8-233-100
February 28, 2004
The Maharaja Dilemma:
Can Pepsi Thrive in Sri Lanka?
On January 1st, 1997, Mano Wikramanayake, Group Director of the Maharaja Corporation, relaxed in his “planter’s chair” having finally arrived home in Colombo, Sri Lanka. His butler brought him a tambali and handed him a fax on Donaldson Lufkin & Jenrette (DLJ)letterhead. Mano asked “is that all?” His butler wiggled his head in affirmation, adjusted his sarong and shuffled away to prepare supper. After his non-stop road show in New York City, Mano had expected a pile of faxes from interested groups looking to enter as 3rd party investors to the existing Olé joint venture between Maharaja and Pepsi. “How could they be the only takers?” he thought to himself. The Sri Lankan economy was on the rise; Pepsi’s brand awareness was growing; and the Maharaja Organization had a strong track record of marketing and distributing a variety of products in the country.
With only one fax in hand, Mano wondered about the fate of the joint venture. He knew the joint venture was highly undercapitalized and that Pepsi was not going to invest any more equity in the project. Feeling the heavy burden of all the high-interest rate domestic loans that had helped the Maharaja’s support operations for the last two years, Mano pondered his alternatives. After large capital investments in bottling equipment, distribution trucks, and warehouses, did it make sense for the Maharaja’s to abandon the joint venture? If not, could they turn things around without the help of a third party investor? What if the DLJ offer is the best they can get given the political instability in Sri Lanka? These questions began to overwhelm Mano, so he decided to call his Finance and Marketing VPs to discuss the DLJ offer.
Joint Venture Inception: Pepsi & Olé Spring Bottlers
In 1985, PepsiCo International became interested in distributing their carbonated products in Sri Lanka and entered into a franchise agreement with Ceylon Cold Stores (CCS). Despite the successful launch, frustration quickly settled in as Pepsi saw itself “white in the market”1 for three straight years. Further complications arose from a labor dispute in 1988 which ultimately
1. “White in the Market” refers to containers in the market with no product.
Sanjay Pamnani, Heidi Pellerano, Dhanusha Sivajee and Vidhi Tambiah, MBAs 2004, prepared this case for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.
Copyright © 2004 by DukeUniversity, The FuquaSchool of Business.
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233-100The Maharaja Dilemma
forced the government to take over the management of the company under emergency regulations. In 1990, Pepsi terminated the franchise agreement. At this time, Les Ham, President of PepsiCo Asia, realized he needed to find a new franchise partner, otherwise,he would be left with no other option but to pull out of the Sri Lankan market completely.
Ham turned to The Maharaja Corporation. AsSri Lanka’s largest privately-held corporation, Maharaja was looking to expand its portfolio of international brands. In 1991, after lengthy negotiations, Pepsi awarded the franchise to the Maharaja Corporation. Under the agreement (Exhibit 1), Maharaja would serve as the exclusive Pepsi franchisee in Sri Lanka and would begin by bottling and marketing 300ml glass bottles of the‘Pepsi’, ‘Mirinda’, and ‘7-Up’ brands for a term of five years. The joint venture was named after Maharaja’s existing “Olé Springs” manufacturing facility which in 1992 was retrofitted into a bottling plant. The plant was located on a 19.5 acre property, in the Eastern outskirts of Colombo. Initially, the plant employed 265 employees and had a capacity level of 480 bottles per minute (bpm)
In 1992, Pepsi was officially re-launched in Sri Lanka under the wardship of a PepsiCo regional office in Pakistan. The Pakistani office supported the launch with an ad campaign featuring model Claudia Schiffer drinking out of a can of Pepsi (Exhibit 2). The launch date which is usually a day of celebration quickly became a day of concern for the Maharaja Corporation. They sat in their offices wondering why the advertisement provided by Pepsi featured a can when only bottles were sold in Sri Lanka. Additionally, the entire Pakistani team did not turn up for the launch on account of a religious festival. Could this be a sign of things to come? Unfortunately, the answer was “yes,” as the Pakistani team continued to demonstrate little commitment to the joint venture. As a result, the venture struggled during the first three years of operation reporting loses of SL Rupees 4.9 million, 0.9 million and 78 million. The operation was highly undercapitalized, but the Maharaja Corporation was not willing to invest further unless Pepsi was willing to do the same.
