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Case Study of the Soft Drink Industry:

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Case Study of the Soft Drink IndustryIncomplete Essay

Table of Contents

Introduction 3Description 3Segments 3Caveats 4Socio-Economic 4Relevant Governmental or Environmental Factors, etc. 4Economic Indicators Relevant for this Industry 4Threat of New Entrants 5Economies of Scale 5Capital Requirements 6

Proprietary Product Differences 7Absolute Cost Advantage 8Learning Curve 8Access to Inputs 8Proprietary Low Cost Production 8Brand Identity 9Access to Distribution 9Expected Retaliation 9Conclusion 10Suppliers 10Supplier concentration 10

Presence of Substitute Inputs 11Differentiation of Inputs 12
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Importance of Volume to Supplier 13Impact of Input on Cost or Differentiation 13Threat of Backward or Forward Integration 13Access to Capital 14Access to Labor 14

Summary of Suppliers 14Buyers 15Buyer Concentration versus Industry Concentration 15Buyer Volume 15Buyer Switching Cost 15Buyer Information 16Threat of Backward Integration 16Pull Through 16Brand Identity of Buyers 17Price Sensitivity 17Impact on Quality and Performance 17

Substitute Products 18Relative price/performance relationship of Substitutes 18Buyer Propensity to Substitute 18Rivalry 18Industry Growth Rate 20Fixed Costs 21Product Differentiation 21Brand Identity 21Informational Complexity 22Corporate Stakes 22Conclusion 23Critical Success Factors 23Prognosis 24Bibliography 26Appendix 27Key Industry Ratios 27

Introduction

DescriptionThe soft drink industry is concentrated with the three major players,

Coca-Cola Co., PepsiCo Inc., and Cadbury Schweppes Plc., making up 90 percent ofthe $52 billion dollar a year domestic soft drink market (Santa, 1996). Thesoft drink market is a relatively mature market with annual growth of 4-5%causing intense rivalry among brands for market share and growth (Crouch, Steve).This paper will explore Porter's Five Forces to determine whether or not thisis an attractive industry and what barriers to entry (if any) exist. Inaddition, we will discuss several critical success factors and thefutureof theindustry.

SegmentsThe soft drink industry has two major segments, the flavor segment and

the distribution segment. The flavor segment is divided into 6 categories andis listed in table 1 by market share. The distribution segment is divided in to
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7 segments: Supermarkets 31.9%, fountain operators 26.8%, vending machines11.5%, convenience stores 11.4%, delis and drug stores 7.9%, club stores 7.3%,and restaurants 3.2%.

Table 1: Market Share

1990 1991 1992 1993 1994

Cola 69.9 69.7 68.3 67 65.9

Lemon-Lime 11.7 11.8 12 12.1 12.3Pepper 5.6 6.2 6.9 7.3 7.6

Root 2.7 2.8 2.3 2.7 2.7

Orange 2.3 2.3 2.6 2.3 2.3

Other 7.8 7.2 7.9 8.6 9.2

Source: Industry Surveys, 1995

The only limitations on access to information were: 1. Financial information hasnot yet been made available for 1996. 2. The majority of the information targetsthe end consumer and not the sales volume from the major soft drink producers to

local distributors. 3. There was no data available to determine over capacity.

Socio-Economic

Relevant Governmental or Environmental Factors, etc.

The Federal Government regulates the soft drink industry, like any industrywhere thepublic ingests the products. The regulations vary from ensuring clean,safe products to regulating what those products can contain. For example, thegovernment has only approved four sweeteners that can be used in the making of asoft drink (Crouch, Steve). The soft drink industry currently has had verylittle impact on the environment. One environmental issue of concern is thatthe use of plastics adversely affects the environment due to the unusually long
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time it takes for it to degrade. To combat this, the major competitors havelead in the recycling effort which starting with aluminum and now plastics. Theonly other adverse environmental impact is the plastic straps that hold the canstogether in 6-packs. These straps have been blamed for the deaths of fish andmammals in both fresh and salt water.

Economic Indicators Relevant for this Industry

The general growth of the economy has had a slight positive influence on thegrowth of the industry. The general growth in volume for the industry, 4-5

percent, has been barely keeping up with inflation and growths on margins havebeen even less, only 2-3 percent (Crouch, Steve).

Threat of New Entrants

Economies of Scale

Size is a crucial factor in reducing operating expenses and being able to makestrategic capital outlays. By consolidating the fragmented bottling side of theindustry, operating expenses may be spread over a larger sales base, whichreduces the per case cost of production. In addition, larger corporate coffersallow for capital investment in automated high speed bottling lines thatincrease efficiency (Industry Surveys, 1995). This trend is supported by thedecline in the number of production workers employed by the industry at higherwages and fewer hours. This in conjunction with the increased value ofshipments over the period shows the increase in efficiency and the economiesgained by consolidation (See table 2).

