Cola Wars Continue

CASE: Cola Wars Continue

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

The soft drink industry has historically been one of the most profitable industries. Coke and Pepsi, the two most dominant players in the soft drink industry, were both originally created in the late 1800’s as “medicines” and were sold exclusively from drug store soda fountains. Over the years both companies have continued to expand and have more recently shifted focus to non-carbonated soft drinks as well.  The reason for the soft drink industry’s profitability can be explained based on Michael Porter’s competitive industry forces framework, while strong marketing techniques and perhaps some luck of being in a growing industry played a role as well.

While the industry could have supported several soft drink manufacturers, Coke and Pepsi were the only major players.  Both companies had a big head start on the competition, and Coke prevented many early entrants by taking legal action against any imitating brands.  Also, even though Coke and Pepsi were competitors they were not hindered by being established rivals since the industry was constantly growing. The former CEO of Pepsi, Roger Encino, even attributed the competition with Coke as a contributing factor towards Pepsi’s continued innovation and success.

A lack of new entrants into the soda industry has also been a component towards the industries’ profitability as well. Over the past century, Coke and Pepsi’s innovative marketing and customer outreach campaigns have created strong brand recognition that has made it extremely challenging for new entrants to enter the market.  Often new entrants can hurt profitability by starting a price war and putting pressure on prices. The absence of many rivals and a low threat level has allowed Coke and Pepsi to focus on research and improving their brands without having to spend resources fighting off competition.

Another major contributing factor was the lack of power of both the buyers and sellers in the vertical value chain. The buyers, such as supermarkets and other outlets, had little negotiating power since Coke and Pepsi had brand recognition and offered a superior product which other companies were not able to successfully imitate. While the power of each buyer depended on size, mass-merchandisers such as Wal-Mart had more leverage, Coke and Pepsi still had a considerable amount of bargaining power.  Coke and Pepsi’s suppliers also had little power as well. Coke and Pepsi’s cost to produce concentrate was low since the ingredients were simple and readily available, and the bottling companies had little power since they relied upon coke and Pepsi and their production lines were not interchangeable. Due to the low buyer and supplier bargaining power, Coke and Pepsi were able to maximize the value created and have high profit margins.

The soft drink industry has been profitable for decades because all participants: consumers, retailers, bottlers, and concentrate producers, in the vertical value chain benefited.  Consumers demanded the product - the size of the soft drink market grew persistently for multiple decades.  Just as important, the average person’s soft drink consumption grew faster than their consumption of other beverage products.  This market climate created an environment for businesses to succeed.  The major players who stood the test of time were always willing to anticipate and quickly respond to changing customer sentiment; when health concerns were raised, industry shifted towards bottled water, low calorie customer sentiment shifted towards healthful products.  

Question #2 Compare the economics of the concentrate business to that of the bottling business: Why is the profitability so different?

The average return on invested capital in the US between the years 1992-2006 for soft drink companies was 37.6% compared to only 11.7% average returns for the bottling industry.  While the concentrate business has many benign competitive forces, bottlers face many intense pressures.  Bottlers’ prices are continually driven down by savvy retailers who force prices lower by playing franchised bottlers against their rivals and cheaper house brands.  Bottlers are also subject to powerful suppliers (concentrate companies) who regularly renegotiate the terms of their bottler agreements leading to an increase in prices for their inputs.  As the bottle industry's costs are driven up by concentrate suppliers and the prices they can charge for their product is driven down by competition in the marketplace, the bottlers share of value has diminished.