Explain why would it be interesting for a student to study this Case Analysis? P

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Explain why would it be interesting for a student to study this Case Analysis?

PEPSI GROWS POTATOES IN CHINA

After entering China in 1982, Pepsi continued to do well in the country, offering a wider range of products than its arch-rival , Coca-Cola. Pepsi's potato chip business was successful despite competition from other multinational rivals and Chinese domestic brands. As its potato chips became more successful, however, the problem of how to secure a supply of quality potatoes also grew. In the North American market, Pepsi relied on external suppliers for its potatoes. But in China, it ran into problems sourcing locally as well as asking its US supplier to grow potatoes on its behalf in China. The matter was further complicated by the fact that the Chinese government had banned the import of potatoes. Faced with numerous obstacles in sourcing potatoes in China, how could Pepsi go about securing this critica l input? Could it grow its own potatoes as it was already doing in other markets? If so, how could it secure the land needed to ensure that it would enjoy economy of scale? If it relied on subcontractors, could it build a stable and reliable pool of potato suppliers in China in the face of China's immature agribusiness industry?

China's Agribusiness

The Agricultural Sector

As part of the rural econom ic reform dming the late 1970s, Deng Xiaoping decided to replace the communal system with the household responsibility system. The government withdrew its control on the cultivation of grains, giving rural farmers the power to decide what to grow for themselves.1 Under the policy, many farmers began to grow fruits and vegetables, which enjoyed a higher market price, and kept only a small portion of their land for growing grains to feed their families.

Growing fruits and vegetables was a labour-intensive ac11v1ty that tapped into China's competitive advantage of cheap labour. As the Chinese economy developed and opened to the outside world, China's agricultural sector became more active in i nternational markets and the country saw a rapid increase in the export of agricultural products. With the country producing a lrnos1 half the world's vegetables and 16% of the world's fru its, the agribusiness industry in China was a burgeoning one.' During the first quarter of 2007 . China's export of fresh food to the United States grew 279% to US$7.4 million, with fresh vegetables growing 66% to US$32 million.'In the early 2000s, China dedicated an additional 5.7 million acres of land to the cultivation of vegetables, equivalent to more than half the land used for vegetable farming in the US. Many saw China's agricultural sector as having the potential to acquire the same internaiional prowess as its manufacturing sector.•

The growth of China's agricultural sector was, to some extent. driven by the growth of supermarkets and hypermarkets such as Walman and Carrefour, both inside and outside China, from which customers had come to expect seasonal fruits and vegetables year-round. In 2007, China had approximately 16,000 supermarkets and hypermarkets run by domcs1ic and foreign operators. Another driver of China's agricultural sector was fast food chains such as McDonald's, which had around 800 outlets in China, and Kentucky Fried Chicken, with around 2,000. Modern supermarkets, hypermarkets and fast food chains required rel iable sources of high quality and standardised produce, making procurement from a large number of small, independent farmers impractical.' ln 1988, long before McDonald's opened its first outle1 in China, Idaho-based J .R. Simplot, one of the world's largest potato processors and a supplier to both McDonald's and Kentucky Fried Chicken, entered China in order to cu l tivate a reliable source of raw material for McDonald 's french fries. These potatoes had to be long in shape, with shallow eyes and high sugar content.• Simplot searched for the right site and right potato species to meet McDonald 's req ui rements and spcn1 years developing a rel iable supply of potatoes at a loss. It did not open a potato processing plant in China until 1 992. Simplot had ro convince Chinese farmers, who had treated potatoes largely as a cash crop, to adopt a three-year growing cycle for growing potatoes commercially. Scale was a problem, as a fam1 needed about 250 acres to justify investment in tractors and fertil ising machinery, and most Chinese farms were small and fragmented as a legacy of the economic reform in the late 1970s; there were some 200 million househo lds with plots of land that averaged 1 .5 acres in China. Only 7% of Chinese villages had formed farming cooperatives, though it was pcm1itted by the Chinese government.' Simplot persisted despite the obstacles and, by 2007, it had reduced the number of suppliers from more than 1,000 to about I 00. mostly through working with large state-controlled farms or private businesses with land leased from local farmers.• Thal year, its potato processing plant, which it had opened in 1992, was capable of producing one billion frcnch fries a year.

