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For the exclusive use of E. Acar, 2021. 9-711-462 REV: MAY 26, 2011 DAVID B. YOFFIE RENEE KIM Cola Wars Continue: Coke and Pepsi in 2010 For more than a century, Coke and Pepsi vied for “throat share” of the world’s beverage market. The most intense battles in the so-called cola wars were fought over the $74 billion carbonated soft drink (CSD) industry in the United States.1 In a “carefully waged competitive struggle” that lasted from 1975 through the mid-1990s, both Coke and Pepsi achieved average annual revenue growth of around 10%, as both U.S. and worldwide CSD consumption rose steadily year after year.2 According to Roger Enrico, former CEO of Pepsi: The warfare must be perceived as a continuing battle without blood. Without Coke, Pepsi would have a tough time being an original and lively competitor. The more successful they are, the sharper we have to be. If the Coca-Cola company didn’t exist, we’d pray for someone to invent them. And on the other side of the fence, I’m sure the folks at Coke would say that nothing contributes as much to the present-day success of the Coca-Cola company than . . . Pepsi.3 That relationship began to fray in the early 2000s, however, as U.S. per-capita CSD consumption started to decline. By 2009, the average American drank 46 gallons of CSDs per year, the lowest CSD consumption level since 1989.4 At the same time, 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. As the cola wars continued into the 21st century, Coke and Pepsi faced new challenges: Could they boost flagging domestic CSD sales? How could they compete in the growing non-CSD category that demanded different bottling, pricing, and brand strategies? What had to be done to ensure sustainable growth and profitability? Economics of the U.S. CSD Industry Americans consumed 23 gallons of CSDs annually in 1970, and consumption grew by an average of 3% per year over the next three decades (see Exhibit 1). Fueling this growth were the increasing availability of CSDs and the introduction of diet and flavored varieties. Declining real (inflationadjusted) prices that made CSDs more affordable played a significant role as well.5 There were many ________________________________________________________________________________________________________________ Professor David B. Yoffie and Research Associate Michael Slind prepared the original version of this case, “Cola Wars Continue: Coke and Pepsi in 2006,” HBS No. 706-447. This version was prepared by Professor David B. Yoffie and Research Associate Renee Kim. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2010, 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. This document is authorized for use only by Enes Acar in Business Policy (BPL 5100)_Fall2021-1 taught by WEILEI (STONE) SHI, CUNY - Baruch College from Aug 2021 to Dec 2021. For the exclusive use of E. Acar, 2021. 711-462 Cola Wars Continue: Coke and Pepsi in 2010 alternatives to CSDs, including beer, milk, coffee, bottled water, juices, tea, powdered drinks, wine, sports drinks, distilled spirits, and tap water. Yet Americans drank more soda than any other beverage. Within the CSD category, the cola segment maintained its dominance, although its market share dropped from 71% in 1990 to 55% in 2009.6 Non-cola CSDs included lemon/lime, citrus, pepper-type, orange, root beer, and other flavors. CSDs consisted of a flavor base (called “concentrate”), a sweetener, and carbonated water. The production and distribution of CSDs involved four major participants: concentrate producers, bottlers, retail channels, and suppliers.7 Concentrate Producers The concentrate producer blended raw material ingredients, packaged the mixture in plastic canisters, and shipped those containers to the bottler. To make concentrate for diet CSDs, concentrate makers often added artificial sweetener; with regular CSDs, bottlers added sugar or high-fructose corn syrup themselves. The concentrate manufacturing process involved relatively little capital investment in machinery, overhead, or labor. A typical concentrate manufacturing plant, which could cover a geographic area as large as the United States, cost between $50 million to $100 million to build.8 A concentrate producer’s most significant costs were for advertising, promotion, market research, and bottler support. Using innovative and sophisticated campaigns, they invested heavily in their trademarks over time. While concentrate producers implemented and financed marketing programs jointly with bottlers, they usually took the lead in developing those programs, particularly when it came to product development, market research, and advertising. They also took charge of negotiating “customer development agreements” (CDAs) with nationwide