyse is
quite weak. The reason why consumers prefer CSDs to other products is that they are perceived as
unique (we will see that this is no longer true from late 1990 as buyers will change their tastes
toward healthier drinks and their propensity to buy CSD will drop). Moreover substitutes cannot
compete with soft drinks producers like Coke and Pepsi as they have well established businesses
and brand, customers are loyal, they invest in vigorous advertising campaigns and their products are
affordable for everybody. The last piece of the puzzle is to understand whether SUPPLIERS AND
BUYERS have POWER in the industry. Suppliers' power is very weak as there is few
concentration, the raw material supplied is easily available in the market and has a low cost
(concentrate producers can obtain it from different sources and switching costs are null), lot of
substitutes are available (for example the packing can be made of plastic, can, glass) and most
important the suppliers are dependent from soft drink industry which is the major buyer of their
goods. The buyers' power is in the hands of 1) final consumers: they have no switching costs but
they are brand-loyal and their demand is price inelastic 2) retailers: they have significant switching
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costs as the major brands attract customers into their stores, nevertheless they have moderate
purchasing power as they buy in bulk and have good information about prices (so they are able to
evaluate potential substitutes), moreover they can influence final consumer's decisions for example
using marketing and advertising tricks. Analysing the 5 forces in an overall perspective we can
notice that only rivalry and buyers' power can be potential threats for the industry, conversely new
entrants, substitutes and suppliers' power are not so strong to undermine the attractiveness of CSD
business. We can conclude saying that the structure of soft drink industry fosters high profitability.

2. Economics of the concentrate business compared to bottling business: why profitability is so

different?

Concentrate producers and bottlers are the two main figures which represents the Carbonated Soft
Drink (CSD) Industry. Coca-Cola and Pepsi “claimed a combined 72% of the U.S. CDS market’s
sales volume in 2009”: they’re among the most important concentrate producers in the world.
Concentrate producers mix raw material ingredients and package the mixture in plastic canisters
then they ship them to the bottlers. The latter in fact are the ones who purchase concentrate and add
carbonated water and sugar to it, they bottle and can the product and deliver it to retailers and
consumers in general. Economics of these two players are quite different and this leads to some
meaningful differences in their profitability. First of all there is a discrepancy in the investment in
capital: while the concentrate producers invest only few in capital and in machinery, bottlers
operate in a very capital intensive industry, usually fighting against expensive investments as for
example in even more efficient production lines (high speed production lines). The costs beard by
them are different: bottlers should pay a lot of money for packaging, labor, general overhead and
invested capitals (i.e. trucks, distribution networks) while concentrate producers ‘ costs are about
advertising the brand, promotions, market research and support. Analyzing this aspect it is easy to
understand that the responsibility differ between the two figures: the concentrates producers are
responsible for brand promotion and investment in trademark, their risks are greater since the
bottler’s business depends by theirs: if the brand is not well advertised and appreciated by people,
bottlers cannot aim at gaining the consensus of consumers and sell products. This is one important
factor that causes difference in profitability. But there is a more important one: the business model
in which they operate. Concentrate producers work with the franchising principle, they negotiate
with the retailers and they are the FRANCHISOR. Bottlers instead, are the FRANCHISEE and
they pay the concentrate producers to enter the bottling network. The former can decide what price
to impose, adjusting it with inflation, the latter should depend on them paying the price imposed.
This difference is very significant for determining profitability difference: concentrate producers
still have higher returns. In the history there have been two important contracts between bottlers and
main concentrate producers as Coca-Cola and Pepsi: the Master Bottler Contract (1987, between
Coca Cola and its bottlers) and the Pepsi ‘s Master Bottling Agreement (between Pepsi and its
bottlers): both aimed at letting great concentrates set the price for bottlers. Another important aspect
which should be underlined is the fact that there still be greater competition among bottlers than
concentrates producers since the former are present in a much higher number in the market. Less
competition for the concentrate producers make it less difficult to them to increase profit. Looking
at some statistical data1 it can be noticed that the concentrate producers’ gross profit (expressed as
percentage of net sales) is 78% compared with the one of bottlers which is 42%. The most