The Simplo1 story reflected the development of China's agribusiness industry as it adap1ed to growing commercial demand. Agribusiness groups that enjoyed some economy of scale slowly began to emerge. Fujian-based Chaoda Modem Agricultura l (Holdings) Lid, the country's largest non-state-owned agribusiness group, had 29 production bases in 14 provinces in China. It specialised in organically grown fruits and vegetables, supplying its wholesale and retai l businesses across the country as well as its export business.9 Sha ngha i­ based Aisen reared organic pigs in 12 pig fanns near Shanghai and supplied main ly to b ig supermarkets. "Agribusiness is in its infancy at the moment in China but it is going to be one of the big phenomena of the next 10 years", said Jonathan Anderson, Asia econom ist at investment bank UBS. "It is a good time to buy into a pig farm if you can."10

The Food Processing Industry

China was one of the largest food-consuming countries in the world. With a rapidly rising standard of living and changing lifestyle, China's food processing industry grew rapidly at an annual rate of 13.1% between 1980 and 2000." With only 300/o of the food consumed in China being processed, compared to an average of 80% in western nations.'2 the country's food processing industry held vast potential. The flourishing of supermarkets, where 46% of processed food was sold,greatly promoted the purchase of processed foods. The food processing industry in China was highly fragmented, with many small companies owned by private owners. Chinese official statistics indicated 19,000 food processors with annual revenues of more than US$600,000, while unofficia l estimates put the number at about 900,000 ventures, covering both mom-and-pop operations and foreign corporations.14 In 2002, foreign enterprises comprised   14% of the food processing sector in 200 I. is Given the allractive opportuniti es the Chinese market offered, the percentage was ex1>cctcd to continue growing.

Infrastructure

China 's underdeveloped infrastrncture, which was one of the weakest points of i ts economy,'6 hampered the development of its agribusiness and food processing industry. The government was well aware of this and put a high priority on the development of energy, which was critical for the refrigeration, processing and transportation of produce. China's poor railway system was being supplemcmcd with a new highway system that was to form a grid spreading all over the country, enabling the efficient transportation of goods and produce. "

China's Potato Industry

China's 1 1.53 million square acres of potato fanning area"produced more than 20% of the world's potatocs. 19 With the dissolution of the Soviet Union, it became the largest potato growing country in the world. However, the country's annual per-cap ita consumption of potatoes was I 8kg, which was quite low compared to 90kg in western Europe and 60kg in the US.20 With the growing presence of fast food chains such as McDonald's and Kentucky Fried Chicken and with western food becoming more common, potatoes were gain ing popu larity in the Chinese diet. Domestic and international fast food chains drove the demand for frozen potato chips up at a rate of 5-10% in 2006." With few local companies possessing the resources or capability to produce frozen potato chips, 700/o of the frozen potato products consumed in China were imported in 2005," with the United States supplying the most, followed by Canada and New Zealand. 23 China's potato processing industry was underdeveloped, hampered by the lack of integration between the industry and Ilic agricult ural sector and also by the lack of affordable domestically made machinery. :. Only a few manufacturers could afford to import the required equipment from abroad.

China processed only about 5-10% of its potatoes.25 Given its potato growing capacity and the country's rapid economic development, however, it was expected to be one of the few countries that would experience growth in the potato processing industry and tradc.26 The Chinese government was well aware of this potential. In 2002, the State Economic and Trade Commission and the Ministry of Agriculture jointly launched a five-year national program to rcstnicturc China's food processing industry. The potato processing industry , which covered the manu facturing of potato starch, potato-based convenience food and potato-based chemical adhesives, was targeted as one of the key industries for restructuring under the program . The government intended the industry to become one of the key industries driving the development of cent ral and western China.27

The launch of the national program quickly led to a flurry of activ ity to promote the development of the industry. Beijing prepared itself to become the count ry's potato processing centre, setting up a potato industrial park at Yanqing in the northwestern suburb of the city, and the Beiji ng Agriculrural Bureau importing equipment to produce frozen otato chips, with plans to expand the production line capacity to I ,500 tonnes i n a few ycars 8 The Chinese government also signed numerous cooperative agreements with international agricu ltura l research institutes on potato research and development. As China's agricultura l sector was not well integrated with its food processing industry, new potato variet ies were brought in from abroad and new species were developed to find one that was suitable for making fried potato chips and frozen chips.29

