CHAPTER 1 Overview of Financial Reporting Financial Statement Analysis , and Valuati Pepsico combines raw materials into a concentrate or syrup base . The ingredients and their mixes are highly confidential . Pepsico transfers the concentrate to its bottiers ( or in the case of syrup to its national fountain accounts ) , which combine it with water and sweeteners and then bottle it to produce the finished soft drink . Porter's Five Forces Classification Framework Porter suggests that five forces influence the level of competition and the profitability of firms in an industry . ' Three of the forces - rivalry among existing firms , potential entry and substitutes - represent horizontal competition among current or potential future firms in the industry and closely related products and services . The other two forces buyer power and suppli er power - depict vertical competition in the value chain , from the suppliers through the ough the existing rivals to the buyers . We discuss each of these forces next and illustrate them within the soft drink / beverage industry . Exhi libit 17 depicts Porter's five forces in the soft drink / beverage industry . 1 . Rivalry among Existing Firms . Direct rivalry among existing firms is often the ong Exist rect riva existing first order of competition in an industry . Some industries can be characterized by concentrated rivalry ( such as a monopoly , a duopoly , or an oligopoly ) , whereas others have diffuse se rivalry across many firms . Economists often assess the level of competition with industry concentration ratios , such as a four- firm concentration index that measures the proportion of industry sales controlled by the four largest competitors . Economics teaches that in general the greater the industry concen tration , the lower the competition between existing rivals and thus the more prof itable the firms will be Pepsico and Coca-cola dominate the soft drink beverage industry in the United States . Because some consumers view the two companies products as being similar intense competition based on price could mature ( that i could develop . Also , the soft drink market in the United States is mature ( that is not growing rapidly ) , so price cutting could become a strategy to gain market share . Although intense rivalries have a tendency to reduce profitability , in this case , Pepsico and Coca-cola appear to tacitly avoid competing based on price and compete instead on brand image , access to key distribution chan nels ( for example , fast - food chains and grocery store shelf space ) , and other attrib lites Growth opportunities do exist in other countries , which both companies pursue aggressively . Thus , we characterize industry rivalry as moderate . Threat of New Entrants . How easily can new firms enter a market ? Are there entry barriers such as large capital investment , technological expertise , patents , or regulations that inhibit new entrants ? Do the existing rivals have distinct compet itive advantages ( such as brand names ) that will make it difficult for other firms to enter and compete successfully ? If so , firms in the industry will likely generate higher profits than if new entrants can enter the market easily and compete awa my potential excess profits . The soft drink beverage industry has no significant barriers to entry . This is evi dent by the numerous small juice , sports drin drink water , and soft drink companies that exist ; the frequency with which new firms enter the industry and the availability of generic and no - name beverage products . However , the existing major players in the soft drink beverage industry have competitive advantages that reduce the threat of new entrants . Brand recognition by Pepsico and Coca-cola serves as a very owerful Michal I Porter , Competitive Strategy Techniques for Analyzing Industries and Competitors ( New YorkStep 1: Identify the Industry Economic Characteristics Exhibit 1.7 Porter's Five Forces in the Soft Drink/Beverage Industry Supplier Power: Low Soft drink/beverage industry utilizes primarily commodity ingredients. Potential Entry: Low Existing Rivalry: Substitutes: Low No barriers to entry, but Moderate Major players (PepsiCo major players (PepsiCo and Industry is oligopolistic and Coca-Cola) offer Coca-Cola) have strong with several very large beverages that span the competitive advantages, players. PepsiCo and entire soft drink/beverage such as brand names and Coca-Cola control large industry. Primary substitute access to distribution market shares of the competition is from alcoholic channels, to deter potential soft drink/beverage beverages such as beer and entrants. industry. wine and from coffee-based beverages. Buyer Power: Low/Moderate Individual consumers of beverages have diffuse power because there are relatively few suppliers, consumers exhibit low price sensitivity due to brand loyalty, and beverage purchases are small expenditures. Certain buyers particularly large retail chains and restaurant chains, do have some buyer power. deterrent to potential new competitors. Another deterrent is these two firms' domi- nation of distribution channels. Most restaurant chains sign exclusive contracts to serve the beverages of one or the other of these two firms. Also, PepsiCo and Coca-Cola often dominate shelf space in grocery stores. 