retailers such as Wal-Mart. Under a CDA, Coke or Pepsi offered funds for marketing and other purposes in exchange for shelf space. With smaller regional accounts, bottlers assumed a key role in developing such relationships, and paid an agreed-upon percentage—typically 50% or more—of promotional and advertising costs. Concentrate producers employed a large staff of people who worked with bottlers by supporting sales efforts, setting standards, and suggesting operational improvements. They also negotiated directly with their bottlers’ major suppliers (especially sweetener and packaging makers) to achieve reliable supply, fast delivery, and low prices.9 Once a fragmented business that featured hundreds of local manufacturers, the U.S. soft drink industry had changed dramatically over time. Among national concentrate producers, Coke and Pepsi claimed a combined 72% of the U.S. CSD market’s sales volume in 2009, followed by Dr Pepper Snapple Group (DPS) and Cott Corporation (see Exhibits 2, 3a and 3b). In addition, there were private-label manufacturers and several dozen other national and regional producers. Bottlers Bottlers purchased concentrate, added carbonated water and high-fructose corn syrup, bottled or canned the resulting CSD product, and delivered it to customer accounts. Coke and Pepsi bottlers offered “direct store door” (DSD) delivery, an arrangement whereby route delivery salespeople managed the CSD brand in stores by securing shelf space, stacking CSD products, positioning the brand’s trademarked label, and setting up point-of-purchase or end-of-aisle displays. (Smaller national brands, such as Shasta and Faygo, distributed through food store warehouses.) Cooperative merchandising agreements, in which retailers agreed to specific promotional activity and discount levels in exchange for a payment from a bottler, were another key ingredient of soft drink sales. The bottling process was capital-intensive and involved high-speed production lines that were interchangeable only for products of similar type and packages of similar size. Bottling and canning 2 This document is authorized for use only by Enes Acar in Business Policy (BPL 5100)_Fall2021-1 taught by WEILEI (STONE) SHI, CUNY - Baruch College from Aug 2021 to Dec 2021. For the exclusive use of E. Acar, 2021. Cola Wars Continue: Coke and Pepsi in 2010 711-462 lines cost from $4 million to $10 million each, depending on volume and package type. But the cost of a large plant with multiple lines and automated warehousing could reach hundreds of millions of dollars. In 2010, DPS completed construction of a production facility in California with a capacity of 40 million cases at an estimated cost of $120 million.10 While a handful of such plants could theoretically provide enough capacity to serve the entire United States, Coke and Pepsi each had around 100 plants for nationwide distribution.11 For bottlers, their main costs components were concentrate and syrup. Other significant expenses included packaging, labor, and overhead.12 Bottlers also invested capital in trucks and distribution networks. For CSDs, bottlers’ gross profits routinely exceeded 40% but operating margins were usually around 8%, about a third of concentrate producers’ operating margins (see Exhibit 4). The number of U.S. soft drink bottlers had fallen steadily, from more than 2,000 in 1970 to fewer than 300 in 2009.13 Coke was the first concentrate producer to build a nationwide franchised bottling network, and Pepsi and DPS followed suit. The typical franchised bottler owned a manufacturing and sales operation in an exclusive geographic territory, with rights granted in perpetuity by the franchiser. In the case of Coke, territorial rights did not extend to national fountain accounts, which the company handled directly. The original Coca-Cola franchise agreement, written in 1899, was a fixed-price contract that did not provide for renegotiation, even if ingredient costs changed. After considerable negotiation, often accompanied by bitter legal disputes, Coca-Cola amended the contract in 1921, 1978, and 1987. By 2009, 92% of Coke’s U.S. concentrate sales for bottled and canned beverages was covered by its 1987 Master Bottler Contract, which granted Coke the right to determine concentrate price and other terms of sale.14 Under this contract, Coke had no legal obligation to assist bottlers with advertising or marketing. Nonetheless, to ensure quality and to match Pepsi, Coke made huge investments to support its bottling network. In 2009, for example, Coke contributed $540 million in marketing support payments to its top bottler.15 The 1987 contract did not give complete pricing control to Coke, but rather used a formula that established a maximum price and adjusted prices quarterly according to