Table 2 General Statistics: YearCompanies Workers Hours Wages Value of Shipments1982 1626 42.4 85.2 7.8416807.5 1983 41.5 85.1 8.24 17320.8 1984 39.881.7 8.51 18052 1985 1414 37.2 77.8 9.1 19358.2 19861335 35.5 73.5 9.77 20686.8 1987 1190 35.4 71.5 10.4522006 1988 1135 35.2 71.8 10.78 23310.3 1989 1027 33.467.7 10.98 23002.1 1990 941 32 65.7 11.48 23847.5 1991

31.9 66.8 11.85 25191.1 1992 29.8 61.6 12.46

26260.4 1993 28.6 59.3 12.93 27224.4 1994 27.456.9 13.39 28188.5 1995 26.2 54.5 13.86 29152.5 199625 52.1 14.32 30116.5 Source: Manufacturing USA, 4th Ed.

Further evidence of economies is supported by the increased return on assetsfrom 1992-1995, as shown in table 3. Coke and Pepsi clearly show increasedreturn on assets as the asset base increases. However, Cadbury/Schweppes doesnot show conclusive evidence from 95 to 96.

Table 3

CADBURY/SCHWEPPES 93 94 95 96 ASSETS 2963100


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3266900 3501500 4595000 SALES 3372400 37248004029600 4776000

NET INCOME 195600 236800 261900 300000Sales/Income 5.80% 6.36%

6.50% 6.28% Income/Assets 6.60% 7.25% 7.48% 6.53%

COKE ASSETS 11051934 12021000 13873000 15041000 SALES13073860 13963000 16181000 18018000

NET INCOME 1664382 2176000 2554000 2986000Sales/Income 12.73% 15.58% 15.78% 16.57%Income/Assets 15.06% 18.10%18.41% 19.85%

PEPSI ASSETS 20951200 23705800 24792000 25432000 SALES

21970000 25021000 28472400 30421000

NET INCOME 374300 1588000 1752000 1606000 Sales/Income1.70% 6.35% 6.15% 5.28%Income/Assets 1.79% 6.70% 7.07% 6.31%

Source: Compact Disclosure

Capital Requirements

The requirements within this industry are very high. Production anddistribution systems are extensive and necessary to compete with the industryleaders. Table 4 shows the average capital expenditures by the three industryleaders.

Table 4Dec-95 Dec-94 Jan-94 Jan-93 Receivables 1624333

1385767 1226633 1077912 Inventories 867666.7803666.7 777366.7 716673.7 Plant & Equip 59863335795367 5246600 4642058 Total Assets 1502266714055500 12997900 11655411 Source: Compact Disclosure

The magnitude of these expenditures causes this to be a high barrier to entry.

Proprietary Product Differences

Each firm has brands that are unique in packaging and image, however any of theproduct differences that may develop are easily duplicated. However, secretformulas do create a difference or good will that cannot be duplicated. The

best example of this is the "New Coke" fiasco of 1985. Coke reformulated itsproduct due to test marketing results that showed New Coke beat Pepsi 47% to 43%

and New Coke was preferred over old Coke by a 10% margin. However, Cokeexecutives did not take into account the good will created by the old Coke name


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and formula. The introduction of New Coke as a replacement of Coke was met byoutrage and unrelenting protest by the public. Three months from the initiallaunch of New Coke, management apologized to the public and reissued the oldCoke formula. Test marking shows that there is only a small difference inactual product taste (52% Pepsi, 48% Coke), but the good will created by a brand

can have significant proprietary differences (Dess, 1993). This is a highbarrier to entry.

Absolute Cost Advantage

Brands do have secret formulas, which makes them unique and new entry into theindustry difficult. New products must remain outside of patented zones butthese differences can be slight. This leads to the conclusion that the absolutecost advantage is a low barrier within this industry.

Learning Curve

The shift in the manufacturing of soft drinks is gravitating toward automationdue to speed and cost. However, industry technology is low and themanufacturing process is not difficult, therefore the learning curve will beshort and will have a low barrier to entry.

Access to Inputs

All the inputs within the soft drink industry are commodity items. Theseinclude cane, beet, corn syrup, honey, concentrated fruit juice, plastic, glass,and aluminum. Access to these inputs is not a barrier to enter the industry.

Proprietary Low Cost Production

The process of manufacturing soft drinks is not a proprietary process. Themethods used in the process are relatively standard within the industry and theknowledge needed to begin production can easily be acquired. This is not a

barrier to entry.

Brand Identity

This is a very strong force within the industry. It takes a long time todevelop a brand that has recognition and customer loyalty. "Brand loyalty isindeed the HOLY GRAIL to American consumer product companies." (IndustrySurveys,1995) A well recognized brand will foster customer loyalty and creates theopportunity for real market share growth, price flexibility, and above average

profitability (Industry Surveys, 1995). Therefore this is a high barrier toentry.

Access to Distribution

Distribution is a critical success factor within the industry. Without thenetwork, the product cannot get to the final consumer. The most successful soft


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drink producers are aggressively expanding their distribution channels andconsolidating the independent bottling and distribution centers. From 1978 tothe present, the number of Coca-Cola bottlers decreased from 370 to 120(Industry Surveys, 1995). In addition, 31.9% of the soft drink business is insupermarkets, where acquiring shelf space is very difficult (Santa, 1996). This

is a high barrier to entry.

