Recall the simple rule that we use to evaluate whether activities should be integrated: if ?(A+B) > ?(A) + ?(B) then activities A and B should be done within the same firm. We want to be very specific about what the synergy between activities A and B might be, and also consider any additional costs that might be incurred if the two activities are done within the same firm.

For Pepsi, we consider activity A to be the manufacture and promotion of concentrate. In turn, we will look at three “Activity B”s – snack foods, fast-food restaurants and bottling.

I. Pepsi and Snack Foods

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Pepsi and Frito-Lay is a horizontal integration issue. Pepsi purchased Frito-Lay in the mid-60s, and seized a latent opportunity.1 As in soft drinks, Pepsi saw that increasing the brand equity of snack foods would generate plenty of consumer B (benefit) because image is a great complement to products used for “mood-enhancement.” Advertising displays quite dramatic economies of scale. Per consumer reached, national advertising is significantly cheaper than regional advertising. Adding image to a national snack food is much more cost effective than adding image to a regional good.

The question we ask next, however, is “In the present, is the market value of Pepsi and Frito-Lay as a single firm greater than the sum of Pepsi and Frito-Lay separately? In other words, is the whole still greater than the sum of its parts? Since Frito-Lay is now a ubiquitous, strong brand on its own, there must be some other synergy in the activities of the two businesses. Pepsi is currently exploring this with their “The Power of One” campaign, which intends to capitalize on the following synergies between Pepsi and Frito-Lay.

* Shared overhead. Until recently, Pepsi and Frito-Lay essentially shared no infrastructure. Pepsi corporate now plans to tie these divisions more tightly together.

* Power over suppliers. Any inputs (such as advertising time) these companies share might be negotiated at lower prices if the two divisions act as one.

* Power over buyers. As a seller of two important brands Pepsi may be able to leverage more desirable shelf space at retail stores.

* As the owner of both brands, Pepsi can effectively “tie” the products together in the minds of consumers leading to higher market shares of both goods.

Qualitatively, these possible synergies might seem quite compelling. However, the value captured from these synergies may be smaller. Why?

1. The soft drink and snack foods divisions separately garner lots of power over suppliers – each is already quite large. Combining efforts may not result in much in the way of additional power or savings.

2. Buyer power, on the other hand, has historically been a challenge. Since, retail outlets (mega-supermarket chains, Walmart, etc.) have been consolidating, their power to negotiate lower wholesale prices has increased. Let’s assume that Pepsi and Frito-Lay (herein called P-F) hits on a great cross promotion campaign-by great I mean that the campaign leads to the generation of increased consumer willingness-to-pay. To the extent that P-F relies on retailers to implement this campaign, P-F may find itself at the mercy of the retailers.

If P-F needs the retailer to implement the campaign, and the retailer sees that the campaign is moving the products and creating profits for P-F, the retailer would like retain some of the gain for itself (particularly if the increased sales of P-F come at the expense of the supermarket’s sales of other colas and chips). As retailers consolidate, they are indeed more empowered in negotiating lower wholesale prices. To the extent the retailer sees a manufacturer earning higher profits and to the extent the retailer itself provides activities that are essential in generating these higher profits, we expect to the profits from any synergy in P-F promotional activities to be shared with retailers

In sum, while taking Frito-Lay national was clearly a positive NPV project. The current “Power of One” is much less compelling given the facts in the case. The synergies are difficult to quantify and any possible value created might not be captured by P-F. Furthermore, we haven’t yet considered the losses the firm incurs as its management abandons its traditional “divisional autonomy” and is stretched to serve the needs of both divisions.

II. Pepsi and the Fast Food Restaurants

Pepsi’s restaurant ownership is a vertical integration question, since the restaurants distribute so much soda. It has a horizontal dimension as well as – the restaurants sell pizza, chicken and tacos, too.

We identified the following possible synergies between Pepsi and the fast food chains:

* Pepsi is uniquely qualified to manage and brand enhance these restaurants (similar to the snack foods).

* The availability of Pepsi’s soft drink at the fountain greatly enhances the brand equity of the drink. Through ownership of the restaurants, Pepsi saves on the transaction costs of having to negotiate with these chains to insure that they carry Pepsi.

Why do the chains earn such high profits on their soft drink sales, while the concentrate producers earn such low returns in fountain sales?

* Chains can effectively play Coke and Pepsi off against each other as both have significant brand equity.

* Consumers are much more likely to choose a chain based on its food offerings rather than on the brand of drink provided. Once the consumer walks in the door, the chain has lots of market power over the soft drink price.

If Pepsi can increase the volume of soft drink sales beyond what the chain could achieve on its own, buying the restaurants could be positive NPV.

But, given that the chain derives huge margins from soft drink sales, why would the chain be unmotivated to increase soft drink sales? We would have to believe that Pepsi’s management is superior and so would be able to increase sales where others would fail.

What about saving on the transaction costs of negotiating with the restaurants? What about increasing the ubiquity and the “fun factor” of Pepsi that derives through their association with the fast food chains? Whatever merit these arguments may have, we learned that restaurants NOT owned by Pepsi that were serving Pepsi at the time subsequently switched to Coke. Coke placed advertisements to convince restaurants that Pepsi could use its proceeds from fountain sales to make their newly-acquired restaurants stronger. Whether this argument has merit or not, the chains bought it. As a result, Pepsi’s post integration market share FELL to just under 20%. In addition, Coke’s margin on fountain sales increased because the restaurants now had a reason to prefer Coke over Pepsi.

