Why has RTE cereal been such a profitable business?
The RTE cereal market is a classic oligopoly with the four dominant players controlling 85% of the market. The return on sales earned by the incumbents in this market (18%) is significantly higher compared to rest of the food industry (5%). Efficient markets typically entice new entrants when the returns are attractive. These returns are gradually eroded with increased price competition as a result of the entry. The RTE market has defied this market theory.
There are two main reasons for this. One, any market that yields a high rate of return but has no new entrants must have significant barriers to entry. The RTE cereal market has significant entry barriers. Two, barriers to entry does not necessarily mean high profits for all incumbents in an oligopoly. However, in the RTE cereal, it has. This is attributable to the fact that players in the oligopoly have demonstrated profit maximizing behavior and have successfully avoided market share maximization motivated price wars.
Barriers to entry are discussed below.
Brand Proliferation Strategy: Incumbents have successfully launched a “brand proliferation” strategy using which every foreseeable market niche is already serviced with a specific brand. Collectively, there are about 200 + brands offered by the three leading suppliers. This approach deters new entrants because no market niches are left out for new providers to exploit. Also, the given market share of any one brand is low in a market which has such a large number of brands. This also makes it difficult for new entrants, as the expected market share from a new launch (and hence revenue/profit) is very low. This would typically not cover the costs associated with initial capital investment required for the manufacturing facilities.
Advertising & Promotional Spend: Spending on advertising and promotions is about 15% of sales. Incumbents are spending 300 million annually on advertising and promotions. The intent is to foster brand loyalty by differentiating similar cereals supplied by competitors. This high level of spending has increased the average amount that needs to be spent during a new product introduction in order to catch customers’ attention, hence adding to list of barriers to entry.
Preferential Privileges in Retail Channel: Incumbents have relationships with the retailers and get the most desirable shelf space to maximize chances of high sales. Shelf space is typically allocated based on historical sales volume. This makes it difficult for new entrants to break into the market, as it is impossible for them to get prime shelf space.
Capital Intensive: Manufacturing plants cost about $300 million to setup to achieve the economies of scale required to be profitable. This is certainly a barrier to entry but not a very strong one as many large companies would have access to this capital (private or from lending institutions) and would be willing to make the investment, given the high profitability potential.
The barriers to entry helped maintain the oligopoly. However, a key factor contributing to high profitability is the implicit collusion amongst members of the oligopoly. The industry has historically demonstrated a pattern in which Kellogg raises prices and the rest of the industry follows suit.
What changes have led to the current industry crisis?
Switching cost and trade promotions: Competitors have made heavy use of coupons based trade promotions. This has reduced switching cost for customers. This has eroded brand loyalty and has promoted price sensitive shopping behavior. Price Increases: The price has increased by about 35% over the past 3 years. Competitors in the RTE cereal market spend heavily on advertising and trade promotions and have justified the price increases based on the additional advertising expense companies have incurred....