In 1995, Roger Enrico took over the reigns of PepsiCo Inc. Mr. Enrico was a brilliant marketer who understood the importance of building truly global brands. In May, he infused the project with a $2 million equity investment and moved wardship to PepsiCo India (Exhibit 3). With PepsiCo’s renewed commitment to the venture and positive outlooks for the Sri Lankan economy, the Maharaja Corporation saw an opportunity to turn this venture around. However, the capital infusions didn’t prove to be sufficient. The Maharaja’s were saddled with high-interest debt and Pepsi’s market share had not grown as projected. Since Pepsi was not willing to make any additional investments in the venture, it became clear that a third party investor was the answer to their financial woes.
In December1996 as the Sri Lankan economy began to recover, Mano Wikramanayake, Group Director of the Maharaja Corporation, flew to New York to pitch Olé to a group of potential investors. He was looking to invoke interest in a private placement in Olé and received favorable reviews from investors who were extremely bullish on Asian economies at that time. Further he disclosed to investors, Olé’s plans to go public after two years first on the local stock exchange and then in the US via an ADR offering which would allows investors an exit and an opportunity to make an attractive return on their initial investment. After two weeks of meetings, Mano returned to Sri Lanka hopeful that Olé was going to receive the necessary capital to restructure operations and begin to rival Pure Beverages and CCS for market share.
To Mano’s dismay, only one investor, Donaldson Lufkin & Jenrette (DLJ), a publicly held U.S.-based investment bank and financial services provider, submitted a proposal. Highlights of DLJ’s offer are shown in Exhibit 4. It was obvious from the offer that DLJ was concerned about the various risks that could plague a project in an emerging market like Sri Lanka and wanted substantial downside protection for its investment. However, were they asking for too much? Where there other ways for the Maharaja’s to mitigate DLJ’s concerns?
Sri Lanka
Sri Lanka,(Exhibit 5), is an island off the southeast coast of India. It is approximately the size of Irelandbut with a population the size of Australia (19m). There are two main ethnic groups, the Singhalese (Buddhist majority) and Tamils (Hindu minority). There are a number of other important minorities such as Muslims, Chettiahs, Sindhis and Eurasian “Burghers”. Sri Lanka is rich in natural resources. Its main industries include agriculture, mining and tourism. Unfortunately, the island has never been able to fully exploit its resources because of the devastating ethnic conflict that has raged since 1983. (Exhibit 6)
Ethnic Conflict
Sri Lanka was colonized in turn by the Portuguese, Dutch and the British. The British employed their “divide and conquer” approach to administering the island. They found a minority of Tamils and Singhalese open to Christian conversion. They gave the top administrative posts to this Christian “elite” who enjoyed power and privilege over the Buddhist majority. After independence in 1948, a Singhalese Christian government came to power and upheld rights for all minorities. However, on the wave of a Buddhist backlash, a leading Christian Singhalese, S.W.R.D Bandaranaike, converted to Buddhism and came to power promising to end non-Buddhist policies. A Buddhist monk later assassinated him because he was yielding too much to his erstwhile Christian colleagues. Thus, consequent governments introduced even more policies favoring the Buddhist majority at the expense of other minorities.
The Tamils started a peaceful struggle for their rights which lasted from the early 50’s to late 70’s. A new pro-Buddhist government in 1978 sidelined Tamil and other minority rights further and introduced a new “executive presidency” that had the rights to dissolve parliament and effect military control without recourse to the parliament. This government instigated yet more policies to favour the majority. The Tamils reacted violently in the North of the country, killing policemen and military personnel. Ethnic tensions rose to a peak in 1983 when an alleged government-led riot was directed towards Tamils in Colombo and several other towns. Tamil businesses and homes were razed. Tamils who could afford to flee the country sought refuge in the UK, US, Canada and Australia. Others risked life and limb crammed on boats headed towards India. Those Tamils left behind waged a guerilla style war led by Vellupillai Prabakaran - “the Fox”. The Tamil Tigers as they became known soon became a highly disciplined and effective guerilla group. Their “suicide bombings” quickly became a trademark. Assassinations attributed to them include Rajiv Gandhi (former Indian Prime Minister – for his decision to send in the Indian Peacekeeping Force) and Ranasinghe Premadasa (President of Sri Lanka). The government responded by incurring curfews and a high military presence in Colombo.