The Snack Market in China

In 2003, the value of the world snack food market was estimated at USS66 billion 0 The United States, which consumed about a third of the world's snacks, comprised the largest market. Japan and the United Kingdom followed with a combined consumption of a quarter of the world's snacks. The global demand for snack food was expected to cont inue rising as western eating habits spread to different parts of the globe and urban lifestyles diminished the role of tradit ional meals.31 Emerging markets such as China gained importance as Americans became more healt h-conscious, slowing the domestic sales of snack food. With a rising standard of living, increasingly westernised consumption habits. longer and less regular working hours and an increasing number of two-<:arccr ho1Leholds. there emerged a rising demand for convenience food and snacking between meals. In 2003, China's savoury snacks market was worth about USSl.54 billion [see Exhibit J].ll Between 2000 and 2005, it grew at an average annual rate of 7.3%." Research shows that almost half of Beijing's residents consumed potato chips at least monthly,35 residents of Shanghai spent approximately 9% of their tota l grocery bill on snacks36 and children in Shanghai spent an average of US$ I on snack food a week. "The kids' market in China was filled with potential, as the one-child policy had caused many children to grow up with both parents working and their grandparents taking care of t hem. Both generations were willing to spend generously on their "little emperors". Chinese snacks were traditionally sold through street vendors, though these vendors were increasingly replaced by supermarkets and convenience stores that provided new and important venues for premium branded snack l ines. Among the d i fferent snack foods, potato chips had gained popularity rapidly in China. China's potato chips market was worth about US$200 million in 2004 and was growing at a rate of 10% per year.3

Major Players in China's Potato Chip Industry

Pepsi

In the mid-nineties, New York-based soft drink company PepsiCo. Inc. wrote ofT US$576 million for its overseas soda business when it failed to compete with Coca-Cola. The write-off led PepsiCo to change its international strategy as it realised that it would have a hard time beating Coca-Cola in foreign markets. Instead of competing head-to-head, Pepsi decided to extend itS domestic strategy of using its snack food and cereal businesses to counter its competitor and focused on using its snack food business to bui l d a global presence. The strategy fit well with the shifti ng trends of snacking worldwide. /s /mcricans became more health-conscious, growth i n PepsiCo's snack food business i n North /merica, which accounted for 75% of its pro fit, slowed. International markets, however, were growing ar three times the domestic rate and becoming ao increasingly important growth driver for the company.19 Pepsi's snack food business was conducted through Frito Lay, Inc.. which held 48% of the salty snacks market worldwide through products such as Doritos corn chips and Lay's potato chips, and accounted for about 65% of PepsiCo's profit.'°

PepsiCo was one of the first multinationa ls to enter China after its economic refonn. In 1982, it set up a bouling plant in Shenzhen under an agreement with the Chinese government. In 1995, it set up PepsiCo (China) Investment Company in Shanghai , which was responsible for overseeing all of PepsiCo's operations in China."

Fritolay in China

PepsiCo introduced Lay's potato chips to China in 1997. The early years were difficult because the Chinese popu lation knew virtually nothing about potato chips and PepsiCo had to educate them from scratch. Lay's early advertisements in China showed potatoes bei ng sliced to ensure Chinese consumers knew where potato chips came from.41 The brand a lso found it di fficult to steer Chinese consumers, with a taste for traditional snacks such as seasoned seaweed and duck gizzards, toward western-sty le potato ch ips. "Whenever you go into anything that goes into the mouth, you're going to have a harder time as a multinational ", said Thomas Doctoroff, who headed advertising agency JWT's operation in China.•l Pepsi Co was willi ng to innovate and create "d ifferentiated products" that catered to local tastes and su pport these products wit h i ntense marketing campaigns. PepsiCo believed that consumers, especially young ones, were drawn to "global products" that were modern and innovative and it positioned Lay's i n China such that most Chinese conswners were not aware that it was an amcrican compa ny."