3. Threat of Substitutes. How easily can customers switch to substitute products or services? How likely are they to switch? When there are close substitutes in a market, competition increases and profitability diminishes (for example, between restaurants and grocery stores for certain types of prepared foods). Unique products with few substitutes, such as certain prescription medications, enhance profitability.CHAPTER 1 Overview of Financial Reporting , Financial Statement Analysis , and Valuation The carbonated soft drink industry faces substitute competition from an array of other beverages that consumers can substitute to quench their thirst . Fruit jui - ces , bottled water sports drinks , teas , coffees , milk , beers , and wines serve a simi lar thirst quenching function to that of soft drinks . Over the years , Coca Cola and Pepsico have expanded their beverage portfolios to encompass virtually nonalcoholic beverages . For example , Pepsico purchased Tropicana and Gatorade to enhance its product offerings in juices , sports drinks , and bottled water , and has joint ventures with Lipton and Starbucks to sell teas and coffees . Because of the wide range of beverage products offered by Pepsico and Coca Cola and because of consumer buying habits , brand loyalty , and channe availability , the threat of substitutes in the soft drink beverage industry is low The primary substitute competition comes from alcoholic beverages such as beer and wine and from coffee - based beverages Buyer Power . Buyer power relates to the the relative number of buyers and sellers in a particular industry and the leverage buyers have with respect to price . Are the myers price takers or price setters ? If there are many sellers of a product and small number of buyers making very large purchase decisions , such as military equipment bought by governments or automobile parts purchased by automobile manufacturers , the buyer can exert significant downward pressure on prices and therefore on the profitability of suppliers . If there few sellers and many as with beverages , the sellers have more bargaining power power also relates to buyers' price sensitivity and the elasticity of demand . How sensitive are consumers to product prices ? If products are similar to those offered by competitors , consumers may switch to the lowest - priced offer ing . If consumers view a particular firm's products as unique , however , they will be less sensitive to price differences . Another dimension of price sensitivity is the relative cost of a product . Consumers are less sensitive to the prices of products that represent small expenditures , such as beverages , than they are to higher priced prod priced products , such as automobiles . However , even though individual consumers may swi lay switch easily between brands or between higher - or lower - priced products , they make individual rather than large collective buying decisions ; so they are likely to continue to be price takers ( not price setters ) . The ease of switching does not make the buyer powerful ; instead it increases the level of competition between the rivals In the beverage industry , buyer power is relatively low because there are very few suppliers and they have access to essential distribution channels . Individual consumers tend to exhibit relatively low price sensitivity because of brand loyalty , and beverages comprise relatively small dollar amount purchases . However , cer tain buyers ( for example , large retail and grocery chains such as Walmart and large fast food chains such as Mcdonald's ) make such large beverage purchases on a national level that they can exert significant buyer power 5 . Supplier Power . A similar set o f factors with respect to leverage in negotiating prices applies on the input side as well . If an industry is comprised of a large number of potential buyers of inputs that are produced by relatively few suppli ers , the suppliers will have greater power in setting prices and generating profits For example , many firms assemble and sell personal computers and laptops , but these firms face significant supplier power because Microsoft is a dominant sup part of operating systems and application software and Intel is a dominant sup plier of microprocessorsStep 1 : Identify the Industry Economic Characteristics Beverage companies produce their concentrates and syrups with raw materials that are commodities . Although Pepsico does not disclose every ingredient , Pepsico is not likely to be dependent on one supplier ( or even a few suppliers ) for its raw materials . It also is unlikely that any of these ingredients are sufficiently unique that the suppliers could exert much power over PepsiCo . Given Pepsico's size , the power more likely resides with Pepsico than with its suppliers In summary : Competition in the soft drink / beverage industry rates low on supplier power , threat of new entrants and threat of substitutes The industry rates tes low on buyer power of consumers but moderate on buyer power of fast food chains and large retail and grocery chains The industry rates moderate on rivalry within the industry . Unless Pepsico or Coca-cola decides to compete on the basis of low price , you might expect these firms to continue to generate relatively high profitability Economic Attributes Framework We find the following framework useful in studying the economic attributes of a busi - ness , in part because it ties in with items reported in the financial statements 1 . Demand . Are customers highly price -sensitive , as in the case of automobiles , or are they relatively insensitive , as in the case of soft drinks ? . Is demand growing rapidly , as in the case of long-term health care , or is the industry relatively mature , as in the case of grocery stores ? . Does demand move with the economic cycle , as in the case of construction of new homes and offices , or is demand insensitive to business cycles , as in the case of food products and medical care ? Does demand vary with the seasons , as in the case of summer clothing and ski equipment , or is demand relatively stable throughout the year , as in the case of most grocery store products ? 