Cases for Lecture 2

Price Wars in the Breakfast Cereal Industry

For decades, the breakfast cereal industry was one of the most profitable in the United States.
The industry has a consolidated structure dominated by Kellogg’s, General Mills, and Kraft
Foods with its Post brand. Strong brand loyalty, coupled with control over the allocation of
supermarket shelf space, helped to limit the potential for new entry. Meanwhile, steady
demand growth of about 3% per annum kept industry revenues expanding. Kellogg’s, which
accounted for more than 40% of the market share, acted as the price leader in the industry.
Every year Kellogg’s increased cereal prices, its rivals followed, and industry profits
remained high.
This favourable industry structure started to change in the early 1990s when growth in
demand slowed and then stagnated as lattes and bagels or muffins replaced cereal as the
morning fare for many American adults. Soon after, the rise of powerful discounters such as
Walmart, which entered the grocery industry in the early 1990s, and began to aggressively
promote their own brands of cereal, priced significantly below the brand-name cereals. As
the decade progressed, other grocery chains such as Kroger’s started to follow suit, and brand
loyalty in the industry began to decline as customers realized that a $2.50 bag of wheat flakes
from Walmart tasted about the same as a $3.50 box of Cornflakes from Kellogg’s. As sales of
cheaper, store-brand cereals began to take off, supermarkets, no longer as dependent on brand
names to bring traffic into their stores, began to demand lower prices from the branded cereal
manufacturers.
For several years, the manufacturers of brand cereals tried to hold out against these
adverse trends, but in the mid-1990s, the dam broke. In 1996, Kraft (then owned by Philip
Morris) aggressively cut prices by 20% for its Post brand in an attempt to gain market share.
Kellogg’s soon followed with a 19% price cut on two-thirds of its brands, and General Mills
quickly did the same. The decades of tacit price collusion were officially over.
If the breakfast cereal companies were hoping that the price cuts would stimulate demand,
they were wrong. Instead, demand remained flat while revenues and margins followed prices
down, and Kellogg’s operating margins dropped from 18% in 1995 to 10.2% in 1996, a trend
experienced by the other brand cereal manufacturers.
By 2000, conditions had only worsened. Private label sales continued to make inroads,
gaining more than 10% of the market. Moreover, sales of breakfast cereals started to contract
at 1% per annum. To cap it off, an aggressive General Mills continued to launch expensive
price and promotion campaigns in an attempt to take share away from the market leader.
Kellogg’s saw its market share slip to just over 30% in 2001, behind the 31% now held by
General Mills. For the first time since 1906, Kellogg’s no longer led the market. Moreover,
profits at all three major producers remained weak in the face of continued price discounting.
In mid-2001, General Mills finally blinked and raised prices a modest 2% in response to
its own rising costs. Competitors followed, signalling perhaps that after a decade of costly
price warfare, pricing discipline might once more emerge in the industry. Both Kellogg’s and
General Mills tried to move further away from price competition by focusing on brand
extensions, such as Special K containing berries and new varieties of Cheerios. Kellogg’s
efforts with Special K helped the company recapture market leadership from General Mills.
More importantly, the renewed emphasis on non-price competition halted years of damaging
price warfare, at least for the time being.
 Circumventing Entry Barriers into the Soft Drink Industry
The soft drink industry has long been dominated by two companies—Coca-Cola and PepsiCo.
By spending large sums of money on advertising and promotion, both companies have
created significant brand loyalty and made it very difficult for new competitors to enter the
industry and take market share away from these two giants. When new competitors do try to
enter, both companies have responded by cutting prices, thus forcing the new entrant to
curtail expansion plans.
However, in the late 1980s, the Cott Corporation, then a small Canadian bottling
company, worked out a strategy for entering the soft drink market. Cott’s strategy was
deceptively simple. The company initially focused on the cola segment of the soft drink
market. Cott signed a deal with Royal Crown Cola for exclusive global rights to its cola
concentrate. RC Cola was a small player in the U.S. cola market. Its products were
recognized as having a high quality, but RC Cola had never been able to effectively challenge
Coke or Pepsi. Next, Cott signed a deal with a Canadian grocery retailer, Loblaw, to provide
the retailer with its own private-label brand of cola. Priced low, the Loblaw private-label
brand, known as President’s Choice, was very successful and took share from both Coke and
Pepsi.