Expected Retaliation

Market share within the industry is critical; therefore any attempt to takemarket share from the leaders will result in significant retaliation. The softdrink industry is a moderately mature market with slow single digit growth(Industry Surveys, 1995). Projected growth rates are 4-5% in sales volume and 2-3% in margin (Crouch, Steve). Therefore, growth in market share is obtained bystealing share from rivals causing retaliation to be high in defense of currentmarket position. This is a high barrier to entry.

Conclusion

To be successful on a large scale, the high capital requirements formanufacturing, distribution, and marketing are high barriers to entry.Therefore the threat of new entrants is low making this an attractive industry.

Suppliers

Supplier concentration

Supplier concentration is low due to the fact that the main ingredients aresugar (cane and beet), water, various chemicals, and aluminum cans, plastic andglass bottles. There are many places to get sugar and ingredients for softdrinks because they are commodity items. The containers (aluminum cans, bottlesetc.) make up 36 percent of all the inputs that the industry uses. Othersupplies like sugars, syrups and extracts account for 23 percent of the inputs(Manufacturing USA). There are five major suppliers of glass bottles. AltristaCorp., Anchor Glass Container, Glassware of Chile, Owens Illinois, and Vistro Saare the major makers of glass bottles (Compact Disclosure). This is a fairamount of suppliers considering that only five percent of soft drink sales are

in glass bottles. There are even more suppliers of plastic bottles. This isgood because 43% of all sales are from plastic bottles (Prince, 1996). All thismakes the concentration for glass and plastic suppliers moderate. The aluminumcan industry is even older and more established than the plastic industry.Reynolds Metal Products, American National Can Company and Metal ContainerCorp.are the main suppliers of aluminum cans. 50.6% of total soft drink sales are

packaged in aluminum cans (Prince, 1996). Since the aluminum industry is olderand more established, these are likely to be the only manufacturers for a while.Even though the concentration of aluminum producers are low there are only threemajor players in the industry, Coke, Pepsi, and Cadbury. These three account

for nearly 90% of domestic soft drink sales (Dawson, 1996). This makes thebalance of power slightly favor the suppliers of aluminum cans, even though the


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number of producers and buyers are equal (3). Syrups and extracts account for16.7% of input costs to the soft drink industry (Manufacturing USA, Fourth Ed.).Even though these are a small percentage of inputs, all the major soft drinkcompanies own companies that produce flavoring extracts and syrups (IndustrySurveys, 1995). This is probably due to the fact that they all have "secret

formulas" and this is how they protect the secret. Coke, Pepsi, and Dr. Pepperall have "secret formulas". This makes the concentration of suppliers forextracts very low but they are owned by the soft drink industry. This backwardintegration by the major players makes the power question moot. Suppliers dohave limited power over the soft drink industry. The concentration of suppliersremains relatively low, which would seem to give the supplier power. The shearmass and volume that the industry buys negates that effect and balances, if nottips it back toward the soft drink industry.

Presence of Substitute Inputs

There is not a lot of variety in inputs. The biggest substitute input was whenthe industry switched from aluminum cans to plastic bottles. This made theglass industry almost shake out completely. The next big substitute input wasfor sugar. Since people were demanding more and more ways to lose weight andconsume fewer calories, the diet soft drink exploded in sales. This demand madethe soft drink industry find an alternative to sugar to sweeten their product.This substitute turned out to be Nutrasweet non-sugar sweetener. This wasfound to reduce the calories and retain the taste of their respective products.Other sweeteners, like molasses, do not work because they change the flavor ofthe product. Most of these substitute inputs had already taken place so they

become less relevant to the industry as time marched on. Substitute inputsusually do not become important until the customer or market changesdramatically. This happens when new studies come out from the government abouthow harmful something is. This was the case when scientists came out with thestudy that stated that saccharin was harmful to rats. The industry had torespond by reducing its use of saccharin and look for a substitute. At thistime, the industry found Nutrasweet to be a reasonable substitute for saccharin,which was used more heavily in diet drinks. All in all, there are a lot ofsubstitutes for packaging but not for sweeteners because these sweeteners musthave government approval (Crouch, Steve). This makes suppliers have power overthe industry as seen in the almost overnight empire of Nutrasweet. This will

most likely change drastically when Aspirtain (Nutrasweet) loses its patent in afew years.

Differentiation of Inputs

Sugar is commonly available while Nutrasweet is patented. There is nodifferentiation for sugar and only one choice in Nutrasweet. As far as theother chemicals and inputs, they are commodity items, and it does not matter whosupplies them. This makes suppliers have littlepower over the soft drinkindustry.

