discussion question need answering

PEPSICO: QTG EMERGING CHANNEL INVESTMENT

John Compton smiled as he returned to his office on the 16th floor of the Quaker Plaza in downtown Chicago. As president and CEO of the newly formed Quaker, Tropicana, Gatorade (QTG) division of PepsiCo, he was still in the process of assessing his new team. Today, he had observed, yet again, the extraordinary talent and dedication of PepsiCo people, a hallmark of the company’s business success. His team’s discussion reflected a powerful mix of long-term strategic thinking coupled with a passionate commitment to the QTG brands and the company’s core values.

His team had debated the potential and strategic fit of two small but rapidly growing channels. The natural foods grocery channel, comprised of fast-growing companies such as Whole Foods and Trader Joe’s, offered one possible option; the Dollar channel, with even faster growing retailers such as Dollar Tree and Dollar General, represented another. Neither channel currently contributed significant revenues or profits for QTG, but either could offer significant incremental growth for the business over time. Each channel also presented major challenges on a variety of fronts. The best path forward was anything but obvious. As he considered the future, Compton reflected on PepsiCo’s strategic priorities as well as the evolving dynamics of its consumer base and channel partners.

PepsiCo: A Rich History and Promising Future

Two companies with rich histories, Frito-Lay and Pepsi-Cola, combined in 1965 to form PepsiCo, Incorporated. Despite a relatively short history in its current form, the company traced its roots along a variety of paths as far back as the early days of the Industrial Revolution. Pepsi-Cola, formulated by druggist Caleb Bradham in New Bern, North Carolina, dated back to 1898. Elmer Doolin introduced Frito’s corn chips in 1932, and Herman W. Lay introduced his brand of potato chips in 1938. More recent brand acquisitions like Quaker Oats traced back to 1901, Tropicana orange juice to 1947, and Gatorade to 1966.

Now a $30 billion global company, PepsiCo owned 16 muscular brands that generated more than $1 billion each in retail sales. The company grew with each innovative new product such as Propel fitness water, Tropicana Fruit Integrity, and Quaker Take Heart Instant Oatmeal. PepsiCo supported these strong brands and innovative products with a powerful go-to-market distribution system ranging from its renowned Direct Store Delivery (DSD) model to a traditional grocery warehouse network to an extensive foodservice distribution network. Together, this array of go-to-market options allowed PepsiCo to provide fresh products and excellent service in a timely and cost-effective manner to its vast array of customers and consumers. At the center of PepsiCo’s strategy resided its 153,000 people who possessed an uncanny passion for the brands and a competitive drive to be the best food and beverage company in the world.

Diversity and inclusion

PepsiCo considered diversity and inclusion as both a fundamental strategic priority and a competitive advantage. The company wanted a workforce as diverse as the consumers, customers, and communities it served. At PepsiCo, diversity encompassed all of the characteristics that make employees unique, including gender, race, ethnicity, religion, and sexual orientation. Inclusion referred to a corporate culture that allowed all associates to perform at their greatest potential. The company took a number of affirmative steps to support diversity and create an inclusive work environment: strictly enforcing equal opportunity policies; setting goals to increase the numbers of women and underrepresented minorities and tying achievement of those goals to the compensation of its executives; ensuring managers and employees participate in inclusion training; recognizing and rewarding groups and individuals for performance that promote diversity and inclusion; working closely with its established ethnic advisory boards to achieve results in these areas both within the organization as well as within the communities in which the company operates. PepsiCo has been the recipient of numerous, prestigious awards in the areas of diversity and inclusion and ranked consistently among the best employers for women and people of color.

