I need six pages of answer.
Cola Wars Continue: Coke and Pepsi in 2006 9-706-447 R E V : A P R I L 1 6 , 2 0 0 9 ________________________________________________________________________________________________________________ Professor David B. Yoffie and Research Associate Yusi Wang prepared the original version of this case, “Cola Wars Continue: Coke and Pepsi in the Twenty-First Century,” HBS No. 702-442, which derives from earlier cases by Professor David B. Yoffie (HBS No. 702-442 and 794-055) and Professor Michael E. Porter (HBS No. 391-179). This version was prepared by Professor David B. Yoffie and Research Associate Michael Slind 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 © 2006, 2007, 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800- 545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. D A V I D B . Y O F F I E Cola Wars Continue: Coke and Pepsi in 2006 For more than a century, Coca-Cola and Pepsi-Cola vied for “throat share” of the world’s beverage market. The most intense battles in the so-called cola wars were fought over the $66 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 cozy relationship began to fray in the late 1990s, however, as U.S. per-capita CSD consumption declined slightly before reaching what appeared to be a plateau. In 2004, the average American drank a little more than 52 gallons of CSDs per year. At the same time, the two companies experienced their own distinct ups and downs, as Coke suffered several operational setbacks and as Pepsi charted a new, aggressive course in alternative beverages. Although their paths diverged, however, both companies began to modify their bottling, pricing, and brand strategies. As the cola wars continued into the 21st century, Coke and Pepsi faced new challenges: Could they boost flagging domestic CSD sales? Would newly popular beverages provide them with new (and profitable) revenue streams? Was their era of sustained growth and profitability coming to a close, or was this slowdown just another blip in the course of the cola giants’ long, enviable history? 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—U.S. Beverage Industry Consumption Statistics.) Fueling this growth were the increasing availability of CSDs and the introduction of diet and flavored varieties. Declining real (inflation-adjusted) prices played a large role as well.4 There were many 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 706-447 Cola Wars Continue: Coke and Pepsi in 2006 2 other beverage. Within the CSD category, the cola segment maintained its dominance, although its market share dropped from 71% in 1990 to 60% in 2004.5 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.6 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 little capital investment in machinery, overhead, or labor. A typical concentrate manufacturing plant cost about $25 million to $50 million to build, and one plant could serve the entire United States.7 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.8 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, Coca-Cola and Pepsi-Cola (the soft drink unit of PepsiCo) claimed a combined 74.8% of the U.S. CSD market in sales volume in 2004, followed by Cadbury Schweppes and Cott Corporation. (See Exhibit 2—U.S. Soft Drink Market Share by Case Volume. See also Exhibit 3—Financial Data for Coca-Cola, Pepsi-Cola, and Their Major Bottlers.) 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 Cola Wars Continue: Coke and Pepsi in 2006 706-447 3 lines cost from $4 million to $10 million each, depending on volume and package type. In 2005, Cott completed construction of a 40-million-case bottling plant in Fort Worth, Texas, at an estimated cost of $40 million.9 But the cost of a large plant with four lines, automated warehousing, and a capacity of 40 million cases, could range as high as $75 million.10 While a handful of such plants could theoretically provide enough capacity to serve the entire United States, Coke and Pepsi each required close to 100 plants to provide effective nationwide distribution.11 For bottlers, packaging accounted for 40% to 45% of the cost of sales, concentrate for roughly the same amount, and sweeteners for 5% to 10%. Labor and overhead made up the remaining variable costs.12 Bottlers also invested capital in trucks and distribution networks. Bottlers’ gross profits routinely exceeded 40%, but operating margins were usually in the 7% to 9% range. (See Exhibit 4—Comparative Costs of a Typical U.S. Concentrate Bottler and Producer.) The number of U.S. soft drink bottlers had fallen steadily, from more than 2,000 in 1970 to fewer than 300 in 2004.13 Coke was the first concentrate producer to build a nationwide franchised bottling network, and Pepsi and Cadbury Schweppes 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 2003, more than 88% of Coke’s U.S. volume 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.15 In 2002, for example, Coke contributed $600 million in marketing support payments to its top bottler alone.16 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