Importance of Volume to Supplier
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The soft drink industry buys a large portion of the Nutrasweet market but theirpercentage of purchases are falling as other products begin to use it. Sugar isbought but not in the volume that the grocery store or other industries do. Thealuminum can, plastic bottles and glass bottles (less now) are all pretty muchdependent on the soft drink industry for their livelihood. This makes the

supplier have pretty much no power over the industry.

Impact of Input on Cost or Differentiation

Since the inputs are basic elements there is no differentiation and therefore noimpact on the final product for using different inputs. If the price of theinput changed, it would dramatically change the price of the product as thealuminum cartel did in 1994. Since the major inputs are commodity items, the

prices can change dramatically due to environmental forces. If the sugarindustry suffers a loss due to weather or because of political unrest (like inCuba), then the prices go up and the soft drink industry is usually left

absorbing them. The soft drink industry can not, in all cases, simply passalong the price increase. Customers and distributors are more price sensitivethan ever. This makes the supplier have a fair amount of bargaining power overthe industry.

Threat of Backward or Forward Integration

With the current climate of "sticking to the core of the company," there islittle threat of backward integration into the supplier's industry. This isafter the fact that they already have integrated into the extracts to protecttheir secrets. The integration into the extract-producing segment of thesuppliers will be the extent of the backward integration. The suppliers do nothave the capital required to forward integrate into the soft drink industry.This makes the industry attractive for investment.

Access to Capital

The soft drink industry is very profitable and therefore looked upon favorablyby financial institutions. This includes the stock market, direct investors(bondholders), and banks. Currently the operating margins for the industry havegrown from 17.9% in 1992 to 19.5% in 1996. The projected operating margins are

projected to grow to 20.5% from 1997 to 2001 (Value Line 1996). The profitmargins and demand are increasing for the soft drink industry (Industry Surveys,1995). What this means is that capital is available for expansion or upgrading,if additional capital is required. This is favorable to the industry.

Access to Labor

The industry is not highly technical except for chemical engineering. Thismeans that the demands for skilled labor are not very high. Which means thatthe soft drink industry will not have trouble finding labor. There are noestablished labor unions. The average labor cost is no more than in any other

industry. The average hourly wage is $11.85 per hour, which just about the sameas all manufacturing firms of $11.49 (Manufacturing USA).


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Summary of Suppliers

When you sum up the different aspects of the suppliers you come to the quickconclusion that the power is definitely in the hands of the soft drink industry.

This makes the industry very attractive for investment and for the companiesalready in the industry from the supply aspect. This means that it isattractive to new entrants as well.

Buyers

Buyer Concentration versus Industry Concentration

The buyers for the soft drink industry are members of a large network ofbottlers and distributors that represent the major soft drink companies at thelocal level. Distributors purchase the finished, packaged product from the soft

drink companies while bottlers purchase the major ingredients. With theconsolidation that has occurred within the industry, there is little difference

between the two. Distributors are assigned to represent a specific geographicarea, for example a town or a county. In turn, these distributors areresponsible for distributing the product to the retailers who sell the productsto the end consumer. In recent years, the national companies have been

purchasing independent bottlers in an effort to consolidate the business andgain some distribution economies of scale (Thompson and Strickland, 1993).

Buyer Volume

The contractual agreements, which are present in this industry, dictate that themajor soft drink companies will sell their products to the distributors.Therefore, buyer volume is not a factor for this industry. Buyer Switching Cost

Independent bottlers have contractual agreements to represent that companywithin a certain area. Switching costs would include establishing newrelationships with other companies to represent and the legal costs associatedwith distributors being released from the contract.

Buyer Information

Distributors are very informed about the product that they are distributing.Information flows freely between the soft drink Companies and the localdistributors and down to the retailers. There are many co-operative promotionswhere distributors and soft drink companies collaborate on price and advertisingcampaigns (Crouch, Steve). For example, major soft drink firms will send aregular report out to its distributors describing upcoming promotional eventswhere the cost will be shared between the two companies. For promotions thatfall outside of this report, the distributors will have to coordinate thatsponsorship with the soft drink company.

Threat of Backward Integration


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It is doubtful that local distributors will move into the actual productionprocess of soft drinks. Distributors specialize in the transportation andpromotion of the product that they rely on the carbonated beverage companiesproduce. However, major retailers; for example Wal-Mart and Harris Teeter havebegun distributing their own private label brands of soft drinks. Wal-Mart now

offers Sam's Choiceand Harris Teeter offers President's Choice at asignificantly lower price. These private label competitors will not provide thevariety of packaging alternatives, which make the national leaders so successful(PepsiCo 1995 Annual Report). For example, Pepsi offers 12-ounce cans, 20 ounce

bottles, 1 liter bottles, six packs, twelve packs, cases and "The Cube" 24 canboxes.

Pull Through

Pull through is not a factor from the independent bottler's perspective. Thesebottlers have a franchise agreement to represent a major carbonated beverage

company on the local level. These distributors are legally bound to representthese companies and therefore cannot choose not to promote certain types of

beverages.

Brand Identity of Buyers

Brand identity of buyers is not relevant to the distributors because of thecontractual relationship that exists where distributors represent the soft drinkcompanies. The distributors have an exclusive contractual agreement torepresent that soft drink brand.