In order to cater to local tastes, PepsiCo launched a Chinese gourmet chip series with navours such as Peking roast duck and spicy crab, which came in oriental packagi ng."Pepsi Co also incorporated the princ iples of yin and yang, which underlay Chinese med icine and the Chinese concepts of ba lance and health, into its chips in China. Fried food was considered ''heating" in Chinese culrure, so in the summer of 2003. Lay introduced lcmon-navourcd potato chips dusted with lime and mint, which were consider "cooling". The chips became PepsiCo's best-selling product in China.46 It also developed different products to cater to the regional preferences of China: Shanghainese bad a sweet tooth, soud1cmcrs liked their chips salty. westerners liked them spicy and northerners preferred meaty tastes. PepsiCo's continual innovation tapped into Chinese consumers' eagerness to try new things and Lay's business in China continued to grow. The rapid growth of large Western supermarkets, including Wal-

Mart from the US and Carrefour from France, helped." In Shanghai, the majority of people purchased all their snack food in supermarkets, which offered more variety and better prices than smaller vendors. PepsiCo focused its marketing on Shanghai when it first l aunched Lay's chips. with Beijing as its second stronghold before slowly expanding to other parts of China.'"' It targeted main ly urban areas where 30% of China's population resided and distributed its potato chips mainly through convenience stores. By 2004, about a third of the 13,000 convenience stores in China carried Lay's potato chips and Lay held some 40% of the USS50 million potato chip market in China...

PringIes

Pringlcs was created by Proctor & Gamble ("P&G") in 1976 in response to the short shelf life of potato chips and the difficulty in transporting them. Pringlcs potato chips were made from dehydrated potatoes that were meshed into potato flakes and then pressed into a uniform shape for frying. Their uniform shape allowed them to be stacked neatly one on top of another and stored in air-scaled cans that extended their shelf life to up to a year, much longer than the two-month shelf life of normal fried potato chips.

By 2007, Pringlcs had spread to more than 100 countries in 45 flavours."' Pringlcs were prod uced in P&G's two manufacturing plants in Belgium and the United States and P&G began exporting Pringlcs to China in 1997. I t managed to bu ild a loyal following for t he brand despite i ts high price. By 2004, the yearly sales volume of Pringles i n China reached between 5,000 and 8,000 tonnes." Nonetheless, competition with other brancl5 was intense and P&G had to slash Pringlcs's price i n China several times. In 2002, Pringles slashed prices a cr Frito Lay acquired Dajiabao, a complex chips brand owed by Beijing Xingyun Corp."Beijing X ingyun was the first domestic player in producing complex chips in China. It was a strong p layer that i ncreased its market share from about 10% of Pringlcs's to 25% between 1998 and 1999. PepsiCo's acqu isition of Dajiabao expanded Lay's range of potato chip products to cover both the high and low ends of the market and extended its packagin g from foil bags to cover air-scaled cans similar co Pringles's, further turning up the competition between the two multinationals. " Lay's canister was smaller •than that of Pringlcs, making it even more convenient for consumers to carry and store. ln 2006, P&G entered into a cooperative agreement with Fujian-based Qinqin Incorporated Co., Ltd to produce Pringles in foil bags while continuing to import potato chips from its manufacturing plant in Belgium."'

Other Players

China's potato chip industry was fragmented, with a large number of domestic players who produced at high cost and small scale. Many domestic potato chip companies occupied the lower end of the market in China due to limitations in capital and experience.and resorted to price-cutting in order to survive." Anecdotal evidence suggested that there was local protectionism in the industry and that it was difficult for potato chip companies to expand beyond their local regions. Only a small number of domestic national players had emerged, such as Fuj ian-based Dali Group, which owned the Capico brand. Some Asia n brands had also made t heir mark i n the China potato chips market, such as the Ph ilippines-based Lewayway Holdings Co. Ltd's Oshi.

