‘Sugar Water’ or iPhone … which is more profitable?

“My heart won't skip a beat

I never look before I leap

Right, just enjoy the ride

Don't need a reason why

Everything's alright.

And you will find

The joy of Pepsi”

-         The Joy of Pepsi, Brittany Spears

In a 1983 conversation that is Silicon Valley lore, 27-year old Steve Jobs asked then Pepsi President John Sculley this life-altering question “Do you want to sell sugar water for the rest of your life, or do you want to come with me and change the world?” That changed Sculley’s mind and he accepted the offer to replace Steve Jobs to become Apple’s CEO.

Why hire a Pepsi exec to lead Apple?

Sculley was a marketing rockstar back in 1983. He had launched the legendary Pepsi Challenge marketing campaign, which was wildly successful and grabbed significant market share from market leader Coca Cola. Jobs was enamored by the marketing genius of Sculley and wanted his help to build Apple into a similarly successful, giant consumer brand.

Apple was in dire straits back in 1982-83. Despite introducing pioneering lines of PCs, Apple’s business was struggling. Apple-III had failed. Lisa had failed. The only real revenue opportunity was for Apple to go back to selling Apple-II. And competitors such as IBM and Atari were outselling Apple’s best products by a wide margin. The Apple Board was not impressed with Jobs and decided to demote him. They didn’t think he was ready to lead the company to success. While Steve was off developing the revolutionary Macintosh, someone had to keep the company afloat by bringing in more revenue and profits by improving Apple-II sales.

The Board thought 27-year old Steve didn’t have the chops to do it. They gave him the unenviable task of finding his own replacement CEO. This was before the world knew Jobs as the marketing genius with his own reality distortion field. Marketing was thought to be the key to promoting and improving the business prospects of Apple. And since Sculley was a proven marketing executive, it was natural for Steve to think he would be the best person to improve Apple’s future prospects and create the required buzz in the consumer market to sell more Apple products.

The Numbers Compared

As promised, here is the chart showing the gross margin % for Pepsi vs. leading Silicon Valley Tech companies. I was shocked and also impressed to find that ‘sugar water’ has one of the highest gross margins. On par with Google. Think about it for a second.

When complicated tech businesses like Apple and Amazon are challenged with lower gross margins, Pepsi consistently brings in 55% gross margins year after year. Very consistently as shown in the chart below. It is the main reason Warren Buffett has held on to his Coca-Cola shares ever since he was 15 years old! Mr.Buffett is 90 years old now. He thinks Coca-Cola has an amazing ‘moat’ around their business ‘castle’ to prevent competitors from attacking them. And margin stability is an amazing indicator of this business health. But how do the cola kings do it so consistently and what lessons can tech businesses learn from them? Below is my attempt to unpack their key business strengths and longevity. 

Strong Brand Identity

The biggest reason for Pepsi and Coca-Cola’s success is a strong brand. A consumer-facing business constantly faces customer churn. Good companies manage the churn but great companies create strong brand loyalty to not only minimize the churn but also attract and retain new loyal customers, effectively offsetting the churn. All consumer-facing companies do this to varying extents. The biggest difference is that most companies engaged in such market creation actually deliver products that bring some tangible benefit to the consumer. I don’t know of a tangible benefit that Coke or Pepsi deliver to the consumer. It is purely an emotional, feel-good purchase. That feeling of instant gratification, taste and the dose of sugar proves irresistible.

In a way, Coke should have been the toughest product to sell. Why would you spend money to ingest phosphoric acid, high fructose corn syrup, and 35gm sugar (one can is 100% DV of sugar)? Marketers know that an emotional connection, rather than rational logic, is key for the sale. Not just one sale but repeat purchases. A consistent way to emotionally connect with customers is critical for improved sales, high customer loyalty, low customer churn and new customer acquisition. That consistent emotional association is achieved through branding. 

Iconic singer Selena Gomez is the latest in a long list of Coca-Cola brand ambassadors

Brand Building and Consistency

“Happiness in a bottle” is the universally understood message for Coca-Cola reinforced through advertising and all other representations of the brand. Brand building is hard. It takes a lot of time and money and constant messaging to end customers. Consistency is required across various product lines, across geographies, demographics, age groups, languages, cultural norms and political identities. There is a story that when Coca-Cola launched in China, its name implied “bite the wax tadpole” or “female horse stuffed with wax” depending on the specific dialect. The company had to work very hard to identify the right phonetically appropriate replacement “kokou kole” which thankfully meant “happiness in the mouth”. Branding disaster avoided.