Exchange Rate and GDP
The Sri Lankan Rupee (SLR) is allowed to float against a basket of currencies with the US$ as the intervention currency. The Central Bank maintains a 2% margin between daily buying and selling rates, to guide commercial banks in quoting their rates. The value of the Rupee has fluctuated since 1978, but the overall trend has been downwards, (Exhibit 7), reflecting the persistent current-account deficit and relatively high inflation rates. (Exhibit 8)
In 1989, a rigorous liberalization program was introduced by Mr. Premadasa’s UNP government. The economic reform programme was supported by an IMF Enhanced Structural Adjustment Facility (ESAF). Stabilization measures included a devaluation of the Rupee and the abolition of major subsidies. These were complemented by an ambitious privatization drive. Tax, tariff and trade reforms were also instituted and the current account was freed of exchange controls. GDP growth rose from 2.3% in 1989 to 6.9% in 1993. The People’s Alliance (PA) government pledged itself to continue with the economic reform programme.
Since 1991, the share of industry (manufacturing, construction and utilities) has increased from 25.7% to 28.8% of real GDP. (Exhibit 9) In particular, manufacturing has emerged as the lead sector underpinning economic growth. Progressive privatization of state enterprises has enabled the private sector to dominate manufacturing. Small and medium enterprises account for nearly 90% of private industrial units. The services sector accounted for 48.7% of GDP in 1995 and is principally composed of wholesale and retail trade, financial services, transport and communications, public administration and defense and tourism.(Exhibit 10)
Monetary Policy
In recent years, monetary policy has focused principally on the control of inflation with the Central Bank relying on indirect policy instruments including open market operations in Treasury bills and Central Bank securities to influence the growth of monetary aggregates. In 1992-93 monetary growth was fuelled to a great extent by a large increase in foreign capital inflows and an expansion in private-sector credit which necessitated the operation of a tight monetary policy.(Exhibit 11) In 1993-95, an even stronger emphasis on controlling inflation led to a tightening of monetary policy to compensate for high defense spending and a widening fiscal deficit.
High inflation has been a persistent problem in Sri Lanka over the past decade. (Exhibit 8) Cost-push factors such as wage adjustments, increases in indirect taxes, high interest rates and exchange rate depreciation have contributed to increases in the price level. (Exhibit 12) Seasonal scarcities of agricultural commodities and inefficient agricultural production have also been responsible. In recent years, the principal causes of demand-induced inflationary pressures have been the high level of government spending and the rapid rate of monetary expansion. In 1988-93 annual average inflation was 13.6%. It was suppressed artificially to 8.4% in 1993 and to 7.7% in 1994 by a combination of subsidies and reductions in key administered prices.
Persistently high inflation has prevented any real increase in incomes since wage increases have generally not kept pace with the rise in prices. There are no reliable statistics for income distribution, but anecdotal evidence suggests a marked deterioration in income disparities. Thus, many industries have been adversely affected by strikes initiated by labor/trade union forces seeking to remedy this malady. (Exhibit 13) Rising food prices have also prevented any significant rise in discretionary spending with more than 85% of incomes being spent on basic necessities.
Since the average rate of inflation in Sri Lanka has tended to be higher than those of its competitors, the country’s export price competitiveness has suffered. This problem has been exacerbated by high interest rates and the lack of sources of concessionary financing to the export sector. Since exchange rate depreciation also fuels inflation, the government has been reluctant to devalue the currency to the extent exporters are demanding.