Price Sensitivity

Distributors are not highly price sensitive buyers. Independent bottlers are ona national contract so all distributors pay the same price for the same products.

Price to Total Purchases

Soft drinks are the single product that the distributors are concerned with soprice is very important to them. Soft drink companies rely on these distributors

to represent them on the local level, so it is important to maintain a healthyrelationship.

Impact on Quality and Performance

All three of the leading carbonated beverage producers, Coca-Cola, PepsiCo, andCadbury Schweppes believe that their buyers (distributors) are an important stepin taking their products to the end consumer. The service, which theirdistributors provide to the retailers, makes a difference to the retailers whosell the product to the end consumer. The actions of that distributor reflect onthe soft drink company so if the distributor does not provide the level of

service that retailer or restaurant desires, it may harm the company's image.
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Substitute Products

Relative price/performance relationship of Substitutes

The carbonated beverage industry provides a non-alcoholic means of satisfying an

individuals desire to quench their thirst. Traditionally, coffee and tea wouldbe considered substitute products. In recent years, carbonated beverages haveseen the emergence of many new substitute products that wish to reduce softdrink's market share. The soft drink market has been traditionally competitive,without the added friction from "ready to drink tea, shelf stable juice, sportsdrinks and still-water" competitors also. (Gleason, 1996) Leaders in theseemerging segments include Quaker Oats, with their Snapple and Gatorade products,Perrier, and Arizona Iced Teas. "In other words, Pepsi isn't Coke's biggestcompetition, Tap water is." (Gleason, 1996). Generally speaking, soft drinksare less expensive to the consumer than these substitute products.

Buyer Propensity to Substitute

Buyer propensity to substitute is low due to the contractual relationshipsbetween the soft drink companies and the distributors.

Rivalry

Degree of Concentration and Balance among Competitors

Three main competitors: Pepsico, Coca-Cola, and Dr. Pepper/Cadburycontrol the Soft Drink industry. Their combined total sales revenues accountfor 90 percent of the entire domestic market. This market dominance makes theindustry a fiercely competitive and dynamic business environment to operate in.The single market leader is Coca-Cola with a 42 percent market share and over$18 billion in sales worldwide. PepsiCo maintains a 31 percent market sharewith $10.5 billion in sales worldwide. The smallest of the three leaders is Dr.Pepper/Cadbury, which holds roughly 16 percent of the market. Coke's consistentdominance of both Pepsi and Dr. Pepper/Cadbury has caused Coke to become ahousehold name when referring to soft drinks.

As far as balance among competitors is concerned, PepsiCo is a muchlarger company than Coke and Dr. Pepper/Cadbury combined. The reason being that

PepsiCo also owns companies in the snack and food industries (Frito-Lay, PizzaHut, Taco Bell, and KFC). With a work force of 480,000 people, PepsiCo is theworld's third largest employer behind General Motors and Wal-Mart. This has notlead to a more profitable soft drink business, nor has it helped PepsiCo use itssize to steal market share from Coke or Dr. Pepper/Cadbury.

Diversity among Competitors

Though Coca-Cola dominates the industry in sales volume and market share,it does not dominate when it comes to innovative marketing and business strategyefforts. For instance, PepsiCo generates 71 percent of its revenues from the

U.S., while Coca-Cola derives 71 percent of its from international markets.Similarly, PepsiCo only gets 41 percent of its total revenues from soft drinks.


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The remaining 59 percent come from its snack and food business. Coke on theother hand gets all of its revenues from its soft drinks. Clearly both of theindustry leaders have different strategies as far as revenue generation isconcerned. However, as far as their product lines are concerned they are verysimilar and operate parallel to one another. Pepsi and Coca-Cola both have

lemon-lime, citrus, root beer, and cola flavors. Dr. Pepper/Cadbury does nothave as similar a product line to that of Pepsico and Coca-Cola. Itmanufactures Dr. Pepper (a unique spicy cola drink), ginger ale, tonic water,and carbonated water under its Schweppes andCanada Dry brands. Coke does havean answer to Dr. Pepper in its Mr. Pibb, but only holds a .4 percent marketshare compared to Dr. Peppers 6 percent market share. The relatively low levelof diversity makes the soft drink industry unattractive for investment.

Industry Growth Rate

Although new product lines have come into the beverage industry over the

past two to three years, the soft drink segment has held and grown its sharesteadily. The onslaught of the sport drink and bottled tea have proven to be a

passing fad that has gained little if no long term market share from soft drinks.Growth figures for the soft drink industry have been very steady since 1993,and are projected to continue to be so into the last part of the twentiethcentury. As can be seen in Figure 1, volatility was somewhat prevalent in the1980's but has since lessened and leveled off (Valueline, 1996). Figure 1

Year '87-'88 '88-'89 '89-'90 '90-'91 '91-'92 '92-'93 '93-'94 '94-'95 Growth 5.7% 5.2% 2%3% 2.9% 4% 4.4% 4%

Over the past ten years soft drinks have gained 5 percent of totalbeverage sales, putting them over the 25 percent share level for allbeverage sales. As for new and emerging markets, both Coke and Pepsi areattacking the international environment. Coca-Cola generates 80 percentof its revenues abroad, and Pepsi is attempting but failing to put moreemphasis there as well. "Pepsi is losing customers to Coke in every majorforeign territory. The company has always struggled overseas, but in the pastfew months it has lost key strongholds in Russia and Venezuela to Coke" (Sellers,1996). Because of the consistent growth of both the domestic and foreign

markets, the soft drink industry is attractive for investment.