changes in sweetener pricing. This contract differed from Pepsi’s Master Bottling Agreement with its top bottler. That agreement granted the bottler perpetual rights to distribute Pepsi’s CSD products but required it to purchase raw materials from Pepsi at prices, and on terms and conditions, determined by Pepsi. Pepsi negotiated concentrate prices with its bottling association, and normally based price increases on the consumer price index (CPI). Over the last two decades, however, concentrate makers regularly raised concentrate prices, often by more than the increase in inflation (see Exhibit 5). Franchise agreements with both Coke and Pepsi allowed bottlers to handle the non-cola brands of other concentrate producers. Bottlers could choose whether to market new beverages introduced by a concentrate producer. However, concentrate producers worked hard to “encourage” bottlers to carry their product offerings. Bottlers could not carry directly competing brands, however. For example, a Coke bottler could not sell Royal Crown Cola, yet it could distribute 7UP if it did not carry Sprite. Franchised bottlers could decide whether to participate in test marketing efforts, local advertising campaigns and promotions, and new package introductions (although they could only use packages authorized by their franchiser). Bottlers also had the final say in decisions about retail pricing. In 1971, the Federal Trade Commission initiated action against eight major concentrate makers, charging that the granting of exclusive territories to bottlers prevented intrabrand competition (that is, two or more bottlers competing in the same area with the same beverage). The concentrate makers argued that interbrand competition was strong enough to warrant continuation of the existing territorial agreements. In 1980, after years of litigation, Congress enacted the Soft Drink Interbrand Competition Act, which preserved the right of concentrate makers to grant exclusive territories. 3 This document is authorized for use only by Enes Acar in Business Policy (BPL 5100)_Fall2021-1 taught by WEILEI (STONE) SHI, CUNY - Baruch College from Aug 2021 to Dec 2021. For the exclusive use of E. Acar, 2021. 711-462 Cola Wars Continue: Coke and Pepsi in 2010 Retail Channels In 2009, the distribution of CSDs in the United States took place through supermarkets (29.1%), fountain outlets (23.1%), vending machines (12.5%), mass merchandisers (16.7%), convenience stores and gas stations (10.8%), and other outlets (7.8%). Small grocery stores and drug chains made up most of the latter category.16 Costs and profitability in each channel varied by delivery method and frequency, drop size, advertising, and marketing (see Exhibit 6). CSDs accounted for $12 billion, or 4% of total store sales in the U.S., and were also a big traffic draw for supermarkets.17 Bottlers fought for shelf space to ensure visibility for their products, and they looked for new ways to drive impulse purchases, such as placing coolers at checkout counters. An ever-expanding array of products and packages created intense competition for shelf space. The mass merchandiser category included discount retailers, such as Wal-Mart and Target. These companies formed an increasingly important channel. Although they sold Coke and Pepsi products, they (along with some drug chains) could also have their own private-label CSD, or sell a generic label such as President’s Choice. Private-label CSDs were usually delivered to a retailer’s warehouse, while branded CSDs were delivered directly to stores. With the warehouse delivery method, the retailer was responsible for storage, transportation, merchandising, and stocking the shelves, thereby incurring additional costs. Historically, Pepsi had focused on sales through retail outlets, while Coke commanded the lead in fountain sales. (The term “fountain,” which originally referred to drug store soda fountains, covered restaurants, cafeterias, and any other outlet that served soft drinks by the glass using fountain-type dispensers.) Competition for national fountain accounts was intense, especially in the 1990s. In 1999, for example, Burger King franchises were believed to pay about $6.20 per gallon for Coke syrup, but they received a substantial rebate on each gallon; one large Midwestern franchise owner said that his annual rebate ran $1.45 per gallon, or about 23%.18 Local fountain accounts, which bottlers handled in most cases, were considerably more profitable than national accounts. To support the fountain channel, Coke and Pepsi invested in the development of service dispensers and other equipment, and provided fountain customers with point-of-sale advertising and other in-store promotional material. After Pepsi entered the fast-food restaurant business by acquiring