Cracking China’s elusive 1.3 billion-people market has never been easy. Some foreign investors have failed and withdrawn, such as Peugeot and Carlsberg. Most, however, are struggling to make a profit and coping with difficult Chinese partners. One such unhappy investor is PepsiCo Inc, which took a joint-venture Chinese partner to an arbitration court in Stockholm on August 2 this year.

Pepsi wants to terminate its business with Sichuan Pepsi-Cola Beverages Company Limited, its bottler in the populous southwestern province of China. It demands the joint venture stop using its brand name and stop producing the drink, after eight years of cooperation.

The multinational accuses its Chinese partner of financial irregularities and keeping Pepsi out of the management. Chu Wah Hui, president of PepsiCo Investment (China) Ltd, says his company has tried to solve the dispute; arbitration is the last resort. “Sichuan Pepsi has breached the terms of the contract many times. It has been a trouble maker, not only for us, but for other Pepsi bottlers,” he says.

In a rebuttal letter, Sichuan Pepsi threatens to report “all the illegal activities” of Pepsi to the State Council (cabinet) and the National People’s Congress (parliament) and says Pepsi should be punished for “damaging the national interests of China”. It also plans to sue Pepsi for stealing its “commercial secrets” and violating the privacy of its employees, according to Beijing Yuobang Law Firm, which represents the Sichuan firm.

In a press conference held on August 23, Sichuan Pepsi also accused its US partner of “commercial hegemonism”, “personal attacks” and “bullying tactics”.

Bottom line

Behind this war of words, the real fight is over profits in the world’s fifth largest carbonated soft drink market. As Pepsi’s operations grow in China, its local partners demand a greater share of the profits. Bottlers such as Sichuan Pepsi see themselves as putting up most of the investment and doing most of the work, in return for slim margins. They also want to develop their own brands and sell to cities and provinces beyond what was agreed in their contracts. Sichuan Pepsi has been the most uncooperative and vocal in expressing these demands, leading to a final showdown with Pepsi.

Pepsi says it spends more than it earns, spending millions on marketing and advertising, the costs of which are not borne by its Chinese partners. The firm is still losing money in China after two decades of operation, says Peter Thompson, president of Pepsi International Group, when he opened Pepsi’s new plant in Shenzhen in April this year.

Extracting concessions

Rival Coca-Cola has the same problem over profit-sharing. In October last year and February this year, three major suppliers of its ring-pull cans in Beijing ganged up suddenly to demand a price increase for the cans. Coke gave in, so that it could meet production targets on the eve of the peak holiday season.

These unhappy episodes are likely to happen more often in future, as Chinese companies become more confident and experienced in extracting concessions. Foreign firms, meanwhile, will be less tolerant of reinterpretations or breaches of contracts, now that China has committed itself to fair-trade practices under the World Trade Organisation.

The upshot is that more foreign investors will opt to set up wholly-owned operations of which they can have total management control, rather than be entangled in unhappy joint-venture marriages.

Pepsi was one of the earliest multinational companies to set up shop in China under the Open Door policy (although it arrived after Coca-Cola). In 1982, Pepsi set up its first bottling plant of 13,000 square metres in Shenzhen, then a rural town adjacent to Hong Kong.

Throughout the 1980s, Pepsi proceeded cautiously, taking small stakes in joint ventures, because of China’s difficult and unpredictable investment climate. Pepsi opted to make money from selling the drink’s concentrate, rather than from income generated by the joint ventures. Coca-Cola’s strategy differed slightly, using so-called anchor bottlers to set up joint ventures with Chinese firms. Its anchor bottlers in China include the Swire Group and the Kerry Group of Hong Kong, both of which have many years’ experience of bottling cooperation with the soft drinks firm.

Pepsi expanded more aggressively after setting up the Pepsi (China) Investment Company in Shanghai in 1994, an umbrella to oversee all its operations on the mainland.