Health and wellness

PepsiCo sought to provide products that consumers wanted and enjoyed across a wide variety of consumer needs. Accordingly, the company provided a spectrum of product choices ranging from the small indulgences consumers loved to a wide variety of better-for-you options such as products enhanced and fortified for better health. In 2004, the company introduced Smart Spot, a green symbol that appeared on more than 100 PepsiCo products that met nutrition criteria based on authoritative statements from the U.S. Food and Drug Administration and the National Academy of Sciences. The symbol guided consumers to products that contributed to healthier lifestyles, the fastest growing part of PepsiCo’s North American product portfolio. Looking forward, the company decided that 50% of its new products would qualify for the Smart Spot symbol. In addition to shifting the product portfolio mix, PepsiCo sponsored a variety of programs designed to help consumers lead healthier lifestyles and understand the importance of energy balance in day-to-day living. For example, a current initiative known as America on the Move helped people improve their health through simple changes in diet and exercise. The company also proudly sponsored numerous organizations promoting healthy lifestyles in children and adults, including the YMCA, International Food Information Council, and the American Council on Fitness and Nutrition.

Company values

Financial considerations played only one part in strategic decision making at PepsiCo. In its 2004 annual report, PepsiCo articulated its “commitment to deliver sustained growth, through empowered people, acting with responsibility and building trust” and identified six guiding principles:

• Care for customers, consumers, and the world we live in

• Sell only products we can be proud of

• Speak with truth and candor

• Balance short term and long term

• Win with diversity and inclusion

• Respect others and succeed together

Consumer Trends

PepsiCo closely tracked the continual evolution of the United States consumer population. The most recent market research highlighted three key demographic trends:

• Shifting priorities of Baby Boomers

• Increasing importance of Generation X households (those born between 1961 and 1981)

• Dramatic Latino population growth

Households headed by the Baby Boomers born during the 15-year period after World War II have been PepsiCo’s core consumers for the past two decades. But as the tail end of the Boomer generation passed the 40-year mark, their household consumption of traditional PepsiCo carbonated beverages and salty snacks began dropping precipitously. With fewer kids at home— two-thirds of Boomer households became empty nesters—Boomer moms stocked less fun-for-you products. Instead, the Boomers sought products for personal consumption and demonstrated a willingness to pay a premium for offerings addressing health and wellness concerns or saving precious time. Although buying for fewer mouths, Boomer households continued to grow in affluence: Boomer households with kids averaged household annual incomes of $72,000.

With the aging of Baby Boomers, Generation X emerged as the core population group. Generation X only accounted for 21% of the population versus 29% for Boomers, but an increasing percentage of the population lived in households headed by a Generation X parent who now dominated the prime parenting age range ( Exhibit 2 ). The Generation X households faced far greater financial pressures than the Boomers. Generation X households with children averaged $58,000 in annual household income. And even adjusting for the earning power differences of the older Boomers, Generation X fared worse: Generation X households faced 78% higher debt levels than their Boomer counterparts had faced at the same age.

In addition to the greater financial pressures, Generation X moms exhibited a changing set of values and shopping habits versus those of the Boomers. Over one-third of Generation X moms stayed at home while only one in five Boomer moms stayed in their homes. Generation X parents of two to five year olds professed a greater desire for a return to traditional values than did Boomers at the same stage in their lives. The Generation X moms also claimed that children had less influence over the brands of groceries they purchased than did the children of Boomer moms. Not surprisingly, Generation X moms displayed a far greater tendency than Boomer moms did to shop at mass merchandisers like Wal-Mart.

In addition to the changing generational demographics, the U.S. consumer population faced a dramatic shift in racial diversity. As shown in Exhibit 3 , at the beginning of the millennium, Hispanic Americans passed African Americans as the largest minority group at 35.5 million versus 34.5 million. More importantly, the U.S. Census Bureau predicted a nearly threefold increase in the Hispanic American population to over 98 million by the year 2050— going from 12.5% of the U.S. population to over 24%. Consumer research showed that the Hispanic population acculturated gradually while Hispanic Americans required a generation or more to become engaged with American cultural norms, such as adopting English as a primary language and preferring football to soccer. More specifically for PepsiCo, 60% to 70% of first-generation Hispanic Americans expressed a preference for Latin American brands, which dropped to less than 40% among second-generation Hispanics and less than 20% among the third generation.