PepsiCo Turns Farmer

PepsiCo's Demonstration Farm

PepsiCo stancd exploring ways to secure a stable supply of potatoes for the manufacturing of Lay's chips in China way before it introduced Lay's chips in China in 1997. During the early years, staff was sent to buy potatoes at the local market at two a.m., before the potatoes were sold oul. But the local variety. which sometimes turned black after frying or came out biner, did not mce1 Lay's standard. It was only when PepsiCo managed lo purchase 2.000 tones of potatoes from a government-run farm in 1997 that it could launch Lay's, though the purchase covered only three months' supply of Lay's oo Shanghai 's retail shelves. What is more, the local supply of potatoes was unsteady. PepsiCo had to cancel Lay's launch in Lanzhou three times because of inadequate supply. Without a stable source of raw materia l, PepsiCo would have to impon Lay's chips, a costly operation as Lay's chips were packaged in bags and crushed easily.

Over the next two years, Pepsi Co gathered some 20,000 tonnes of potatoes from state-run farms and local cooperatives for the manufacturing of Lay's. PepsiCo had a difficult time gathering potatoes that met Lay's requirements,even though China harvested some 65 mill ion tonnes of potatoes a year. •• Lay req uired a potato variety that was large, round and similar to a basebal l i n shape and size to accommodate the shape of its chips. Potatoes for producing Lay's chips also had to be low in sugar and water content to ensure that the whiteness of the potato would be preserved after frying, and high in solids to maintain a high yie ld after processing."Sourcing the right kind of potatoes was further complicated by the logistica l need to deliver the potatoes to the manufacmring plant on an exact schedule.•• PepsiCo's difficulties with securing the right kind of potatoes increased as the demand for Lay's potato chips increased.

Ultimately. all of these problems had been brought about by the Chinese government' s ban on imponing potatoes. ,. With few choices available. PepsiCo had begun exploring potato fanning in China as early as 1993. Since the Chinese government had also banned the impon of potato seedlings, PepsiCo experimented with the American Atla111ic species using vitro potato tuber cultivation technology, investing US$7 million to establish a potato research centre.'° In 1998, PepsiCo decided to build a demonstration potato fann in the Kubuqi dcscn in Inner Mongolia, one of the largest potato growing areas in China. The 2,470-acre demonstration farm•• served the double purpose of enabling PepsiCo to learn first-hand the uniq ue conditions of potato growing in China and as a base for PepsiCo to teach Chinese fanncrs about commercial potato growing. Potatoes were grown mainly as a cash crop among Chinese fanners and intensive education was needed to guide them through t11c process of growing potatoes commercially. Manual farming methods and the way Chinese farmers handled potatoes bruised them, making them unsuitable for producing Lay's chips.•i

The decision to bu il d the demonstration potato farm in a desert came after careful deliberation. The desert offered PepsiCo the acreage it needed at a low cost and also allowed PepsiCo the option of expanding the farm in the future. Potatoes tended to expand in areas where the soil was loose, causing potatoes to be irregular in shape and uneven on the surface. Growing them in sand would eliminate this problem, as any pockets of space would be automatically filled up by loose sand. The desert also offered long hours of sunlight, which helps the accumulation of solids, an important criterion in the production of potatoes intended for commercial processing. Since the desert land bad never been fanned before. it was free of pesticide residue or viruses, making it ideal for experimenting with new species. "'

PepsiCo countered the many drawbacks of growing potatoes in a desert such as a waier source that resided three to five metres underground,..the inability of the desert sand to hold fertilisers and water, and a high salt level with modem technology. The field was laced wit h chemicals to reduce its salt level. A sprinkler irrigation system was installed and 1hc faml was organised around 1hesc sprinklers. The farmland was divided into growth circles of about 65 acres or 135 acres in accordance with the capacity of the sprinkler system, and desert willow and poplars were grown around each growth circle to reduce erosion and to proicct the crop from sand5torms, which easily pulled newly-planted potato plants out of the soil. Potatoes were usually planted around May and harvested in September in China. PepsiCo grew wheat and corn after t he potatoes were harvested to prevent !he wind from engulfing the sand. The wheat and corn were also ploughed back into the fields as ferti lisers.