Maharaja Corporation
The Maharaja Group is Sri Lanka’s largest conglomerate in terms of sales with an annual turnover of US $ 175 million for the year ended March 31, 1996. The two founding members Mr. S Mahadevan and Mr. S Rajandram had worked for an American firm called Dodge & Seymore Ltd which held agencies in Sri Lanka for prominent companies such as Union Carbide Limited, Colgate Palmolive Limited, Yale & Towne Limited, Champion Spark Plugs Limited, Parker Pen Limited and Cheeseborough-Pond’s Inc. At the time of World War II, Dodge & Seymore closed their office in Sri Lanka (then known as Ceylon) and handed over the agencies to Messrs S Mahadevan and S Rajandram.
At the inception, the agencies were serviced on an indirect basis however gradually through time the distribution reach extended beyond the capital city of Colombo to other parts of the country. This effectively laid the foundations for a formidable sales network that was leveraged in later years to introduce products from other agencies and joint ventures.
The Maharaja Organization was incorporated in 1967 though a merger between the various subsidiaries – Rajadrams Limited, Maharaja Distributors Limited and A.F. Jones & Co. Limited. Since 1967 the Maharaja Group has been run by Messrs R Maharaja and R Rajamahendran jointly as Managing Directors
In 1997, the Group’s operations remained highly diversified with interests in imports, local manufacturing, distribution and marketing, export commodity trading, tourism, clearing and forwarding, project development, computer services, soft drink bottling, television and radio broadcasting, satellite communications, beauty care, a flying school and a domestic air service. One of the Group’s most successful joint ventures was with the New Zealand Dairy Board that manufactures and markets milk and milk products in Sri Lanka under the ‘Anchor’ Brand name. The Maharaja Group’s excellent distribution network has made it a household name in a predominantly rural country and its marketing track record made the company the top choice of partners in joint ventures in the Sri Lankan market. Furthermore, the Group was also able to utilize its ownership and presence in media operations to promote its joint venture and marketing operations.
PepsiCo International(Exhibit 14)
The carbonated soft drink market had, in recent years become increasingly competitive as Western markets matured and multinational firms began increasing global operations as a means of continued growth. Historically, the early mover into a “white market” (an area with no previous distribution of Coke or Pepsi) continued to hold the majority market share as the market matured. Thus, it was seen as critical to enter new markets as soon as they became politically and economically accessible.
Instead of going head-to-head with Coke in almost every market in the world, Pepsi had focused its efforts on high-potential emerging markets such as China, India, Russia and Vietnam.These countries had high populations and low soft drink consumption rates, which translated into tremendous growth prospects. (Exhibit 15) Pepsi’s strategy was to capitalize on this growth by leveraging its already strong market position (at least 20% market share) in these markets. (Exhibit 16)
By 1997, PepsiCo was selling about three billion 8-oz cases of soft drinks outside North America under a different set of brands that included Seven-Up, Mirinda (orange soda) and Pepsi Max (no calorie cola). About 60% of Pepsi’s international volume was sold by independent bottlers, while the remaining 40% was handled by bottlers in which PepsiCo either controlled or had some equity stake.
In evaluating the merits of entering a new market or making a major investment in reviving an old one, PepsiCo looked for a 14% internal rate of return, after adjusting for expected inflation and country risk, over a 12-year horizon. PepsiCo also measured the success of an investment against a 7% corporate ROA target. These criteria where then supplemented with a fivefold characterization of investment opportunities:
- Big developed soft drink markets;
- Smaller or riskier markets;
- Opportunities to invest in jump-starting channels or segments within the first two categories;
- 21st century markets; and
- Turnaround opportunities as the bottler of last resort.
PepsiCo had categorized Sri Lanka in the second of these five categories. It looked at Sri Lanka as a natural extension of its investment in India, which it categorized as a twenty-first century market. However, they could not ignore the inherent limits on size of population and growth plus the risks that Sri Lanka bore as a country engaged in civil war. From Pepsi’s perspective, it was critically important for Olé to capture market share. Revenue from the sale of bottles was a secondary concern for Pepsi, especially as its returns would be largely generated by the sales of concentrate to Olé.