Today, Pepsi is a beverage giant in China, with 40 wholly-owned and joint ventures, including 15 bottling plants and four snack-food factories, and employs 10,000 people. It has invested over $800m with annual revenues of $700m. It pays an average of $50m in taxes to the Chinese government each year, Pepsi executives say. Almost all of Pepsi’s brands are marketed in China, including Pepsi-Cola, 7-UP, Mirinda, Mountain Dew, Pepsi-Light, Pepsi-Twist and Dole juice.

It also has some popular local brands, such as Yazhou in Guangdong, Bei Bing Yang in Beijing and Tianfu Cola in Sichuan.

Pepsi has splashed out millions of dollars on advertising to build its brand in China, using pop stars and soccer players to endorse its products. Pepsi’s sponsorship of China’s League A soccer game alone costs $6m a year.

The marketing blitz has worked. In Beijing, Shanghai, Shenzhen and six other major Chinese cities, Pepsi has an impressive market share of 44%, according to a survey by AC Neilsen in January 2002.

Overall, however, Pepsi is still behind its long-standing rival Coca-Cola, which entered the market earlier than Pepsi and has 23 bottling plants in China. In 2000, Coca-Cola had an output of 2.43m tonnes, or a share of 39% of China’s soft drink market; Pepsi’s bottlers produced 1.72m tonnes, a market share of 17%. Up-and-coming local brands are also growing bigger, particularly Wahaha’s Future Cola.

The Hangzhou-based producer, which already has about 10% of the market, urges Chinese to drink cola produced by an indigenous producer, a marketing tactic that appeals to nationalistic Chinese.

Government interest

Making life tougher for Pepsi and other foreign cola makers is the government’s heavy intervention in the market. Beijing protects domestic beverage companies and tries to spread competition evenly throughout the country. That is why it is the central government, not market conditions, that will decide to which Chinese province or city foreign investors should go to set up their plants. It also requires them to devote 30% of their investment to developing local brands.

It is in this highly competitive environment that Pepsi and its Sichuan partner fell out over future strategy and management style.

Pepsi set up the joint venture in 1994 with Sichuan Radio and Television Industrial Development Company, a subsidiary of the provincial government’s Bureau of Radio, Film and Television. Pepsi contributed $1m to the registered capital of $4m and had a stake of 27%. It also provided free of charge $10m in production equipment and an interest-free loan of Rmb15m ($1.8m) to the venture. The Chinese partner claimed it spent six years persuading the government to let Pepsi into this “highly protected” market.

Seeds of discontent were already planted when the joint venture was set up. First, it was an arranged marriage, with partners having different goals. Sichuan picked an industrial firm affiliated to the local broadcasting authorities for the venture. It wanted to use profits generated from the project to help finance local media business.

Pepsi’s goal was to build a solid beverage business in China’s most populous province. Coca-Cola has had the same experience. Ministries and provincial governments “proposed” to the soft drinks firm state enterprises as potential partners.

The second weakness of the deal was the structure of the management. As the majority shareholder, the Chinese partner appoints all important personnel positions – legal representative, managing director and general manager. As a result, Hu Fengxian, the point man on the Chinese side, appointed himself to all three positions.

There is a six-member board of directors, with three representatives from each side. Mr Hu is the dominant voice on the board, as the two other Chinese representatives were retired workers with no real power. Mr Hu has not spoken to the press since Pepsi’s showdown. His assistant said he was away for business.

Mr Hu is no simple manager. As a former senior bureaucrat at the local state-owned radio station, he is politically well connected.

His guanxi (connections) helped the joint venture take off in the early days. Production began in August 1995 and the soft drink soon dominated the Sichuan market, where consumers found the fizzy water went well with their local hot and spicy cuisine.

Sichuan Pepsi has an impressive output of 20 million boxes a year, the same volume as for the whole of South Korea, its executives claim. Its success is due partly to the fact that Coca-Cola did not have a bottling plant there until 1999. By end-1999, Sichuan Pepsi had made an accumulated profit of Rmb52m, which placed it among the most profitable Pepsi bottlers in China.