1
Source : Compiled from estimates provided by beverage industry source, October 2010.
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expensive expenses for concentrate producers are the general and administrative ones (25%) while
for bottlers, as said before, the selling and delivery ones (18%). The operating income differs a lot
between the two players: the concentrate producers’ one is 32% (as percentage of net sale) while the
bottlers’ one is 8%. It is clear also from this specific analysis that concentrate producers earn more
than bottlers but anyway another thing is sure: no one of the two could live without the other.

3. How has the competition between Coke and Pepsi affected the industry’s profits?

The two companies experienced their own distinct ups and downs; Coke suffered several
operational setbacks while Pepsi charted a new, aggressive course in alternative beverages and
snack acquisitions.
Talking about the goals of Coke and Pepsi might be a good way to interpret the competition along
this Coke War. On one side, Pepsi: modernized plants and improved store delivery services, built
bottles with larger size, very popular among families. Furthermore, during Great Depression, the
price of its 12-oz bottle was a nickel (w.r.t. 6.5-oz bottle of Coke). Pepsi also redesigned a new
logo, which cost over $1billion (2008) as a new market strategy. On the other side, instead, Coke:
had independent franchised bottlers, which obtained greater flexibility and the advertisement of its
brand (between 1981 and 1984).Coke also switched to high-fructose corn syrup (a lower-priced
alternative of sugar). As well as Pepsi, in 1985, Coke changed the 99-year-old- Coca-Cola formula
(big fail: they switch again back with: Coca Cola Classic); later on, the new name was: Coca-Cola
(2009).
Both Coke and Pepsi strategies had (and currently have) the goal of earning more than other
competitors (like Dottor Pepper’s for example).The competition between this two important firms
also reached the diversification point, as a corporate growth strategy in which a firm could expand
its operation by moving into a different industry.
First the products have been diversified and launched into the CSD’ market: Coke with Fanta
(1960), Sprite (1961), Diet Coke (1982), Caffeine-Free Coke (1983), Cherry Coke (1985) while on
the other side Pepsi counted with: Teem (1960), Mountain Dew (1964), Diet Pepsi (1964), Lemon-
Lime Slice (1984), Caffeine-Free Pepsi-Cola (1987), tea Lipton (2004).

Despite some success with diet drinks, Coke and Pepsi realized that growth would involve «non-
carbs» and also bottled water, so they tried to diversify also into non-CSD’ market: they both
moved into the bottled-water segment of the market with Aquafina (by Pepsi in 1998) and Dasani
(by Coke in 1999).
The last chance to diversify was with the energy sports drinks: PowerAde (by Coke) and Gatorade
(by Pepsi). This is because, energy sport drinks commanded premium prices and were usually
chosen for immediate, single-serve consumption. Furthermore the average case price is was of
$34.32 compared to CSD’s $8.99!
However, declining CSD sales, declining cola sales (volume of beverage was down from 81% in
2000), and the rapid emergence of non-carbonated drinks appeared to be changing the game in the
cola wars: this is the new side of “Cola Wars”.
However, along this “Cola War” they (Coke and Pepsi) had been largely criticized for their
environmental and health policies. This damaged a lot their images and also their industry’s profits.

Anyway they also tried to expand to foreign countries in order to increase and internationalize their
distribution as a way for increasing profits.

The diversification process has increased for sure the shareholder value. On one hand, there is the
answer to the “better-off test” because the diversification produced opportunities for synergies and
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then the overall company was better off (in this case, Pepsi is a clear example). On the other hand,
there is the answer to “the best-alternative test” made of the contracts, licenses and joint-ventures
side of the diversification (Coke has been dominant in this part).