Aftcr three years of preparation , the fields were ready for their first crop in 200 I . Pepsi Co brought i n US-based Black Gold Potato Sales, one of its largest suppli ers in the US, to help."' Black Gold was founded i n 1985 in North Dakota and had expanded to 13 locat ions across the US by 2007.66 But Black Gold was not so lucky in China. During its first season, more than half of t he potatoes it planted did not sprout, leaving PepsiCo some 3,000 tonnes short of the potatoes it needed. Black Gold used the same fungicide in China as the one it used in 1hc US, ordering it from a Chinese company, but it appeared that the fungicide it received in China was not the same product, though it bore the same nan1c. Gregg Halveson , Black Gold's president, believed the fungicide his company ordered in China contained fillers that killed the potatoes. After 1hc failure of the first season, Black Gold decided to discominue its work for PepsiCo in China. Halverson contended that the working conditions in China were too difficult. In the US, the advanced development of the agribusiness industry me.ant that there were specialised companies for spraying pesticides and harvesting crops. In China, Black Gold had to struggle with even the simplest tasks, such as ordering parts and training workers. The spread of Severe Acute Respiratory Syndrome (SARS) in China that year also made ii more risky for Black Gold to stay on io China.

With the departure of Black Gold, PepsiCo decided to run the fam1 itself using local management. •7 The Chinese manager was able to communicate better with farm workers, posting large sheets on the walls of the farm's office showing the steps that had to be taken i n each stage of the cultivation process, making it easy for the local workers to understand what they had to do. "PepsiCo is not a farming company'', said Bob Shi, operations director for PepsiCo's snack busi ness i n China, "but to build a market we had to take extra steps like this". Grow ing its own raw materia l was not new for PepsiCo. It grew and exported tomatoes, citrus fruits. chili and basmat i rice in lndia.68

Other Local Sources

At the same time PepsiCo was building its demonstration farm. it was also cultivat ing a group of local suppliers that could meet its growing need for potatoes by working with farming associations. The package that PepsiCo offered to local farmers was an attractive one. The average yield of potatoes in China was I0.000 tonnes per acre and the market price ranged between USS66.3"' and US$79.6 per tonne. PepsiCo provided its supplying farmers with seed potatoes that yielded an average of 20,000 tonnes per acre, and PepsiCo paid local farmers around USS 145.9 pcrtonne.10 In 1996, PepsiCo began cultivating potato suppliers in Jiaozhou of Shangdong province that soon supplied I0,000 tonnes of potatoes for PepsiCo each year."

PepsiCo worked closely with their supplying farmers, sending specia lists to help them with the preparation work, from making projections to securing water sources for the fields." PepsiCo supplied contracted farmers with species imported from the US and taught them to strict ly follow its potato growing protocols. PepsiCo e11cm1raged local farmers to engage in moderni sed farming, introducing new technology, pushing farmers to use more mechanical equipment to increase crop size and quality, and helping them to purchase tractors at reduced rates. Nonet heless, changing the loca l agricultural culture was not easy. Even large state-nm farms that would benefit most from mechani sed farming were reluctant to change when it took them 200 workers a week to harvest a 75-acre field, working from dawn till the early evening for USS4 a day, even when PepsiCo could harvest the same i n less than 48 hours using modern machinery." It was also difficult to find interested farmers with suitable land and a willingness to make the necessary investment."

The Way Forward

Lay's increasing success in China put pressure on its supply of raw potatoes. Hypermarkets such as Walrnart showed little patience when inventories of Lay's chips ran dry. PepsiCo's demonstration farm became a success story after the mu ltinational take over its operation . but PepsiCo still faced the challenge of devising a long-term strategy that would ensure a stable supply of potatoes for the production of its chips. Did its success in running the demonstration farm mean that it should integrate backwards vertically to grow its own potatoes? Should it build more of its own farms in China? How would such a decision affect its core business? On the other hand, how viable would it be to contract more farmers to grow potatoes for Lay's?         What          was         the         best          way         forward          for         PepsiCo?

Explanation / Answer

A student can learn the startegic orientation of the global business organizations and their innovative business operations. Even , he might learn the tactics to enter into global business and managing the dynamic business environment. This case has many important inputs like marketing strategies, creating right set for marketing mix elements like price, product,place and promotion, learning from other competitors of a industry leader.

It can be learned by himself that how supply chain relationship is too much important for them. A better forward and backward channel management can be learn by a student. He will learn the challenges and risks associated with every single business transactions while doing business in an international market.

This case will give him some introduction to strategic management and identification to business scope in global perspective.

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