Overlaying these demographic trends, PepsiCo faced an increasingly bifurcated consumer populace. Economic realities forced part of the population to watch food budgets carefully, which opens up opportunities on the low end, while others showed a willingness to pay for greater convenience or healthier products. Overall, as shown in Exhibit 4 , price ranked as the leading factor in food-purchase decisions with a variety of convenience considerations proving to be increasingly important. Many nutritional factors also affected food-purchase decisions, but the relative importance of concerns tended to shift fairly rapidly in response to various dietary trends. For example, between 2002 and 2004, the low-fat label dropped in importance while the low-carbs label gained in importance. In fact, around 70% of consumers, across age groups, admitted confusion when they tried to determine what they should or should not eat. Ominously, the importance of a trusted brand declined, particularly in certain product categories. For example, 55% of bottled water consumers did not consider branded products better, while only 23% of soft drink consumers expressed such reservations. And although 40% of soft drink consumers expressed a willingness to pay a brand premium, only 16% of bottled water consumers did so.

Channel Dynamics

Over the last 20 years, product brands lost power, as retail brands such as Wal-Mart gained power and fundamentally altered the dynamics along the supply chain. Although traditional grocery stores held dominant share of the food and beverage retail sales, mass merchandisers such as Wal-Mart and Target continued to gain share through the introduction of super centers that offered both mass merchandise and groceries under the same roof. Projections suggested moderate revenue growth in the grocery channel but significant share erosion as consumers migrated to super centers and other value formats such as club stores and the Dollar channel. Estimates suggested that growth in the Natural Food channel would taper slightly but continue at a rate between 14% and 15& per year. Growth in the Dollar channel would be about half the rate of the Natural Channel overall but an increase in the proportion of food and beverage sales would likely produce a growth rate approaching 10%. Exhibit 5 provides information on channel mix and key trends affecting future growth projections by channel.

PepsiCo held strong positions with all of the channels except for the emerging Dollar and Natural Food channels. Although currently small, both channels offered potentially rapid growth. More importantly, the two channels addressed the opposite extremes of the bifurcating consumer population. The Dollar channel focused on the most budget-conscious consumers, and leading players plan to significantly increase the proportion of food sales as a way to build traffic. The Natural Food channel served the high-end consumers seeking healthier offerings, typically at a price premium. Traditionally, both channels relied heavily upon private-label store brands.

Dollar channel 1

Three key players, Dollar General Corporation, Family Dollar Stores Incorporated, and Dollar Tree Stores Incorporated, dominated the Dollar channel. The Dollar channel comprised over 15,000 stores—a threefold increase over the past decade. Stores tended to be relatively small, typically less than 10,000 square feet, compared to superstores or hypermarkets that averaged between 50,000 to over 150,000 square feet. Bare-bones service and relatively slow inventory turns allowed for minimal staffing, typically 10 or fewer employees including the store manager. The core consumers tended to be moms with household incomes of around $25,000 per year or retirees on fixed incomes. Nonetheless, 59% of American households had shopped in a Dollar store in 2003, which collectively compared favorably to the 86% of households garnered by Wal-Mart. Unfortunately, the average Dollar-store shopper visited a store 11.5 times per year and spent less than $12 per trip, while Wal-Mart shoppers visited twice as frequently and spent over four times as much per trip.

Although classified together, each of the major Dollar-store chains operated a somewhat different model. The Goodlettsville, Tennessee-based Dollar General led the industry with 2004 sales of $7.7 billion by pricing about 30% of its goods at $1 or less and its most expensive items at no more than $35. Its stores, located primarily in the South, East, and Midwestern United States, tended to be in small towns with populations of 20,000 or fewer—off the radar screen of the big discounters like Wal-Mart and Target. Stores ran around 6,800 square feet, but the company was experimenting with a new format, Dollar General Market. Averaging 17,500 square feet, the new format added fresh produce and a range of frozen, refrigerated, and shelf-stable food products in addition to its traditional merchandise offering. The plans for 2005 called for at least 30 of the new format stores upon a base of 20 such outlets—still small considering that the chain opened a total of 700 new stores in 2004 to bring its total up to 7,700.

