Cola Wars

1. Cola Wars Key Take-aways

2. 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

3. 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

4. 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: • Coke: C2 • Pepsi: Pepsi Edge • … • Most games played to a stalemate

5. 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)

6. 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

7. Summary • 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?

8. Buy, Sell, or Hold? Source: Yahoo Finance, 3/17/2005

9. 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 companies

10. Average Economic Profits of U.S. Industry Groups, 1978-1996 Value Line Industry Groups Source: Ghemawat, Strategy and the Business Landscape, p20. How much does industry matter really?

11. 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 industry? • Establish a foundation for making a strategic choice • e.g., decisions about entry, exit, or expansion • Highlight important relationships that need to be managed • Rivals, buyers, suppliers, complementors, potential entrants

12. GE / McKinsey Nine-Block Matrix Industry Attractiveness High Medium Low Investment and Growth Selective Growth Selectivity High Selective Growth Harvest/ Divest Medium Selectivity Harvest/ Divest Harvest/ Divest Business Strength Harvest/ Harvest/ Low Selectivity Divest Divest Industry analysis has traditionally been a major input into portfolio analysis for diversified firms

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

14. Bargaining Power of Customers Rivalry Among Existing Competitors • Growing industry • Some products highly differentiated (although some are commodities) Biotech Supply Industry: Investment thesis for Invitrogen Threat of New Entry • Patents and physical control over biological materials (such as cell lines) limits entry • Exclusive licenses to sell some products • Economies of scope makes it difficult to enter with a half-full product line • Niche entry feasible Bargaining Power of Suppliers • Many new research tools come out of university labs – must be licensed but universities have limited bargaining power since they can’t commercialize these products themselves • Internal R&D ?? • Varies by segment • University research labs –fragmented, buy based on grant money – have little information and little incentive to bargain down price • Biotech research industry is also fragmented, but has more bargaining power – especially when sharing procurement effort across a variety of products • Switching costs high insome lines of business (bio-informatics SW) • Informationalcomplexity Threat of Substitutes • None – these products are absolutely critical to biotechnology research

15. Invitrogen performance

16. Rivalry • 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

17. 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

18. 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 substitutes

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

20. 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

21. Dynamics • 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 bottlers • Franchising • Exclusivity • Consolidation and spin-off

22. An example of industry dynamics Number of Firms, Entry and Exit In the US Tire Industry (1905-1980) • Industry structure is frequently changing • Many, but not all, industries follow predictable patterns corresponding to product life-cycles • S-curve adoption • Introduction • Growth • Maturity • Decline (?) Source: Klepper and Simons (2000). “The Making of an Oligopoly: Firm Survival and Technological Change in the Evolution of the U.S. Tire Industry” Journal of Political Economy. 108:4, p. 731

23. Some common long-run dynamics

24. “Everything should be made as simple as possible, but no simpler” — Albert Einstein 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 considered? • Geographic scope • Which geographic markets?

25. 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 control • The role of the strategist is to identify these changes and adapt the firm’s strategy to them