2 . Supply Are many suppliers offering similar products , or are a few suppliers offering unique products ? Are there high barriers to entry , or can new entrants gain easy access ? Are there high barriers to exit , as in the case of firms that face substantial environment cleanup costs ? Manufacturing anufact . Is the manufacturing process capital - intensive , as in the case of electric power generation ; labor- intensive , as in the case of advertising , investment banking , auditing , and other professional services ; or a combination of the two , as in the case of automobile manufacturing and airline transportation ? Is the manufacturing process complex with low tolerance for error , as in the case of heart pacemakers and microchips , or relatively simple with ranges of products that are of acceptable quality , as in the case of apparel and nonmechanized toys ? Marketing Is the product promoted to other businesses , in which case a sales staff plays a key role , or is it marketed to consumers , so that advertising , location , and coupons serve as principal promotion mechanisms ?CHAPTER1 Overview of Financial Reporting , Financial Statement Analysis , and Valuation Does steady demand pull products through distribution channels , or must firms continually create demand ? 5 . Investing and Financing Are the assets of firms in the industry relatively short -term , as in the case of commercial banks , which require short-term sources of funds to finance them ? Or are assets relatively long-term , as in the case of electric utilities , which require primarily long-term financing ? . Is there relatively little risk in the assets of firms in the industry , such as from technological obsolescence , so that firms can carry high proportions of debt financing ? Alternatively , are there high risks resulting from short product life cycles or product liability concerns that dictate low debt and high shareholders equity financing ? . Is the industry relatively profitable and mature , generating more cash flow from operations than is needed for acquisitions of property , plant , and equipment ? idly as Alternatively , is the industry growing rapidly and in need of external financing ? Exhibit 1 .8 summarizes the economic attributes of the soft drink / beverage industry what you Demand Demand is relatively insensitive to price There is low growth in the United States , but more rapid growth opportunities are available in other countries Demand is not cyclical supply Two principal suppliers ( Pepsico and Coca-cola ) sell branded products Branded products and domination of distribution channels by two principal suppliers create significant competitive advantages Manufacturing Manufacturing process for concentrate syrup is not capital - intensive Bottling and distribution of final product are capital - intensive Manufacturing process is simple ( essentially a mixing operation ) with some tolerance for quality variation Marketing rand recognition and established demand pull products through distribution channels ation channels , but advertising can stimulate demand to some extent . Investing and Financing * Bottling operations and transportation of products to retailers require long-term financing * Profitability is relatively high and growth is slow in the United States , leading to excess cash flo generation Growth markets in other countries require financing from internal domestic cash flow or from external sourcesStep 2 : Identify the Company Strategies Step 2 : Identify the Company Strategies ONE Identify firm - specific Firms establish business strategies to differential late themselves from competitors , but strategies for achievi industry's economic characteristics affect the flexibility that firms have in designing competitive advan those strategies . In cases , firms can create sustainable competitive advantages an industry Pepsico's size , brand name , and access to distribution channels give it sustainable com - petitive advantages over smaller , less - known beverage companies Similarly , the reputa tion for quality family entertainment provides Disney with a sustainable advantage whereas a reputation for low prices generates advantages for Walmart In many industries , however , products and ideas quickly get copied . Consider the following examples : cell phones , tablets , and computer hardware ; chicken , pizza , and hamburger restaurant chains ; and financial services . In these cases , firms may achieve competitive advantage by being the first with a new concept or idea ( referred to as first mover advantage ) or by continually investing in product development to remain on the leading edge of change in an industry . Such competitive advantages are difficult ( but not impossible ) to sustain for long periods of time Framework for Strategy Analysi The set of strategic choices confronting a particular firm varies across industries following framework dealing with product and firm characteristics helps you identify and structure the set of trade - offs and choices a firm must face Nature of Product or Service . Is a firm attempting to create unique products or services for