Wars: Coca-Cola vs. PepsiCo

By Manu Chauhan, WMP 6029 Mukul Priyadarshi, WMP 6030 Nikhil Nangia, WMP 6031 Nilanjan Sen, WMP 6032 Nitin Saxena, WMP 6033 Nitin Verma, WMP 6034

A project report submitted in fulfillment for Managerial Economics WMP 2010-13

Indian Institute of Management, Lucknow Noida Campus

Date: 05-09-2010 Table of Contents

Introduction 3

The Evolution of the Industry 4

Soft Drink Industry – why is it so profitable? 5

Perfect Substitutes: Analysis 6

Pricing Decisions 7

Cooperation between Coca-Cola and PepsiCo 8

Beverages: The Big Three 9

Consumption patterns in India 10

Current Market ...... 10

Market Share and Consumer Behavior...... 11

Rivalry in India ...... 11

Legal and Ethical Issue in Indian Market 14

Bibliography 15 Introduction

For over a century, Coca Cola and vied for “throat Share” of the world’s beverage market. The most intense battles of cola wars were fought over the $60-billion industry in the United States, where the average American consumed 53 gallons of carbonated soft drinks (CSD) per year. In a “carefully waged competitive struggle”, from 1975 to 1995 both Coke and Pepsi achieved average annual growth of around 10% as both U.S and worldwide consumption consistently rose. According to Roger Enrice, former CEO of Pepsi-Cola:

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 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.

This cozy relationship was threatened in the late 1990s, however,, when US CSD consumption dropped for two consecutive years and worldwide shipment slowed for with Coke and Pepsi. In response, both firms began to modify their bottling, pricing, and brand strategies. They also looked to emerging international markets to fuel growth and broadened their brand portfolios to include non-carbonated beverages like tea, juice, mineral water and sports drinks.

As the cola wars continued into the twenty-first century, the cola giants faced new challenges: could they boost flagging domestic cola sales? Where could they find new revenue streams? Was their era of sustained growth and profitability coming to a close, or was this apparent slowdown just another blip in the course of Coke’s and Pepsi’s enviable performance? The Evolution of the Soft Drink Industry

Early History

Coca-Cola was formulated in 1886 by John Pemberton, a pharmacist in Atlanta, Georgia, who sold it at drug store fountains as a “potion for mental and physical disorders.” A few years later, Asa Candler acquired the formula, established a sales force, and began brand advertising of Coca-Cola. 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. But the company’s bottling network grew quickly.

Robert Woodruff, who became CEO in 1923, began working with franchised bottles to make Coke available wherever and whenever a consumer might want it. He pused his sales force to place the beverage “in arm’s reach of desire”, and argued that if Coke were not conveniently available when the consumer was thirsty, the sale would be lost forever. He initiated “lifestyle” advertising for Coca-Cola, emphasizing the role of Coke in a consumer’s life.

Woodruff also developed Coke’s international business. In the onset of World War II, at the request of General Eisenhower, he promised that “every man in uniform gets a bottle of Coca- Cola for five cents wherever he is and whatever it costs the company.” Beginning in 1942, Coke was exempted from wartime sugar rationing whenever the product was destined for the military or retailers serving soldiers. Government aids contributed to Coke’s dominant market shares in most European and Asian countries.

Pepsi-Cola was invented in 1893 by a North Carolina pharmacist, . Like Coke, Pepsi adopted a franchise bottling system, and by 1910 it had built a network of 270 franchised bottlers. However, Pepsi struggled declaring bankruptcy in 1923 and again in 1932. Business began to pick up in the midst of the Great Depression, when Pepsi lowered the price for its 12-ounce bottle to a nickel, the same price Coke charged for its 6.5-ounce bottle. When Pepsi tried to expend its bottling network in late 1930s, its choices were small local bottlers striving to compete with wealthy Coke franchisees. Pepsi nevertheless began to gain market shares.

Gradually, Pepsi’s U.S. sales surpassed those of Royal Crown and in 1940s, trialing only Coca-Cola. In 1950, Coke’s U.S. market share was 47% and Pepsi’s was 10%.

The Cola Wars Begin

In 1950, Alfred Steele, Pepsi’s new CEO, made “Beat Coke” his theme and encouraged bottlers on take-home sales through supermarkets. In 1963, Pepsi launched its “Pepsi Generation” campaign that targeted young generation, which worked well.

