- Detection of substitutes can be difficult because they frequently arise from outside traditional industry boundaries. Companies must develop peripheral vision and sensing capabilities to avoid being ambushed by their arrival.
- There are three core strategies to respond to and manage substitute threats:
- The nature of the threat and the alignment of corporate resources and competencies help to determine the response, which may include a combination of strategies.
Substitute products have the potential not only to constrain the profitability of companies but to disrupt and transform entire industries. We have witnessed multiple examples of such disruption: digital cameras virtually eliminating film-based photography; online retailing displacing brick-and-mortar stores; social media companies such as Facebook and YouTube eroding traditional print and broadcast businesses; and sharing economy firms such as Uber and Airbnb disrupting the taxi and hotel industries.
In contrast to other traditional forces of competition (buyers, suppliers, rivals, and new entrants) whose assessment and management fall naturally to specific business functions, substitutes often catch companies by surprise. Unlike rivals and new entrants, substitutes frequently arise from outside the industry, making early detection difficult. For example, neither Uber nor Airbnb came from within the traditional competitors in the taxi and hotel businesses.
Companies typically fight the threat of substitutes by adopting one of three approaches: a
join strategy (diversifying product portfolios to include substitutes), a
fight strategy (enhancing product attributes and positioning), or a
focus strategy that narrows strategic focus onto core offerings.
Substitute products abound in the beverage industry, and companies there offer useful illustrations of and lessons about the implementation of these various responses. It is not news that consumers are drinking less soda. Per capita consumption of carbonated soft drinks in the U.S. has fallen from 46 gallons in 2005 to 35 gallons in 2015, and is expected to drop to 29 gallons by 20201, as increased health awareness drives consumers to substitute healthier beverages for sugary sodas. In another segment, mass-market beer has been losing volume to wine and hard liquors, and more recently, to craft brews2.
A common response by beverage companies is to join the substitutes. In the join strategy, companies see substitute products not as threats but as opportunities, and they offer the substitute products themselves. For example, The Coca-Cola Company and PepsiCo have vastly expanded their product portfolios outside their core carbonated soft drinks. Coca-Cola currently offers more than 700 beverage options in North America, and nearly half of Pepsi’s beverage sales are in low-calorie beverages, juices, or sports drinks, more than double the proportion these drinks represented 15 years ago.
New products can be created through extensions of existing products lines, developed through internal R&D, or obtained through corporate acquisition. PepsiCo has made substantial investments in R&D to create numerous new products, such as the expansion of the Gatorade portfolio to include the Gatorade G Series, which enabled entry into the competitive athlete market segment.
Coca-Cola has acquired dozens of brands, some of which, such as Fuze Tea, Smartwater, and Vitaminwater have grown significantly and now generate more than $1 billion annual sales each. Coca-Cola’s commitment to the acquisition strategy is evidenced by its creation of a Venturing & Emerging Brands unit—a team consisting of corporate venture capitalists, brand incubators, and industry forecasters—to identify acquisition targets with potential to become the company’s next generation of billion-dollar brands.
Fighting the substitutes to defend market share or even recapture lost territory is another option. Fighting can involve enhanced promotion of the value of one’s own products to counter the value proposition of the substitutes. In one such example, Anheuser Busch, the brewer of Budweiser beer, decided to fight the wine industry as American consumers moved up to wine at the expense of mass-market beer brands in 1990s and 2000s. Anheuser Busch initiated an industrywide campaign touting the finer aspects of beer. Just as wine makers excelled at educating restaurants and consumers about what foods go best with different wines, brewers believed that they could teach retailers how to “pair” beer with various types of food.
The fight strategy also can be built around product enhancement, as demonstrated by the craft beer movement. Craft brews offer more refined palate-pleasing tastes that enhance the image of beers, attracting drinkers who show a similar level of devotion to fine beers as do wine enthusiasts to wine. Indeed, craft beers are gaining momentum—with sales experiencing double-digit growth in eight of the last 10 years. Today, in restaurants around the U.S., wine lists are getting shorter while beer lists are expanding3.