Family Dollar, based in Charlotte, North Carolina, and the second-largest Dollar chain at $5.8 billion in revenue, sold most items for under $10 and priced nothing over $20. Its 5,900 stores expanded over a broader geographic footprint reaching 44 states and the District of Columbia. In response to competition from Wal-Mart, Family Dollar shifted from promotional advertisement to everyday low pricing with new store openings increasingly focused in the more urban areas. The company continued its rapid expansion with 500 store openings in 2004 and a plan for another 560 in 2005.

The third-largest Dollar chain, Dollar Tree of Chesapeake, Virginia generated $3.1 billion in revenue and considered itself the purest example in the Dollar channel: Literally every item in a Dollar Tree store sold for $1. Founded in 1986, it had expanded aggressively through store opening and acquisitions to offset the advantage of the 25- to 30-year head start held by its two larger competitors. Initially the company operated mall-based stores with 1,500 to 2,000 square feet of retail space but expansion focused on strip malls and stores ranging between 10,000 and 15,000 square feet in size. Dollar Tree operated 2,900 stores in 48 states with an average selling space of around 7,500 square feet. The chain added frozen and refrigerated coolers to its stores to expand its offering of branded and private-label grocery items beyond dry goods. Although most Dollar Tree customers came from the lower income ranks, the chain drew far more shoppers from families with $45,000 or more in annual household income than its two larger competitors.

Each of the three Dollar chains operated a sophisticated network of seven to eight highly automated distribution centers that received goods from domestic and international manufacturers in full-container loads. Given the relatively small stores—most of which had limited storage space—the distribution centers typically delivered goods to the stores once or twice per week with “milk runs” serving three to four stores from a full truckload. Although the distribution centers turned their inventory 12 to 15 times per year, the actual stores turned inventory at a much lower rate. Overall, the Dollar channel turned inventory three or four times per year versus 7.5 for discounters overall and 12.2 for the grocery industry. Exhibit 6 provides comparative financial and operational metrics for each of the three Dollar chains.

Natural channel 2

Although overall food and beverage sales continued to grow at 2% to 3% per year, retail sales of natural and organic foods grew at a compounded annual rate of 13% since 2001 to a total of over $7 billion in 2004 with forecasted growth of 16% to 17% in the coming years. About 30% of those retail sales came through the emerging Natural channel, comprised of natural supermarket chains such as Whole Foods Markets Incorporated, Trader Joe’s Company Incorporated, and Wild Oats Markets Incorporated. About 57% of consumers shopped natural supermarket chains or nutrition centers such as GNC. These consumers tended to be younger, more affluent, and better educated than shoppers who did not frequent the Natural Foods channel. Around 40% had at least a four-year college degree compared with only 28% of those who did not shop on the Natural channel. Although 25% of households had annual incomes below $25,000 overall, only 23% of Natural channel shoppers fell below that threshold versus the 28% of those who do not shop the channel. At the other extreme, 25% of natural channel shoppers had household incomes exceeding $75,000 versus 20% of non-natural channel shoppers. Natural channel shoppers included a disproportionately high level of professionals (33% versus 26%) and far fewer retirees (16% versus 23%).

The Austin, Texas-based Whole Foods pioneered the supermarket format for health foods and ranked as the world’s number-one natural foods chain with 2004 sales of $3.9 billion. Whole Foods operated more than 170 stores in 28 states of the United States, the District of Columbia, Canada, and the United Kingdom. Perishables accounted for about two-thirds of store revenues. Its six lines of private-label products—for example, Whole Kids, an organic line for moms concerned about feeding pesticides to their children—included a total of 1,200 different items, and it planned to add more items to boost margins. The chain planned to add 20 stores in 2005 as it worked toward a goal of $10 billion in revenues and 300 Whole Foods stores by 2010. Recent store openings had average square footage of around 45,000 square feet versus the 25,000 square feet for the older stores.