particular market niches , thereby achieving relatively high profit mar gins ( referred to as a product differentiation strategy ) ? Or is it offering nondiffer entiated products at lo low prices , accepting a lower profit margin in return for a higher sales volume and market share ( referred to as a low - cost leadership strategy ) ? Is a firm attempting to achieve both objectives by differentiating ( perhaps by creating brand loyalty or technological innovation ) and being price ompetitive by maintaining tight control over costs ? Degree of Integration in Value Chain , Is the firm pursuing a vertical integration strategy , participating in all phases of the value chain , or selecting just certain phases in the chain ? With respect to manufacturing , is the firm conducting all manufacturing operations itself as usually occurs in steel manufacturing ) , out sourcing all manufacturing ( common in athletic shoes ) , or outsourcing the man Ufacturing of components but conducting the assembly operation in- house ( common in automobile and computer hardware manufacturing ) With respect to distribution , is the firm maintaining control over the distribu - jon function or outsourcing it ? Some restaurant chains , for example , own all of their restaurants , while other chains operate through independently owned franchises . Computer hardware firms have recently shifted from selling through their own sales staffs to using various indirect sellers , such as value-added resellers and systems integrators - in effect shifting from in - house sourcing to outsourcing the distribution function Degree of Geographical Diversification . Is the firm targeting its products to its domestic market or integrating horizontally across many countries ? Operating in other countries creates opportunities for growth but exposes firms to risks from changes in exchange rates , political uncertainties , and additional competitorsCHAPTER 1 Overview of Financial 4. Degree of Industry Diversification. Is the firm operating in a single industry or diversifying across multiple industries? Operating in multiple industries permits firms to diversify product, cyclical, regulatory, and other risks encountered when operating in a single industry but raises questions about management's ability to understand and manage multiple and different businesses effectively. Application of Strategy Framework to Pepsico's Beverage Division To apply this strategy framework to PepsiCo's beverage division, we rely on the descrip- tion provided by PepsiCo's management (Appendix B). Most U.S. firms include this type of management discussion and analysis in their Form 10-K filing with the Securities and Exchange Commission (SEC). 1. Nature of Product or Service. PepsiCo's beverage division competes broadly in the beverage industry, with offerings in soft drinks, fruit juices, bottled waters, sports drinks, teas, and coffees. However, its principal beverage products are soft drinks. Although one might debate whether its products differ from similar products offered by Coca-Cola and other competitors (a debate that invariably involves taste), PepsiCo relies on brand recognition and distribution channels to differentiate its products. . Degree of Integration in Value Chain. PepsiCo engages in new product devel- opment, manufactures concentrates and syrups, and bottles, distributes, and pro- motes its products. Maintaining product quality and efficient and effective distribution channels are critical to PepsiCo's success, so PepsiCo emphasizes the important role of much of the value chain. However, bottling operations are rela- tively simple, yet capital-intensive, and require long-term financing, typically debt. After many years of these operations being delegated to affiliated bottlers, PepsiCo recently began repurchasing financial interests in such operations, which has resulted in an increase in debt financing. . Degree of Geographical Diversification. Note 1 to PepsiCo's financial state- ments and Exhibit 1.5 indicate that the PepsiCo Americas Beverages division gen- erated 33% of the firm's revenues during 2012. PepsiCo Europe and PepsiCo Asia, Middle East and Africa (AMEA) represented 21% and 10% of revenues, respectively. The remainder of revenues came from the three distinct foods divi- sions (Frito-Lay North America, Quaker Foods North America, and Latin America Foods). Note that the Europe and AMEA divisions include both bever- age and food sales, so it is not possible from these disclosures to identify the exact amount of food versus beverage revenues for PepsiCo overall. Nevertheless, it is clear that PepsiCo is not strictly a beverage company. 4. Degree of Industry Diversification. To focus and streamline the presentation of industry analysis and strategic analysis techniques, our discussion thus far has focused on PepsiCo's beverages business. However, PepsiCo generates greater reve- nues and higher operating profit margins from the snack food and breakfast foods divisions than from the beverage division. As seen in Exhibit 1.5, PepsiCo's three foods divisions generated nearly 37% of the company's total revenues. Although PepsiCo is more industry-diverse than Coca-Cola, many economic characteristics of the beverage, snack food, and cereal industries are similar in nature, involving the selling of branded consumer products. These industries can be characterized as hav- ing low barriers to entry but a small number of powerful rivals with brand recogni tion and access to key distribution channels. These industries rely on commodity