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					MBA299: Strategy
     Cola Wars


     March 16, 2006

Explaining differences in firm-level profitability

   Historically, the CP industry has been very profitable,
    while the bottling industry has been less so
       Exhibit 5: pretax margin 35% vs. 9%
       Exhibit 4: average ROE 20-25% vs 5-10%

   Five forces analysis is a good starting point in
    explaining these differences

   Key factors that differ between these two industries:
       supplier & buyer power
       rivalry

How intense was the Cola War? How do Coke
and Pepsi compete with each other?

   The competitive front:
       shelf-space
       advertising
       direct store delivery
       selective discounting downstream

   Concentrate prices rising (Ex. 6)—CPs do not
    compete on price

Factors that mitigate the intensity of rivalry
     By the 1980s any move made by one player can be
      matched by the other
         ad campaigns:
              Pepsi--Michael Jackson then Britney Spears
              Coke--Bill Cosby then Harry Potter
         Vertical integration
              Coke buys and recapitalizes bottlers
              Pepsi does same
         New products:
              Lemon Cola: Coke – 2001, Pepsi – 2001
              Vanilla Cola: Coke – 2002, Pepsi – 2003
              C2/Pepsi Edge: Coke – 2004, Pepsi – 2004
              Lime Cola: Coke – 2004, Pepsi – 2005
         …
     Most games played to a stalemate

How did Pepsi catch up?

   Pepsi‘s Strategy
       Take-away market; lower price; youth emphasis  different segment
       Pepsi Challenge

   Why didn‘t Coke respond more aggressively?
       Fat/happy/lazy(?), arrogant(?), focused on international expansion

   Lessons:
       Indirect attack
       Exploit inflexibility
       Different segment
       Exploit (technological) change (i.e., growth of supermarkets)

Vertical integration in the beverage industry

   Historically, CPs wrote (semi-)exclusive contracts with bottlers,
    but did not own them
        contracts gave bottlers ‗correct‘ incentives
        non-integration kept the capital requirements of the CP industry small

   In the 1980 and 1990s, CPs moved toward ―anchor bottler‖ model
        ownership over bottlers allowed CPs to reap economic efficiencies
         as well as to ensure that bottlers would adapt to changing product
         strategies (intro of many new products, new packages, competition in
         a growing number of channels, etc.)
        equity market‘s appetite for new offerings allowed CPs to do this
         relatively cheaply

Why did bottlers go from a reasonably strong to
a very poor position over the 20th Century?
      Early period: Coke/Pepsi needs them
           Offers reasonably attractive terms (fixed price contracts, only semi-
           Creates incentive for bottlers to enter
           Bottler margins/profitability fairly good

      Coke and Pepsi vs Bottlers: Who has the most ―valuable‖ or
       ―exclusive‖ assets?
           CPs: Branding, Product Formula, Product R&D
           Bottlers: manufacturing and distribution (almost like contract
           Even though bottlers have BTE, they are subject to extremely strong
            supplier power

      What could bottlers have done differently?


   Coke and Pepsi are examples of how firms can create
    and exercise market power
       they didn‘t inherit this business, they created it
       future success will depend on their ability to structure the
        industry as well as their own businesses

   Coke and Pepsi are smart
       when they go to war, they kill the bystanders, not themselves!

Will these factors change as the basis of competition expands
                     to include non-carbs?
Post-script: What may threaten this relatively
polite war?
    Smaller players extinguished
    Substitutes
    Market not growing
     ―The next generation may not be the Pepsi generation — or the Coke generation, for
     that matter. For years, soda has been the quintessential American drink, considered
     the perfect thirst quencher, morning pick-me-up or accompaniment to lunch or dinner.
     But that is slowly changing.
     As Americans look for greater variety in their drinks and strive for healthier diets,
     consumption of soda — with its 250 calories and 67 grams of sugar in a 20-ounce
     bottle — is slipping.
     Data released yesterday by Beverage Digest, the industry trade publication, shows
     that for the first time in 20 years, the number of cases of soda sold in the United
     States declined. Case volume in 2005 was down 0.7 percent, to 10.2 billion cases.
     Coke's flagship brand, Coca-Cola Classic, was down 2 percent, and original Pepsi
     from PepsiCo was down 3.2 percent.‖
           - “Soda Sales Fall for First Time in 20 Years”, New York Times, March 9, 2006

    Greater balance
How much does industry matter?

   10-20% of the variation in firms‘ profits accounted for
    by the industry in which the firm competes
       Analysis based on accounting profits in publicly held

     How much does industry matter really?
          Average Economic Profits of U.S. Industry Groups, 1978-1996
                                                 Value Line Industry Groups

    ROE-Ke Spread
          20%        Toiletries/Cosmetics
                      Soft Drink
                          Food Processing
          10%                Household Products
                              Electrical Equipment
                                 Financial Services
           5%                       Specialty Chemicals
                                         Newspaper Integrated Petroleum Electric Utility - East
                                              Bank                           Retail Store
                                                                     Tire & Rubber
                                                               Electric Utility - Central
          (5%)                                                            Medical Services
                                                                                       Auto & Truck
                                                                                   Computer & Peripheral
         (10%)                                                                                  Paper & Forest
                                                                                                    Air Transport
                                                  Average Invested Equity ($B)                                 Steel
                 0       100    200      300     400   500    600     700       800     900 1,000 1,100 1,200 1,300