Based in Monrovia, California, Trader Joe’s started out as a convenience store chain but soon ranked second among natural foods chains with an estimated $2.5 billion in revenues. 3 The company offered more than 2,000 private-label products—including beverages, soups, snacks, and frozen items—and a wide variety of exotic imports. Averaging around 10,000 square feet each, Trader Joe’s 215 stores had no service departments and fewer total stock-keeping units than its larger rival Whole Foods. Concentrated in 19 states in the Northeast, Midwest, and West Coast regions by 2005, Trader Joe’s planned future growth through further store openings in some of the same states.

With just over $1 billion in revenues, Wild Oats Markets, based in Boulder Colorado, ranked third among natural food chains with 110 stores in 24 states in the United States as well as British Columbia. Having grown through a number of acquisitions, the company operated its full-service stores—most of which had bakeries, coffee and juice bars, and massage therapists— under several different monikers. Despite a poor financial performance, the company planned to open a dozen new stores in 2005 and 40 in 2006. Looking to leverage its private label brands, the company had sold through the Internet retailer Peapod and was testing a store-within-a-store concept with the traditional grocer Stop & Shop. The company introduced 500 new private-label items in 2004 and planned a similar expansion in 2005.

Natural and organic foods cost more than conventional foods for a variety of reasons. For example, abstaining from herbicide and pesticide meant expensive manual weeding and typically lower yields. The compost and animal manure used by organic farmers was bulkier and more expensive to ship than chemical fertilizers. Similarly, organic cattle feed cost 50% to 80% more than conventional feed. Also, the Natural channel had to turn to natural and specialty distributors as intermediaries to the producers. The distributors earned an 8% margin serving the large natural foods chains and up to 25% to 30% margins with the independents, because they offered distribution economies not available to these small retailers. Retailers also marked up the products somewhat more than conventional food products because some organic products did not turn as quickly. In the end, consumers had to pay significantly more for organic and natural products.

PepsiCo Channel Considerations

Due to the popularity of their retail formats both the Dollar channel and the Natural channel faced increasing competition from the traditional channels, which were PepsiCo’s current customers. Noting the above-average growth rates of these emerging channels, grocery and mass merchandisers responded by creating special Dollar sections within their stores and increased the number of natural and organic offerings. Though no one could predict the effectiveness of these competitive responses, it was known with certainty that shoppers already frequented multiple channels to meet their needs. Even the heavy Dollar channel shoppers— those who allocated 10% to 15% of their shopping trips to the Dollar Store—shopped just as frequently at Wal-Mart and did most of their shopping at traditional grocery stores, which garnered about one-third of their shopping trips. About 16% of organic shoppers bought exclusively from natural specialty stores while 38% only bought their organics from traditional grocery, drug, and mass-merchandise stores. Forty percent of organic shoppers bought from both channels and the remaining 6% of shoppers bought from nonstore retailers exclusively—or some combination of nonstore and the other two options.

The relative mix of products sold in each channel was also a consideration for PepsiCo. For example, the top-product categories in the Dollar channel—based upon an analysis of the number of trips to Dollar General and Family Dollar stores—included a different mix of products from the mega-retailer Wal-Mart. Laundry detergent (2.3% of sales), household cleaners (2.0%), chocolate candy (1.7%), food and trash bags (1.6%), toilet tissue (1.6%), nonchocolate candy (1.3%), carbonated beverages (1.2%), dish detergent (1.1%), salty snacks (1.1%), soap (1.0%), and cookies (1.0%) were the top categories for the top-two Dollar retailers. Five of these were also top categories at Wal-Mart: carbonated beverages (1.3%), salty snacks (.9%), chocolate candy (.8%), nonchocolate candy (.5%), and cookies (.5%). Wal-Mart’s other top-five categories reflected its growing presence in the grocery sector through its super center format: milk (.9%), cold cereal (.8%), fresh bread and rolls (.6%), crackers (.5%), and dog food (.2%). Of course, given Wal-Mart’s relative size versus the Dollar retailers, it dominated category sales even where it held a lower percentage: Dollar General and Family Dollar together sold over $50 million in salty snacks in 2003, but Wal-Mart sold nearly $1 billion.