Emboldened by this success, Cott decided to try to convince other retailers to carry
private-label cola. To retailers, the value proposition was simple because, unlike its major
rivals, Cott spent almost nothing on advertising and promotion. This constituted a major
source of cost savings, which Cott passed on to retailers in the form of lower prices. For their
part, the retailers found that they could significantly undercut the price of Coke and Pepsi and
still make better profit margins on private-label brands than on branded colas.
Despite this compelling value proposition, few retailers were willing to sell private-label
colas for fear of alienating Coca-Cola and PepsiCo., whose products were a major draw of
grocery store traffic. Cott’s breakthrough came in the early 1990s when it signed a deal with
Walmart to supply the retailing giant with a private-label cola called “Sam’s Choice” (named
after Walmart founder Sam Walton). Walmart proved to be the perfect distribution channel
for Cott. The retailer was just starting to get into the grocery business, and consumers went to
Walmart not to buy branded merchandise but to get low prices. As Walmart’s grocery
business grew, so did Cott’s sales. Cott soon added other flavors to its offerings, such as
lemonlime soda, which would compete with 7Up and Sprite. Moreover, pressured by
Walmart, by the late 1990s, other U.S. grocers had also started to introduce private-label
sodas, often turning to Cott to supply their needs.
By 2008, Cott had grown to become a $1.7 billion company. Cott captured more than 6%
of the United States soda market, up from almost nothing a decade earlier, and held onto a
15% share of sodas in grocery stores, its core channel. The losers in this process have been
Coca-Cola and PepsiCo, which are now facing the steady erosion of their brand loyalty and
market share as consumers increasingly come to recognize the high quality and low price of
private-label sodas.
Walmart’s Bargaining Power over Suppliers
When Walmart and other discount retailers began in the 1960s, they were small operations
with little purchasing power. To generate store traffic, they depended in large part on
stocking nationally branded merchandise from well-known companies such as Procter &
Gamble and Rubbermaid. Because the discounters did not have high sales volume, the
nationally branded companies set the price. This meant that the discounters had to look for
other ways to cut costs, which they typically did by emphasizing self-service in stripped-
down stores located in the suburbs where land was cheaper. (In the 1960s, the main
competitors for discounters were full service department stores such as Sears, Roebuck that
were often located in downtown shopping areas.)
Discounters such as Kmart purchased their merchandise through wholesalers, who in
turned bought from manufacturers. The wholesaler would come into a store and write an
order, and when the merchandise arrived, the wholesaler would come in and stock the shelves,
saving the retailer labor costs. However, Walmart was located in Arkansas and placed its
stores in small towns. Wholesalers were not particularly interested in serving a company that
built its stores in such out-of-the-way places. They would do it only if Walmart paid higher
prices.
Walmart’s Sam Walton refused to pay higher prices. Instead, he took his fledgling
company public and used the capital raised to build a distribution center to stock merchandise.
The distribution center would serve all stores within a 300-mile radius, with trucks leaving
the distribution center daily to restock the stores. Because the distribution center was serving
a collection of stores and thus buying in larger volumes, Walton found that he was able to cut
the wholesalers out of the equation and order directly from manufacturers. The cost savings
generated by not having to pay profits to wholesalers were then passed on to consumers in
the form of lower prices, which helped Walmart continue growing. This growth increased its
buying power and thus its ability to demand deeper discounts from manufacturers.
Today Walmart has turned its buying process into an art form. Because 8% of all retail
sales in the United States are made in a Walmart store, the company has enormous bargaining
power over its suppliers. Suppliers of nationally branded products, such as Procter & Gamble,
are no longer in a position to demand high prices. Instead, Walmart is now so important to
Procter & Gamble that it is able to demand deep discounts from them. Moreover, Walmart
has itself become a brand that is more powerful than the brands of manufacturers. People do
not go to Walmart to buy branded goods; they go to Walmart for the low prices. This simple
fact has enabled Walmart to bargain down the prices it pays, always passing on cost savings
to consumers in the form of lower prices.
Since the early 1990s, Walmart has provided suppliers with real-time information on
store sales through the use of individual stock keeping units (SKUs). These have allowed
suppliers to optimize their own production processes, matching output to Walmart’s demands
and avoiding under- or overproduction and the need to store inventory. The efficiencies that
manufacturers gain from such information are passed on to Walmart in the form of lower
prices, which then passes on those cost savings to consumers.