Furthermore, operating the chains was very managerially taxing for Pepsi. Franchised restaurants are terribly complex and time intensive operations- not necessarily the “Big Ideas” management style at which Pepsi was expert. It might be argued that the acquisitions ultimately came at a great cost to Pepsi’s other businesses. While Pepsi was busy running restaurants, Coke invested in lots of soft-drink related activities. Pepsi’s loss of the Venezuela market was a tangible example. Analysts pressured Pepsi to spin off the restaurants for many years, and the reaction to the divestiture was quite positive.

III. Pepsi and the Bottlers

Since the bottlers purchase concentrate from Pepsi, their relationship is a vertical integration issue.

Generally how do concentrate producers (CP) create shareholder value? The most fruitful activities a concentrate producer can engage in are those which lead to the creation of B. Increasing B draws more individuals into the consumption of the product, increases the consumption of those who already consume and makes consumers of the product LESS price sensitive. Increasing B can be thought of as shifting the demand curve for Pepsi Cola products to the right. The CP cares about selling more syrup!

Along the vertical chain for the production of soft drinks, how would we explain two critical aspects of the CP’s historical arrangements with bottlers: giving the rights to bottle the beverage in perpetuity and giving the rights exclusively within a particular territory. Since their core activities – marketing and concentrate production – exhibit such strong scale economies, the CP’s profits increase as Q increases. Therefore, we want to explain the bottling contract in light of the CP’s desire to generate B and maximize Q.

1. Exclusivity: You might think that the CP could negotiate better concentrate prices if it had more than one bottler in each territory.2 However, marketing at the local level is an important bottler function. The bottler may possess knowledge of the local market that could effectively be used in promotion. Furthermore, the bottler can concentrate on building relationships with retailers that contribute to building brand equity. All these activities serve to shift the demand curve to the right, thereby increasing Q. If there were multiple bottlers in each region, each would have reduced incentive to advertise, as all the bottlers would share the benefits of the ads. This is an example of a free-rider problem.

2. Perpetuity: This may also reduce the bargaining power of the CP, but since Coke and Pepsi both give the rights to bottle the beverage in perpetuity, the bottlers are essentially captive customers. The practice avoids potential price wars that could reduce margins and impact the firms’ abilities to brand build through marketing. Perpetuity also mitigates the hold-up problem to a large degree – the bottlers will invest because they know that they will be able to be the Pepsi bottler as long as they want.

It appears that exclusivity and perpetuity serve to keep the bottler and the CP well aligned. However, there may be some limits to the degree to which the bottlers want to keep increasing Q. As they reach full capacity, for example, expansion may require additional investment and average bottler costs may actually INCREASE when Q increases. If the CP has control of the bottler’s actions, such investments would take place. In this way, the profits of CP and the bottlers combined may be greater than the sum of the two operating independently.

Let’s be precise about where the gain from vertically integrating comes from:

* The bottler underinvests because the incentives aren’t perfectly aligned. While the CP gives the bottler the right to bottle in perpetuity – this way the bottler does not have to worry about losing his franchise in the future – this does not completely mitigate his incentive to underinvest. This problem may be exacerbated by the historical boundaries of the bottler territory agreements. Where bottlers have reached their capacity and neighboring ones have not, simply combining the two territories can solve the investment problem. Furthermore, a larger bottler can negotiate better with the bigger retail chains that now exist. It is probably easier for Pepsi to execute these bottler combinations (given their size and management experience) than having the individual bottlers combine on their own.

Combining the bottling territories make a lot of sense, but what are the potential costs to vertical integration between the CP and the bottlers:

* The CP has to monitor the bottling division. This puts a strain on upper management’s time. Furthermore, how do we manage a high margin business like concentrate (where managers are highly compensated) with a low margin business like bottling (which, with lower value added, will have managers less highly compensated)? This combination could create a lot of internal strife.

* Agency Costs: Because of the individualized effort and experience needed to do a bottler’s job well, the original franchisees are probably the best qualified to be the bottling managers under Pepsi’s ownership. Since they no longer own the business, however, these former franchisees are probably not as motivated to do their jobs well…

In summary, I think there are two big points to take away from the Pepsi case:

1. Determining the value created by synergies is extremely speculative. Besides which, all the value created may not be captured by the newly integrated firms:

* Another party (like buyers) may be powerful enough to claim some of the created value for themselves.

* Competitors may make strategic decisions subsequent to the integration that reduces the value created and captured.

* The costs (perhaps to the detriment of the original activity) that result from integrating must also be factored in.

2. As the underlying economic conditions change, the factors influencing whether activities generate more profits together or separately may change as well. Firms should be continually reevaluating their integration and/or divestment strategies!

1 Taking Frito-Lay national was a profitable strategy. Why was this opportunity available to Pepsi? The source of the ex ante limit to competition is limited only by your imagination. Perhaps Pepsi’s managers were more insightful than others (they saw the opportunity that others missed) were. Perhaps Pepsi was uniquely well suited to creating brand equity for Frito-Lay (Pepsi was the only or one of few firms that were able to make the strategy profitable). Perhaps there were information asymmetries that worked to Pepsi’s advantage.

Note that Pepsi acquired other businesses (e.g., Wilson Sporting Goods, North American Van Lines) that they incorrectly thought they could make more profitable. To the extent that these unsuccessful acquisitions resulted in losses for Pepsi, it may be appropriate to discount successful acquisitions such as Frito-Lay to some degree.

2 Furthermore, if multiple bottlers are selling Pepsi productions, the competition among them should result in lower retail prices and increase Q (sliding down the demand curve). Of course, Pepsi’s competition with Coke does bring retail prices down – at least to some extent.

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