Source: Ghemawat, Strategy and the Business Landscape, p20.
Objectives of industry analysis

   Explain the differences in profitability across industries
   Identify the drivers of industry-level profitability
       Who in the value chain captures the value generated by the
   Establish a foundation for making a strategic choice
       e.g., decisions about entry, exit, or expansion
   Highlight important relationships that need to be
       Rivals, buyers, suppliers, complementors, potential entrants

Industry analysis has traditionally been a major
input into portfolio analysis for diversified firms
     GE / McKinsey Nine-Block Matrix
                                                         Industry Attractiveness

                                       High        Medium            Low

                            High                    Selective    Selectivity

                           Medium     Selective                    Harvest/
                                      Growth      Selectivity
       Business Strength

                                                   Harvest/        Harvest/
                            Low     Selectivity    Divest         Divest
                                                     Divest         Divest
        Porter’s Five Forces
                                        Threat of New Entry
                                • Economies of scale        •   Capital requirements
                                • Proprietary product       •   Access to distribution
                                  differences               •   Absolute cost advantages
                                • Brand identity            •   Government policy
                                • Switching costs           •   Expected retaliation
Bargaining Power                                                                           Bargaining Power
  of Suppliers                                                                               of Customers
• Differentiation of inputs                                                                •   Buyer concentration
• Switching costs
                                          Rivalry Among                                    •   Buyer volume
• Presence of substitute                Existing Competitors                               •   Buyer switching costs
  inputs                        • Industry growth       •   Switching costs                •   Buyer information
• Supplier concentration        • Fixed costs / value   •   Concentration and balance      •   Ability to integrate
• Importance of volume to         added                 •   Informational complexity           backward
  supplier                      • Overcapacity          •   Diversity of competitors       •   Substitute products
• Cost relative to total        • Product differences   •   Corporate stakes               •   Price / total purchases
  purchases                     • Brand identity        •   Exit barriers                  •   Product differences
• Impact of inputs on cost or                                                              •   Brand identity
  differentiation                                                                          •   Impact of quality /
• Threat of forward                                                                            performance
  integration                                                                              •   Buyer profits
                                        Threat of Substitutes
                                    • Relative price performance of substitutes
                                    • Switching costs
                                    • Buyer propensity to substitute                               Source: Michael E. Porter,
                                                                                                   Competitive Advantage 14
                                                                                                   (New York: Free Press, 1985)

   How hard firms compete on price (or increase quality
    levels at a given price) depends on:
       Concentration and balance
       Industry growth
       Fixed (or storage costs)/Value added
       Product differences
       Brand identity
       Switching costs
       Intermittent over-capacity
       Diverse stakes
       Exit barriers

Threat of Entry

     Factors that create barriers to entry include:
          Economies of scale
          Proprietary product differences
          Brand image
          Switching costs
          Capital requirements
          Access to distribution
          Absolute cost advantages
               Learning curve
               Access to necessary inputs
               Low cost product design
          Government policy
          Expected retaliation
          Network externalities

Threat of Substitutes

   The ability of the industry as a whole to profitably raise
    price (the elasticity of the industry‘s demand curve)
       Tobacco & pharmaceuticals – inelastic demand
       Steel – elastic demand
   Likely to change over time with technological changes
    or changes in consumer tastes
   Determined in part by relative performance / price of

Buyer power

   Intrinsic Strength           Price Sensitivity
       Buyer concentration          Price/Total purchase
       Buyer volume                 Product differences
       Switching costs              Brand identity
       Buyer information            Impact on
       Ability to backward           quality/performance
        integrate                    Buyer profits
       Substitute products          Decision maker‘s
       Pull through                  incentives

Supplier Power

   Mirror image of buyer power
   Amount of value chain captured by suppliers
    influenced by:
       size and concentration of suppliers
       degree to which suppliers provide commodity vs. custom
        inputs (differentiation)
       availability of substitute inputs
       ability to backward integrate
       importance of volume to suppliers


   Industry analysis provides a ―snapshot‖ of current
    conditions in an industry
   As we saw in Coors, the industry ―landscape‖ is
    subject to ―tectonic shifts‖ over time.
   Some of these shifts are under the control of the
    players in the industry
       Coke and Pepsi shaped the terrain with respect to their
            Franchising
            Exclusivity
            Consolidation and spin-off

A major challenge for industry analysis is where
to draw the boundaries

    Typically, industry analysis will be motivated by some choice or
     set of possible strategic choices

    Horizontal scope
         Which product markets?
    Vertical scope
         How many vertically-linked stages in the value chain should be
    Geographic scope
         Which geographic markets?

    “Everything should be made as simple as possible, but no simpler”
                               — Albert Einstein                           21
Final words on industry analysis

   A starting point for many types of strategic decisions
       Strategy should fit the external business environment

   In the long run, the business environment is not fixed
       It can be shaped by the strategic choices taken by a firm and
        its rivals
       It also changes based on factors over which the firm has little
            The role of the strategist is to identify these changes and adapt the firm‘s
             strategy to them