As shown in Exhibit 8 , by 2002, 15 natural-food product categories had grown to a level of over $100 million in annual sales—and 15 categories had annual growth rates in excess of 20%. But, for most categories the majority of natural-food sales came through channels other than the natural-food chains. Although both channels offered significant opportunities, it might have been possible to access those same consumers through PepsiCo’s traditional retail partners.

Conclusion

John Compton reflected on the meeting as he approached his office, where he saw Tom Vitro waiting outside his office.

“How are you doing, John?” Vitro asked.

“Never been better,” replied Compton.

“I can see that,” said Vitro. “You seem deep in thought while at the same time barely able to control your enthusiasm about something. It must have been a great meeting.”

“Was I that obvious?” asked Compton. “I was reflecting on how pleased I am with my new team. We just had an engaging debate about some new growth opportunities, and I was delighted by the quality of thinking of everyone in the room.”

Then the two men sat down at the office table as Compton summarized some of the issues and opportunities in the Natural Foods and Dollar channels that he and his team had discussed at his staff meeting.

“So what did your team members say that struck you as so profound?” probed Vitro.

“Lots of things,” replied Compton. “But let me give you some examples”:

Todd Magazine, president of Quaker Foods, spoke passionately about the importance of protecting the 130-year-old brand equity of the Quaker Man, affectionately known as “Larry” within the company, while leveraging the trademark to extend our reach into the health and wellness arena. Chuck Maniscalco, president of Gatorade, challenged all of us by asking whether our health and wellness efforts reflect a rational, business response to an increasingly important consumer trend or is it about the fundamental essence of “who we are.” Greg Shearson, president of the Tropicana chilled-juice segment, commented on the ongoing consumer misperceptions that inaccurately challenge orange juice as a good choice because of its carbohydrate content. His team produces premium, not-from-concentrate O.J. that is incredibly rich in vitamins, minerals and fiber— and yet consumers question its health benefits! Finally, Albert Manzone, senior vice president and general manager of PepsiCo Shelf-Stable Juices, a newly created business unit that brings together all shelf-stable or ambient juices and juice drinks across the corporation, reminded us of the significant opportunities we have to drive volume by optimizing use of our dual Go-To-Market systems in North America: DSD and warehouse.

“Those are provocative perspectives,” responded Vitro.

“And such broad strategic thinking wasn’t limited to my general managers,” elaborated Compton. “Jim Lynch, senior vice-president of supply chain, talked eloquently about the cost-to-serve in each channel but also elevated the discussion by asking whether we had the right product portfolio to even aspire to making health and wellness ‘who we are’ as a company.”

“Of course, that’s not why you’re here,” Compton said to stop himself from discussing this supposed tangent. “These are not immediately urgent issues but could be critical five to ten years out.”

Vitro replied:

Maybe this discussion was tangential but perhaps not. I wanted to talk to you about possible projects for our Leadership Development Program for summer interns in QTG this year. Historically, we have given them individual projects, but it might be interesting to assign a team of interns to look at these issues. They would bring a fresh set of eyes—and if we’ve really picked the right people for the program, they will be the ones driving the solutions on such issues for this organization 10 to 15 years from now.

“That sounds like an excellent idea,” Compton replied. “I look forward to seeing their conclusions and hearing about their recommendations.”