Of course, craft beers also are a substitute for mass-market beers, prompting large brewers to fight back in multiple ways. Mergers and acquisitions offer a competitive advantage over niche craft brewers by enabling large brewers to bring beer brands from around the world to local consumers. Although a brand may be a mass-market beer in its home market, it can gain an exotic brand identity in a foreign market. Sometimes, large brewers produce foreign brand beers in facilities at or near the destination countries, thereby vastly cutting transportation costs. Collectively, these foreign brands form a distinct and exotic product category that enable large brewers to fight against craft beers.
Fighting also can take place in arenas hidden from the consumer. For example, mass-market breweries can leverage their market power to influence distributors, making it easier for customers to purchase their products rather than craft beers. The recent wave of mergers and acquisitions, highlighted by the upcoming $100 billion InBev and SABMiller merger (forming the largest brewery in the world), could further bolster the market power of mass-market beer players over distributors. This pending aggregation of power has prompted regulators to set up guardrails to prevent such potential anti-competitive behaviors.
In another behind-the-scenes tactic, companies can work the political system to fight against substitutes. For example, soda companies have been countering the public’s health concerns over sugar, which drive consumers to substitute beverages. According to a recent report, Coca-Cola and PepsiCo sponsored almost 100 national health organizations between 2011 and 2015 in an attempt to dampen their support for government legislation to reduce soda consumption. Although the size of such sponsorships might seem small relative to the soda companies’ marketing budget—average annual sponsorship budgets for Coca-Cola and PepsiCo were $6 million and $3 million, respectively—the impacts on the health organizations can be significant. For example, when New York City announced plans to ban the sale of extra-large sodas in 2012, the Academy of Nutrition and Dietetics—a longtime advocate against high-sugar diets—surprisingly did not support the legislation. In that same year, the organization accepted more than $500,000 in donations from Coca-Cola.
Join versus Fight
How do companies choose between the join and the fight strategies?
A useful starting point is to evaluate the external industry environment and the nature of the threat, such as whether the substitute is likely to be a fad or is here to stay. If it is a fad, a fight strategy can constrain the intensity or even hasten the substitute’s demise. Alternatively, companies can simply hunker down and ride out the substitute threat if the fad is expected to be short-lived.
On the other hand, if the substitute is likely to have durability, companies might consider joining the substitute. To assess the feasibility of adopting a join strategy, companies need to understand and evaluate the barriers to entry.
High entry barriers could sway a company from the join strategy to the fight strategy. For example, large breweries contemplating mass-market entry into the wine business may find it difficult to access specialized assets such as vineyards. In comparison, beer production relies primarily on easily accessible commodity inputs such as grains.
Additionally, an assessment of whether a company’s resources, competencies, and knowledge can be applied to the production and sale of substitute products also can influence the decision between join and fight. For example, Coca-Cola’s and PepsiCo’s vast distribution networks for carbonated soft drinks work well for many types of nonalcoholic beverages. This internal strength is a powerful enabler for their join strategy.
By contrast, the distribution system and regulations governing alcoholic beverages are very specific to products and geographies, and thus these resources and expertise would not help breweries aspiring to sell nonalcoholic beverages.
Join and Fight, Simultaneously
Even when a company chooses the join strategy, it can still fight the substitutes. For example, while Coca-Cola actively diversifies its product portfolio, it remains deeply committed to and vigorously defends its traditional carbonated soft drink brands.
More importantly, rather than adopting a blanket strategy to manage substitute threats, companies should formulate a specific response strategy toward each substitute. Often, this might involve fighting one substitute while joining another, as Anheuser Busch has done, fighting wine, as described above, but adopting a join strategy toward craft beer and liquor. The company acquired eight craft breweries in the last five years and created in-house brands, such as Shock Top. The brewer also formed a subsidiary company to develop, test, and market spirits, leveraging its vast wholesale network to distribute liquor-based products. In addition to signing numerous distribution deals with boutique liquor companies, the subsidiary also launched new products such as Jekyll & Hyde, a liqueur brand, and Purus, a high-end vodka made from organic wheat grown in Italy.
