Cola WarsKey Take-aways

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: Coke: C2 Pepsi: Pepsi Edge

… 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

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 expandsto include non-carbs?

Will these factors change as the basis of competition expandsto include non-carbs?

Buy, Sell, or Hold?

Company Beta P/E (Forward) Mean Analyst Recommendation

Coca Cola .23 19.0 2.6

Pepsi .35 18.3 1.8

Cadbury Schwepes .28 14.5 2.8

Source: Yahoo Finance, 3/17/2005

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

How much does industry matter really?

ROE-Ke Spread

(15%)

(10%)

(5%)

0%

5%

10%

15%

20%

0 100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300

Average Invested Equity ($B)

Toiletries/Cosmetics

Steel

PharmaceuticalsSoft Drink

TobaccoFood Processing

Household ProductsElectrical Equipment

Financial ServicesSpecialty Chemicals

NewspaperBank

Integrated PetroleumTelecom Retail Store

Tire & RubberElectric Utility - Central

Electric Utility - East

Medical ServicesMachinery

Auto & TruckComputer & Peripheral

Paper & ForestAir Transport

Average Economic Profits of U.S. Industry Groups, 1978-1996Value Line Industry Groups

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 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

Industry analysis has traditionally been a major input into portfolio analysis for diversified firms

High

High

Low

Low

Medium

Medium

Selectivity

Harvest/ Divest

Harvest/ DivestSelectivity

Selectivity

Industry Attractiveness B

usi

nes

s S

tren

gth

SelectiveGrowth

SelectiveGrowth

Harvest/Divest

Harvest/Divest

Investmentand

Growth

Harvest/Divest

GE / McKinsey Nine-Block Matrix

Porter’s Five ForcesThreat of New Entry

Bargaining Powerof Customers

Threat of Substitutes

Bargaining Powerof Suppliers

• Economies of scale• Proprietary product

differences• Brand identity• Switching costs

• Capital requirements• Access to distribution• Absolute cost advantages• Government policy• Expected retaliation

• Relative price performance of substitutes• Switching costs• Buyer propensity to substitute

Rivalry Among Existing Competitors

• Industry growth• Fixed costs / value

added• Overcapacity• Product differences• Brand identity

• Switching costs• Concentration and balance• Informational complexity• Diversity of competitors• Corporate stakes• Exit barriers

• 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

Source: Michael E. Porter, Competitive Advantage(New York: Free Press, 1985)

Biotech Supply Industry: Investment thesis for Invitrogen

Threat of New Entry

Bargaining Powerof Customers

Threat of Substitutes

Bargaining Powerof Suppliers

• 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

• None – these products are absolutely critical to biotechnology research

Rivalry Among Existing Competitors

• Growing industry• Some products highly

differentiated (although some are commodities)

• Switching costs high insome lines of business (bio-informatics SW)

• Informationalcomplexity

• 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

Invitrogen performance

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

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

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

Buyer power

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

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

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

An example of industry dynamics

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

Number of Firms, Entry and ExitIn the US Tire Industry

(1905-1980)

Some common long-run dynamics

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?

“Everything should be made as simple as possible, but no simpler”— Albert Einstein

“Everything should be made as simple as possible, but no simpler”— Albert Einstein

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