As the operation grew bigger but margins got squeezed by increased competition, the Chinese partner demanded better business terms. It complained it was paying Pepsi too much for the concentrate needed to produce the soft drink. At the press conference, Sichuan Pepsi estimated that it had paid Rmb322m for the concentrate, from which Pepsi had “made an enormous profit from its mere $1m of initial capital.”

Taiwan competition

To generate more profits, Sichuan Pepsi proposed developing its own brands that would not require Pepsi’s pricey concentrate. It argued that it needed new products to meet the increased competition from Taiwan producers of juice and tea-based drinks that stormed into the Sichuan market in 1999. Pepsi turned down Sichuan Pepsi’s proposal in July last year.

Mr Chu says: “We asked a number of questions about the proposal. So far, they have given us some market research data, which led to even more questions about the viability of the proposal. We are still waiting for more data to ascertain if the proposed product meets our quality and safety standards.”

As disagreements mounted, mutual suspicions grew. “There is a big difference in the corporate culture of the Chinese and its foreign partners. Problems accumulated, communication broke down and eventually they reached a point of no return,” says a beverage expert who has worked with Pepsi and Coca-Cola in China.

The strained relationship has deteriorated rapidly since last year.

Mr Hu was so unhappy with Pepsi’s various decisions that he encouraged other bottlers to challenge the multinational at an industry meeting in Chengdu on 13 July last year. “If we do not unite together against Pepsi, we would incur enormous losses,” Mr Hu was reported as saying by the Guangzhou-based 21st Century Business Herald weekly.

A month later, Pepsi discovered another unhappy development: an ownership change of its Chinese partner. Sichuan Radio And Television Industrial Development Company was transferred from its parent to the National State Assets Management Bureau of Sichuan. State enterprises in other provinces also had similar changes, under a national plan to separate government departments from their business subsidiaries.

Pepsi was unhappy that it was not consulted about the new status. “It is a change that was carried out without our agreement or prior knowledge. This is a material breach of our contract,” says Mr Chu.

Sichuan Pepsi said in a statement that this change has nothing to do with Pepsi and yet the US side has used it “as a pretext to criticise the Chinese side”.

Sichuan Pepsi argued that Pepsi refused to send any representatives to the board to meetings arranged to solve the problems. “We also asked Pepsi to take over the entire management of the joint venture if it did not have confidence in the Chinese managers. It, however, flatly refused [to do so],” it said in a statement.

Shut out

Pepsi recently sent auditors twice to Sichuan Pepsi to check its finances but they were not allowed in. Mr Chu says: “Based on two sources, we know that there are financial irregularities: documents that Sichuan Pepsi submitted to us in its reimbursement requests for certain advertising expenditures; the financial audit conducted by the government’s Sichuan Provincial Audit Bureau.”

As the last resort, Pepsi asked for a change of management when the board’s term officially expired in January this year. Mr Hu, however, continues to head the board, without any representative from Pepsi. “We have no one with the joint venture now. We seconded a deputy general manager once, but his responsibilities were changed unilaterally by the general manager, without prior consultation with us or the board,” says Mr Chu.

In parting ways with Sichuan Pepsi, Pepsi has chosen to do it with an arbitration panel in Sweden, rather than a local court. This way, Pepsi thinks it will have a better chance of a fair hearing. Sichuan Pepsi said it welcomes the use of arbitration to sort out their differences, rather than letting Pepsi make threats and slanders in the media.

Pepsi has been careful not to turn the dispute into a nationalist issue of a Chinese company versus a greedy multinational.

Pepsi chooses its language carefully to avoid misunderstanding. When Mr Chu met with the Chinese press on August 5 this year to explain the dispute to them, he used bland phrases such as “Party A in the contract”, instead of the more sensitive description of “the Chinese side”.

The arbitration process will take about one and half years. Sichuan Pepsi has left a door open to work again with Pepsi in future. “Arbitration does not mean the joint venture has to be dissolved or that there is no possibility or room for the partners to continue with their operation,” said Sichuan Pepsi’s lawyer Mr Zhou.

However, Pepsi seems to have had enough of the unhappy marriage: it says it is looking for new partners for its business in Sichuan.

Printer friendly version

Email this to a friend