While the two-pronged strategy of join and fight might seems appealing, the reality of managing multiple strategies for products with distinct characteristics can drain a company’s resources and overload managerial attention. An alternative approach to improve one’s position against substitutes is to revert to a more focused strategy, as some diversified beverage companies have done.
For example, Diageo, famous for its spirits and beer brands, such as Johnnie Walker and Guinness, recently sold off most of its wine business to Australia’s Treasury Wine Estates in a deal worth $600 million. Despite Diageo’s £150m loss on the sale, industry analysts viewed the transaction favorably because the divestment would enable the company to focus on improving its core spirits and beer brands.
In addition to reconfiguring product portfolios, the focus strategy also applies to geographical markets. For example, in 2015, Diageo engaged with Heineken in a series of asset swaps across their Latin American, Asian, and African beer operations. Ivan Menezes, CEO of Diageo, argued that these corporate transactions enhanced the company’s ability to focus on achieving their performance ambitions.
Finding a Balanced Strategy
The examples from the beverage industry illustrate the various strategies and implementation options for managing substitute threats. Each has its strengths and weaknesses.
While diversification can enable a company to capture opportunities presented by the substitutes, too much emphasis on diversification might overload executives’ attention and management time. Moreover, diversification can lead to conflicts with key external partners. For example, the product proliferation strategies adopted by Coca-Cola and Pepsi overwhelmed their bottlers with logistics complexities. Lack of alignment around incentives (i.e. a diversified portfolio generates sales for soda companies but adds costs for bottlers) ultimately compelled Coke and Pepsi to spend $13 billion and $7.8 billion, respectively, to acquire their largest bottlers.
On the other hand, although defending core products is a less complex strategy than diversification, a too-narrow product focus can backfire by constraining strategic growth opportunities. For example, Pernod Ricard divested its Wild Turkey bourbon brand in 2009 as part of its divestiture of nonstrategic assets, only to see bourbon category sales take off soon afterward.
Often there is no simple solution when successful substitutes begin taking market share, weakening a company’s core business and even threatening industry disruption. While some companies may adopt a single strategy to manage substitute threats, others employ combinations of
focus to retain share and grow in new markets. The key to successfully managing substitute threats is to understand and carefully balance the tradeoffs involved with the multiple strategies and be prepared to shift approaches based on changes in industry dynamics and competitors’ strengths.
For a concluding example, we turn to Constellation Brands, a company that has successfully crafted a balanced strategy. Beginning as a pure-play bulk wine purveyor in 1945, Constellation has become the largest wine producer in the world. Three years ago, the company entered the beer business by acquiring the U.S. distribution rights to Corona and Modelo. Today, Constellation is the third-largest beer seller in the U.S., with beer sales accounting for more than half of its revenue. But, the company is not sitting still. In the last quarter of 2016, Constellation announced a plan to divest its Canadian wine business to focus on premium wines and beers in the U.S. At the same time, it joined the liquor industry by acquiring a U.S. distillery. Analysts predict the company will enjoy double-digit earnings growth in each of the next five years, a rare feat in the current hypercompetitive beverage industry environment.
As described at the outset, many substitutes have fundamentally transformed industries. They can be a potent threat that requires constant vigilance. When you identify such threats, the lessons from the beverage industry could help you formulate your response strategy.
- IBISWorld Business Environment Profiles.
Per capita soft drink consumption. November 2016.
- CNN Money.
What, no keg? Beer gets a makeover. By Parija Bhatnagar, CNNMoney.com staff writer. January 20, 2006.
- FOX News.
Craft beer becoming alternative to wine at the dinner table. By Patrick Manning. January 24, 2013.