Coca-Cola and Pepsi began to experiment with new cola and non-cola flavors and a variety of packaging options in 1960s. Coke introduced (1960), (1961), and low- calorie (1963). Pepsi countered with (1960), (1964), and (1964). In 1974, Pepsi launched the “” in Texas. In blind taste test hosted by Pepsi’s bottler, the company tried to demonstrate that consumers in fact preferred Pepsi to Coke. Coke countered with rebates, rival claims, retail price cuts, and a series of advertisements questioning the tests’ validity. Pepsi Challenge was quite successful and in 1979, Pepsi passed Coke in food store sales for the first time.

Balancing Market Growth, Market Share, and profitability

During early 1990s, Coke and PepsiCo bottlers employed a low price strategy in supermarket channel in order to compete more effectively with high-quality, low-price store brands. Both elevated their advertising expenditure to a larger extent. Both of them set about to boost the flagging cola market in other ways, including exclusive marketing agreements with Britney Spears (Pepsi) and Harry Potter (Coke).

Soft Drink Industry – why is it so profitable?

According to the 2003 Global Soft Drinks Report from leading drinks consultancy Zenith International, Soft drinks has been world’s leading beverage sector. Global consumption of Soft drinks is rising by 5% a year, well ahead of all other beverage categories. An industry analysis through Porter’s Five Forces reveals that market forces are favorable for profitability.

Defining the industry: Both concentrate producers (CP) and bottlers are profitable. These two parts of the industry are extremely interdependent, sharing costs in procurement, production, marketing and distribution. Many of their functions overlap; for instance, CPs do some bottling, and bottlers conduct many promotional activities. The industry is already vertically integrated to some extent. They also deal with similar suppliers and buyers. Entry into the industry would involve developing operations in either or both disciplines.

Rivalry: Revenues are extremely concentrated in this industry, with Coke and Pepsi, together with their associated bottlers, commanding 73% of the case market in 1994. Adding in the next tier of soft drink companies, the top six controlled 89% of the market. In fact, one could characterize the soft drink market as an oligopoly, or even a duopoly between Coke and Pepsi, resulting in positive economic profits. To be sure, there was tough competition between Coke and Pepsi for market share, and this occasionally hampered profitability. For example, price wars resulted in weak brand loyalty and eroded margins for both companies in the 1980s. The Pepsi Challenge, meanwhile, affected market share without hampering per case profitability, as Pepsi was able to compete on attributes other than price.

Substitutes: Through the early 1960s, soft drinks were synonymous with “” in the mind of consumers. Over time, however, other beverages, from to teas, became more popular, especially in the 1980s and 1990s. Coke and Pepsi responded by expanding their offerings, through alliances (e.g. Coke and ), acquisitions (e.g. Coke and ), and internal product innovation (e.g. Pepsi creating Orange ), capturing the value of increasingly popular substitutes internally.

Power of buyers: The soft drink industry sold to consumers through five principal channels: food stores, convenience and gas, fountain, vending, and mass merchandisers. Barriers to Entry: It would be nearly impossible for either a new CP or a new bottler to enter the industry. New CPs would need to overcome the tremendous marketing muscle and market presence of Coke, Pepsi, and a few others, who had established brand names that were as much as a century old.

Perfect Substitutes: Analysis

It It can be inferred from the above article that Coca-Colaa and Pepsi are perfect substitutes and hence the pricing strstrategy of one didirerectlctly impacts ththe demand for ththee other product. Hence, the indifference curve of Coca- Cola and Pepsi would be a straight line with equal slopes across all points on the line.

Pepsi slashed the price of its 300ml bottles from Rs.8 tto RRss..66, tthhus aannttiicicippaatiting aan iinnccrereaase iin tthhee ddemaand aand ccoonsnsuummppttiion of iitts prprododucuctt. TThhee ssaamme ccaan bbe ddeeppiicctteed bby pplloottttiinng tthhee price eellaassttiicciitty oof ddeemmaanndd for Pepsi. Pepsi reduced itits prprice frfrom P1(R(Rs.8) to P2(R(Rs.6), whicich would reresusult in an inincrcreaease in coconsnsumptptioion frfrom Q1 to Q2.