Fixed Costs

The S&P Industry Survey has shown the soft drink industry profit marginto be on a steady incline over the past fifteen years. Levels in 1980 were near14%, while as of year-end 1995 were over 20% and expected to flatten a bit.This flattening effect may be an indication that fixed costs are on the rise dueto expansion

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DEFINITION

Firms in this industry acquire ingredients such as liquid beverage bases, syrup,sweeteners and other ingredients like caffeine, potassium and sodium from theirvarious manufacturers and blend these ingredients into soft drink beverages. Alongwith water acquired from natural springs, and other sources, these beverages are

bottled in glass or plastic or otherwise canned in aluminum for sale to grocery productwholesalers, retailers.

1. Why is the soft drink industry so profitable?

An industry analysis through Porters Five Forces reveals that market forces are favorable forprofitability.Defining the industry: Both concentrate producers (CP) and bottlers are profitable. These two parts oftheindustry are extremely interdependent, sharing costs in procurement, production, marketing anddistribution.Many of their functions overlap; for instance, CPs do some bottling, and bottlers conduct many

promotionalactivities. The industry is already vertically integrated to some extent. They also deal with similarsuppliersand buyers. Entry into the industry would involve developing operations in either or both disciplines.Beverage substitutes would threaten both CPs and their associated bottlers. Because of operationaloverlapand similarities in their market environment, we can include both CPs and bottlers in our definition ofthe softdrink industry. In 1993, CPs earned 29% pretax profits on their sales, while bottlers earned 9% profitson theirsales, for a total industry profitability of 14% (Exhibit 1). This industry as a whole generates positiveeconomic profits.Rivalry: Revenues are extremely concentrated in this industry, with Coke and Pepsi, together with theirassociated bottlers, commanding 73% of the case market in 1994. Adding in the next tier of soft drinkcompanies, the top six controlled 89% of the market. In fact, one could characterize the soft drinkmarket as anoligopoly, or even a duopoly between Coke and Pepsi, resulting in positive economic profits. To besure, therewas tough competition between Coke and Pepsi for market share, and this occasionally hampered

profitability.For example, price wars resulted in weak brand loyalty and eroded margins for both companies in the1980s.The Pepsi Challenge, meanwhile, affected market share without hampering per case profitability, asPepsi wasable to compete on attributes other than price.Substitutes: Through the early 1960s, soft drinks were synonymous with colas in the mind of

consumers.Over time, however, other beverages, from bottled water to teas, became more popular, especially inthe 1980s


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and 1990s. Coke and Pepsi responded by expanding their offerings, through alliances (e.g. Coke andNestea),acquisitions (e.g. Coke and Minute Maid), and internal product innovation (e.g. Pepsi creating OrangeSlice),capturing the value of increasingly popular substitutes internally. Proliferation in the number of brandsdid

threaten the profitability of bottlers through 1986, as they more frequent line set-ups, increased capitalinvestment, and development of special management skills for more complex manufacturing operationsanddistribution. Bottlers were able to overcome these operational challenges through consolidation toachieveeconomies of scale. Overall, because of the CPs efforts in diversification, however, substitutes becameless ofa threat.Power of Suppliers: The inputs for Coke and Pepsis products were primarily sugar and packaging.Sugarcould be purchased from many sources on the open market, and if sugar became too expensive, thefirms couldeasily switch to corn syrup, as they did in the early 1980s. So suppliers of nutritive sweeteners did not

havemuch bargaining power against Coke, Pepsi, or their bottlers. NutraSweet, meanwhile, had recentlycome off

patent in 1992, and the soft drink industry gained another supplier, Holland Sweetener, which reducedSearles

bargaining power and lowering the price of aspartame.2With an abundant supply of inexpensive aluminum in the early 1990s and several can companiescompeting for contracts with bottlers, can suppliers had very little supplier power. Furthermore, CokeandPepsi effectively further reduced the supplier of can makers by negotiating on behalf of their bottlers,therebyreducing the number of major contracts available to two. With more than two companies vying for

thesecontracts, Coke and Pepsi were able to negotiate extremely favorable agreements. In the plastic bottle

business, again there were more suppliers than major contracts, so direct negotiation by the CPs wasagaineffective at reducing supplier power.Power of buyers: The soft drink industry sold to consumers through five principal channels: foodstores,convenience and gas, fountain, vending, and mass merchandisers (primary part of Other in ColaWarscase).Supermarkets, the principal customer for soft drink makers, were a highly fragmented industry. Thestores counted on soft drinks to generate consumer traffic, so they needed Coke and Pepsi products.But due

to their tremendous degree of fragmentation (the biggest chain made up 6% of food retail sales, and thelargestchains controlled up to 25% of a region), these stores did not have much bargaining power. Their only

powerwas control over premium shelf space, which could be allocated to Coke or Pepsi products. This powerdidgive them some control over soft drink profitability. Furthermore, consumers expected to pay lessthrough thischannel, so prices were lower, resulting in somewhat lower profitability.