Pizza Hut (1978), Taco Bell (1986), and Kentucky Fried Chicken (1986), Coca-Cola persuaded competing chains such as Wendy’s and Burger King to switch to Coke. In 1997, PepsiCo spun off its restaurant business under the name Tricon, but fountain “pouring rights” remained split along largely pre-Tricon lines.19 In 2009, Pepsi supplied all Taco Bell and KFC restaurants and the great majority of Pizza Hut restaurants, and Coke retained deals with Burger King and McDonald’s (the largest national account in terms of sales). Competition remained vigorous: In 2004, Coke won the Subway account away from Pepsi, while Pepsi grabbed the Quiznos account from Coke. (Subway was the largest account as measured by number of outlets.) In April 2009, DPS secured rights for Dr Pepper at all U.S. McDonald’s restaurants.20 Yet Coke continued to lead the channel with a 69% share of national pouring rights, against Pepsi’s 20% and DPS’ 11%.21 Coke and DPS had long retained control of national fountain accounts, negotiating pouring-rights contracts that in some cases (as with big restaurant chains) covered the entire United States or even the world. Local bottlers or the franchisors’ fountain divisions serviced these accounts. (In such cases, bottlers received a fee for delivering syrup and maintaining machines.) Historically, PepsiCo had ceded fountain rights to local Pepsi bottlers. But in the late 1990s, Pepsi began a successful campaign to gain from its bottlers the right to sell fountain syrup via restaurant commissary companies.22 4 This document is authorized for use only by Enes Acar in Business Policy (BPL 5100)_Fall2021-1 taught by WEILEI (STONE) SHI, CUNY - Baruch College from Aug 2021 to Dec 2021. For the exclusive use of E. Acar, 2021. Cola Wars Continue: Coke and Pepsi in 2010 711-462 In the vending channel, bottlers took charge of buying, installing, and servicing machines, and for negotiating contracts with property owners, who typically received a sales commission in exchange for accommodating those machines. But concentrate makers offered bottlers financial incentives to encourage investment in machines, and also played a large role in the development of vending technology. Coke and Pepsi were by far the largest suppliers of CSDs to this channel. Suppliers to Concentrate Producers and Bottlers Concentrate producers required few inputs: the concentrate for most regular colas consisted of caramel coloring, phosphoric or citric acid, natural flavors, and caffeine.23 Bottlers purchased two major inputs: packaging (including cans, plastic bottles, and glass bottles), and sweeteners (including high-fructose corn syrup and sugar, as well as artificial sweeteners such as aspartame). The majority of U.S. CSDs were packaged in metal cans (56%), with plastic bottles (42%) and glass bottles (2%) accounting for the remainder.24 Cans were an attractive packaging material because they were easily handled and displayed, weighed little, and were durable and recyclable. Plastic packaging, introduced in 1978, allowed for larger and more varied bottle sizes. Single-serve 20-oz PET bottles, introduced in 1993, steadily gained popularity; in 2009, they represented 35% of CSD volume (and 52% of CSD revenues) in convenience stores.25 The concentrate producers’ strategy toward can manufacturers was typical of their supplier relationships. Coke and Pepsi negotiated on behalf of their bottling networks, and were among the metal can industry’s largest customers. In the 1960s and 1970s, both companies took control of a portion of their own can production, but by 1990 they had largely exited that business. Thereafter, they sought instead to establish stable long-term relationships with suppliers. In 2009, major can producers included Ball, Rexam (through its American National Can subsidiary), and Crown Cork & Seal.26 Metal cans were essentially a commodity, and often two or three can manufacturers competed for a single contract. The Evolution of the U.S. Soft Drink Industry27 Early History Coca-Cola was formulated in 1886 by John Pemberton, a pharmacist in Atlanta, Georgia, who sold it at drug store soda fountains as a “potion for mental and physical disorders.” In 1891, Asa Candler acquired the formula, established a sales force, and began brand advertising of Coca-Cola. The formula for Coca-Cola syrup, known as “Merchandise 7X,” remained a well-protected secret that the company kept under guard in an Atlanta bank vault. Candler granted Coca-Cola’s first bottling franchise in 1899 for a nominal one dollar, believing that the future of the drink rested with soda fountains. The company’s bottling network grew quickly, however, reaching 370 franchisees by 1910. In its early years, imitations and counterfeit versions of Coke plagued the company, which aggressivel...