Since, Coca-Colala aannd PPeeppssi aarree perfect substitutes; aan iinnccrreeaasse iinn coconsnsumptptioion onon Pepsi would result in a proportionate ddeeccrreeaasse iin tthhee ccoonsnsuummppttiioon of CCooccaa--CCoollaa. IInn

order to maintainn ththe babalalancnce anandd nonot loloosose ouout onon the market share,e, Coca-Cola decided to offer Sunfill sachets priced at Rs2. for free along wiwith ththe 300ml bottltle, ththereby inincreasing the Marginal Utility of its product. This would also result in an increase in the consumption of Coca-Cola. Thus, as Coca-Cola’s Marginal Utility moved from MU1 to MU2, due to the value addition, so would the Quantity move from Q1 to Q2.

However, since Pepsi reduced the price of its 300ml bottle, it resulted in the movement of the budget line, due to which more customers will be prompted to consume Pepsi instead of Coca- Cola. As depicted in the adjoining figure, since the price of Pepsi reduced, theBudget Line of PePepsi and Cocaca-C-Cola, moved frfrom B1 to B2. This reresulted in a fufurther inincrease in the consumption of Pepsi from P1 to P2. Hence, it can be concluded that the best way for Coca- Cola to counter this would be by reducing the price of its 300ml bottle to match it to that of Pepsi’s. This would be needed since Pepsi and Coca-Cola are perfect substitutes.

Pricing Decisions

The US CSD market is mature. The industry sales growth is largely driven by population growth as well as the amount of advertising and product innovation taking place in the industry. Given the mature nature of the market, both Pepsi and Coca Cola have resorted to pricing discrimination strategies to maximize the value of consumer demand.

Direct Price Discrimination – the simplest form of extracting customer surplus is charging customers with different prices based on their location and purchasing power. This is evident in the international operations of both Pepsi and Coca Cola. Cola prices in Mexico, Brazil and Eastern Europe are lower than prices in the U.S., even though the cost of the concentrate is practically the same. Domestically, direct price discrimination is based on distribution channel segmentation. Restaurant fountain drinks, single drinks at gas stations and take-home packs at supermarkets have all different prices on a per-unit basis even though their costs adjusted for packaging and distribution would not warrant such a discrepancy. Obviously, such segmentation helps situational-based pricing differences: the most price insensitive consumers seem to be restaurant customers who need a drink to go with their meal. Also, single-drink buyers at gas stations are more likely to be impulse buyers and therefore have less price sensitivity than weekend family shoppers at supermarkets that purchase 12-packs for home consumption.

Indirect Price Discrimination – Quantity discounts along with price coupons used in supermarkets are obvious indirect price discrimination tools Pepsi can use. However, the most effective indirect price discrimination tool Pepsi has is in fact its brand name. The Pepsi brand equity actually allows the company to maintain its pricing power. Its product image translates into perception for higher quality vis-à-vis private labels and other substitute drinks. Also, for both supermarkets and convenience stores the CSDs represent the number one and number three top-selling items 5. Retailers use this product category to induce store traffic and create additional sales, which in turn reduces their power relative to Pepsi. Given the 80% margin on concentrate, it is easy to see why Wal-Mart and other discount retailers can undercut Pepsi’s pricing with private labels, but still they will be ineffective in ‘stealing’ Pepsi customers as long as Pepsi’s brand (and Coke’s for that sake) maintains high customer loyalty. Pepsi may enhance its price discrimination capability though creating bundle offers to restaurants and convenience stores. The Frito Lay brand, controlled by PepsiCo through Frito Lay North America, is the undisputed leader in the salty snack segment. If Pepsi bundles snacks with soft drinks as part of its pricing strategy aimed at fast food restaurants and stores it may be able to increase sales and obtain better shelf space from retailers. This may prove a very important tactic in trying to re-claim share in the fountain drink segment, a large part of which was lost after Pepsi’s exit from the restaurant business in 1997. Currently, Coca Cola holds approximately 67% share of the total fountain cola sales.

Cooperation between Coca-Cola and PepsiCo

Despite sharing a number of common interests, Pepsi and Coke appear to take little advantage of potential cooperative strategies. In fact, recent evidence suggests that both companies have actually engaged in mutually destructive behavior despite potential benefits from tacit collusion. In the following section, we have identified areas in which opportunities for cooperation exist and should be exploited for the benefit of both Pepsi and Coke.