Careful brand building is done through marketing campaigns, advertising, event sponsorship and other outbound promotional activities. Glamorous personalities are recruited as brand ambassadors and paid lots of money to promote the brand. Consumers’ emotional connection to brand identity is a reliable way to increase product stickiness. Coca-Cola, the world’s sixth best brand, spent $4.2 Billion in 2019 on advertising (nearly 11% of its entire revenue, as shown in the chart below). Ongoing advertising is an important way to constantly remind and reinforce the brand.

Apple’s brand identity is about innovation, simplicity, passion, liberty, even rebellion against status quo. This emotional connection is what led Apple fans to endure hours of waiting in long lines on the first day of new iphone releases back in 2000s. It is what keeps Tesla customers delighted despite the myriads of growth pains and quality problems experienced by the company. Branding is extremely powerful. It can even motivate you to gulp phosphoric acid and feel good about it.

Global Reach

Coca-Cola is available in all the 195 countries around the world, except two. Cuba and North Korea have long-term embargoes on American products. This is the maximum global reach that any company can hope for and it offers Coca-Cola unparalleled economies of scale. Along with its vertical integration and pricing power, this forms an incredibly powerful competitive advantage.

Vertical Integration

Coca-Cola headquarters are located in Atlanta, Georgia. However, it has production, bottling, additional bottling partners, distribution, warehousing facilities, wholesalers and retailers all around the world. This vertical integration and streamlining is a huge competitive advantage and business moat that Warren Buffet loves to talk about as a sustainable business advantage. No other company, besides Pepsi, can even think of challenging Coca-Cola due to this sustainable business advantage.

Product Breadth

Coca-Cola has a broadly diversified portfolio of non-alcoholic beverages. There are a number of brands within Coca Cola that generate more than a billion dollars in annual revenue, and cater to the taste and preferences of the demographically and geographically diverse customer base: water, sparkling drinks, flavored water, carbonated beverages, soda, diet soda, juice, sports drinks, energy drinks, dairy-based drinks, plant-based drinks, energy drinks, tea, and coffee. Such diversification enables the capture of a broader customer base. It also presents an intriguing challenge to the consistency of marketing campaigns and brand messaging.

Industry Consolidation

Coke and Pepsi together control about 75% of the beverage market. And, in order to protect their market share and profits, they aggressively hunt for and acquire smaller players in the non-alcoholic beverage industry. Some are acquired to kill competition and protect market share while others are acquired to diversify and grow the business. 

Pricing Power

Coca-Cola and Pepsi’s large scale operations allow tremendous flexibility in adopting aggressive pricing strategies. Their economies of scale are unparalleled in the beverage world. And they use it to the fullest extent. Smaller competitors usually can’t keep up and end up pricing their products higher. Individual servings are the most expensive. As the purchase volume get higher, discounted pricing takes over. This pricing and packaging strategy enables Coca-Cola to sell nearly 2 billion servings every single day. Low prices, backed by consistent quality and an attractive brand. And with limited alternatives. Why would a consumer go anywhere else?

Summary

In summary, it is an interesting world where ‘sugar water’ can make a sustainable profit margin of 55% whereas more technologically complex businesses often find this challenging. Some tech companies have realized the power of branding, emotional connection and customer stickiness. This is exactly why the five best brands in the world in 2019 were tech companies – Apple, Google, Amazon, Microsoft and Samsung in that order. Next came Coca-Cola. For comparison, back in year 2000, the top five brands were Coca-Cola, Microsoft, IBM, Intel and Nokia. Coca-Cola has consistently been a top spender on building its brand.

As investors might appreciate, a sustainable moat is crucial to building a stable business with predictable margins. Coca-Cola and Pepsi have achieved this and demonstrated it over many, many decades. The younger tech industry certainly has some interesting lessons to learn from these old, low-tech companies. If you see anything missing in the list above, please feel free to add. Happy Labor Day!