National mass merchandising chains such as Wal-Mart, on the other hand, had much more bargainingpower. While these stores did carry both Coke and Pepsi products, they could negotiate moreeffectively dueto their scale and the magnitude of their contracts. For this reason, the mass merchandiser channel wasrelatively less profitable for soft drink makers.The least profitable channel for soft drinks, however, was fountain sales. Profitability at these


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locations was so abysmal for Coke and Pepsi that they considered this channel paid sampling. Thiswas

because buyers at major fast food chains only needed to stock the products of one manufacturer, sothey couldnegotiate for optimal pricing. Coke and Pepsi found these channels important, however, as an avenueto build

brand recognition and loyalty, so they invested in the fountain equipment and cups that were used toserve their

products at these outlets. As a result, while Coke and Pepsi gained only 5% margins, fast food chainsmade75% gross margin on fountain drinks.Vending, meanwhile, was the most profitable channel for the soft drink industry. Essentially therewere no buyers to bargain with at these locations, where Coke and Pepsi bottlers could sell directly toconsumers through machines owned by bottlers. Property owners were paid a sales commission onCoke andPepsi products sold through machines on their property, so their incentives were properly aligned withthose ofthe soft drink makers, and prices remained high. The customer in this case was the consumer, who wasgenerally limited on thirst quenching alternatives.

The final channel to consider is convenience stores and gas stations. If Mobil or Seven-Eleven wereto negotiate on behalf of its stations, it would be able to exert significant buyer power in transactionswith3Coke and Pepsi. Apparently, though, this was not the nature of the relationship between soft drink

producersand this channel, where bottlers profits were relatively high, at $0.40 per case, in 1993. With this high

profitability, it seems likely that Coke and Pepsi bottlers negotiated directly with convenience store andgasstation owners.So the only buyers with dominant power were fast food outlets. Although these outlets captured mostof the soft drink profitability in their channel, they accounted for less than 20% of total soft drink sales.Through other markets, however, the industry enjoyed substantial profitability because of limited buyer

power.Barriers to Entry: It would be nearly impossible for either a new CP or a new bottler to enter theindustry.

New CPs would need to overcome the tremendous marketing muscle and market presence of Coke,Pepsi, anda few others, who had established brand names that were as much as a century old. Through their DSD

practices, these companies had intimate relationships with their retail channels and would be able todefendtheir positions effectively through discounting or other tactics. So, although the CP industry is not verycapitalintensive, other barriers would prevent entry. Entering bottling, meanwhile, would require substantialcapitalinvestment, which would deter entry. Further complicating entry into this market, existing bottlers had

exclusive territories in which to distribute their products. Regulatory approval of intrabrand exclusiveterritories, via the Soft Drink Interbrand Competition Act of 1980, ratified this strategy, making itimpossiblefor new bottlers to get started in any region where an existing bottler operated, which included everysignificant market in the US.In conclusion, an industry analysis by Porters Five Forces reveals that the soft drink industry in 1994was favorable for positive economic profitability, as evidenced in companies financial outcomes.2. Compare the economics of the concentrate business to the bottling business. Why is the profitabilityso

different?

In some ways, the economics of the concentrate business and the bottling business should beinextricably linked. The CPs negotiate on behalf of their suppliers, and they are ultimately dependenton thesame customers. Even in the case of materials, such as aspartame, that are incorporated directly into


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concentrates, CPs pass along any negotiated savings directly to their bottlers. Yet the industries arequitedifferent in terms of profitability.The fundamental difference between CPs and bottlers is added value. The biggest source of addedvalue for CPs is their proprietary, branded products. Coke has protected its recipe for over a hundredyears as

a trade secret, and has gone to great lengths to prevent others from learning its cola formula. Thecompanyeven left a billion-person market (India) to avoid revealing this information. As a result of extendedhistoriesand successful advertising efforts, Coke and Pepsi are respected household names, giving their

products anaura of value that cannot be easily replicated. Also hard to replicate are Coke and Pepsis sophisticatedstrategic and operational management practices, another source of added value.Bottlers have significantly less added value. Unlike their CP counterparts, they do not have branded

products or unique formulas. Their added value stems from their relationships with CPs and with their4customers. They have repeatedly negotiated contracts with their customers, with whom they work onan

ongoing basis, and whose idiosyncratic needs are familiar to them. Through long-term, in depthrelationshipswith their customers, they are able to serve customers effectively. Through DSD programs, they lowertheircustomers costs, making it possible for their customers to purchase and sell more product. In this way,