Development of Overseas Markets – – Although Pepsi and Coke have avoided the temptation to run negative advertising in the U.S. where consumer penetration approaches 100%, both companies have engaged in ruthless advertising tactics abroad, where the opportunity for growth far exceed those domestically. Perhaps most confounding are Pepsi and Coke’s recent spate of vicious attack advertisements in India.

More importantly, although per-capita consumption of soft drinks in India is only six bottles per year, one-third of India’s one billion citizens are under 18, an important demographic whose consumption habits Pepsi and Coke would like to affect through compelling marketing. Coke’s director of external affairs, Rahul Dhawan, asserts that the Indian ad war between the cola giants is “dirty.” Few years ago, both companies were fined by the Indian Supreme Court for causing “environmental damage” by defacing Himalayan rocks with painted advertisements. Given the enormous size of the potential Indian soft drink market and the existing reluctance of Indian consumers to drink colas daily (Coke and Pepsi are simply too bland to go with typical Indian cuisine), it is baffling why these companies have engaged in behavior that damages both firms. Instead, Coke and Pepsi should cooperate to generate consumer goodwill toward the cola industry thereby increasing widespread acceptance of soft drinks by India’s massive emerging youth market.

Distribution – – Ethical issues aside, clearly both Pepsi and Coke share a common interest in generating revenues through distribution of their products through vending machines on primary and high school campuses across the country. Unfortunately, both companies have been ineffective in responding to outspoken critics such as the Center for Science in the Public Interest (CSPI). The CSPI is leading a campaign of public health experts to raise awareness of the adverse health consequences of increased soda consumption. However, Pepsi and Coke would benefit through a concerted marketing effort to encourage distribution of soft drinks in schools. Pepsi and Coke would stand to benefit from shifting their focus from competitive actions to obtain exclusive school district contracts to creating a unified marketing approach that educates consumers about their community involvement and eliminates negative misperceptions. As a result, both companies would benefit from potential widespread acceptance of soft drink distribution in schools.

Pricing – – Although price-fixing between Pepsi and Coke would likely lead to legal action, there are other ways in which both companies have missed opportunities for cooperation in pricing. For example, in a 1999 Brazilian magazine interview, Coke’s chairman, Doug Ivester, mentioned the development of a vending machine which would automatically increase prices during hot weather. The story ran worldwide and generated a public outcry. Pepsi criticized Coke’s intentions as exploitative and opportunistic.

However, both companies missed an opportunity to build pricing flexibility into the distribution of carbonated beverages through vending machines – a common interest for both companies. Rather than join the chorus of contempt for Coke’s actions, Pepsi should have attempted to explain the consumer benefits of lower soda prices in cool weather. As a result, both companies could have enjoyed the economic benefits of flexible pricing.

Beverages: The Big Three

•• Coca Cola...... 44.50%

•• Pepsi...... 31.40%

•• Cadbury ...... 14.40%

•• Total...... 90.30%

HHI = 10.000 [(44.5/90.3) + (31.4/90.3) + (14.4/90.3)] = 3,892 (Highly concentrated.) Consumption patterns in India

In Tier 1, 2 and 3 cities in India, 29% of Indian consumers report consuming carbonated beverages/soft drinks during a fixed time of the day suggesting consumption has become a routine part of their day, with most consumption taking place during the 'afternoon to evening' time period. Not surprisingly, consumption is highest in Tier I cities such as Mumbai, Delhi, Kolkata, Chennai, Hyderabad and Bangalore. The level of consumption is seen to increase with rising household incomes (with the exception of the highest income level) while decreasing with age.

Current Market

Soft drinks recorded robust double digit off-trade value growth in 2009, which was higher than tthhaat wwiittnneesssseed iin 22000088. BBoottttlleed wwaatteer aanndd fruit/vegetable juice continued to grow strongly asas more consumers turned to these products in the search of healthier options. Carbonates also witnessed good sales growth as the long summer helped to fuel sales. Enerergy drdrinks has wiwitnessed a slslowdown in saleses growth as it is a premium priced product type and therefore not considered a necessity. Importantly, more