bottlers are able to grow the pie of the soft drink market. Their other source of profitability is theircontractrelationships with CPs, which grant them exclusive territories and share some cost savings. Exclusiveterritories prevent intrabrand competition, creating oligopolies at the bottler level, which reduce rivalryandallow profits. To further build glass houses, as described by Nalebuff and Brandenberger (Co-opetition, p.88), for their bottlers, CPs pass along some of their negotiated supply savings to their bottlers. Coke

gives 2/3of negotiated aspartame savings to its bottlers by contract, and Pepsi does this in practice. This practicekeeps

bottlers comfortable enough, so that they are unlikely to challenge their contracts. Bottlers principalability isto use their capital resources effectively. Such operational effectiveness is not a driver of added value,however, as operational effectiveness is easily replicated.Between 1986 and 1993, the differences in added value between CPs and bottlers resulted in a majorshift in profitability within the industry. Exhibit 1 demonstrates these dramatic changes. While industry

profitability increased by 11%, CP profits rose by 130% on a per case basis, from $0.10 to $0.23.During this

period, bottler profits actually dropped on a per case basis by 23%, from $0.35 to 0.27.One possibility is that product line expansion in defense against new age beverages helped CPs but

hurt bottlers. This would be expected if bottlers per case costs increased due to the operationalchallenges andcapital costs of producing and distributing broader product lines. This, however, was not the case; costof sales

per case decreased for both CPs and bottlers by 27% during this period, mostly due to economies ofscaledeveloped through consolidation. The real difference between the fortunes of CPs and bottlers throughthis

period, then, is in top line revenues. While CPs were able to charge more for their products, bottlersfaced

price pressure, resulting in lower revenues per case.These per case revenue changes occurred during a period of slowing growth in the industry, as shownin Exhibit 2. Growth in per capita consumption of soft drinks slowed to a 1.2% CAGR in the period1989 to1993, while case volume growth tapered to 2.3%. In an struggle to secure limited shelf space with more


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products and slower overall growth, bottlers were probably forced to give up more margin on theirproducts.CPs, meanwhile, could continue increasing the prices for their concentrates with the consumer priceindex.Coke had negotiated this flexibility into its Master Bottling Contact in 1986, and Pepsi had worked

price

increases based on the CPI into its bottling contracts. So, while the bottlers faced increasing pricepressure in aslowing market, CPs could continue raising their prices. Despite improvements in per case costs,

bottlerscould not improve their profitability as a percent of total sales. As a result, through the period of 1986to 1993,

bottlers did not gain any of the profitability gains enjoyed by CPs.3. Why have contracts between CPs and bottlers taken the form they have in the soft drink industry?

5Contracts between CPs and bottlers were strategically constructed by the CPs. Although beneficial to

bottlers on the surface, the contracts favored the CPs long-term strategies in important ways.First, territorial exclusivity is beneficial to bottlers, as it prevents intrabrand competition, ensures

bargaining power over buyers and establishes barriers to entry. But it is also beneficial to CPs, who are

alsonot subject to price wars within their own brand. The contracts also excluded bottlers from producingtheflagship products of competitors. This created monopoly status for the CPs, from the bottler

perspective. Eachbottler could only negotiate with one supplier for its premium product. Violation of this stipulationwouldresult in termination of the contract, which would leave the bottler in a difficult position.Historically, contracts were designed hold syrup prices constant into perpetuity, only influenced byrising prices of sugar. This changed in 1978 and 1986, as contracts were renegotiated, first toaccommodatefor rises in the CPI, and then to give general flexibility to the CP (Coke) in setting prices. Coke couldnegotiate this more flexible pricing because its bottlers were dependent on it for business. It further

ensuredthat its bottlers would be captive to its monopoly status by buying major bottlers and then selling theminto theCCE holding company, which would only produce Coke products. Coke would capture 49% of thedividendsfrom CCE, without the complications of vertical integration.4. Should concentrate producers vertically integrate into bottling?

Given the data in Exhibit 1, indicating the CP business has grown more profitable over the last sevenyears, while the bottling industry has struggled to retain any profitability, it would not be advisable toverticallyintegrate.Stuckey and White (p. 78) indicate that a firm should Integrate into those stages of the industry chainwhere the most economic surplus is available, irrespective of closeness to the customer or the absolute

size ofthe value added. In the soft drink industry, CPs generally miss out on the profits earned throughfountainsales. Pepsi, realizing that fast food chains were capturing most of the value of fountain sales, enteredthe fastfood business by purchasing Taco Bell, Pizza Hut, and KFC. These mergers allowed the firm to capturemorevalue from its soft drink sales, but these mergers could also be problematic. For example, PepsiComight nothave a core competency in food sales or a strong position in the industry. Because it might not be abletoeffectively transfer skills or share activities with its fast food businesses, the mergers might not besuccessful inthe long run. Stuckey and White also point out that high-surplus stages must, by definition, be

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