Vertical Mergers: Fast Food, Folklore, and Fake News

Eric Fruits —  17 September 2019

In the Federal Trade Commission’s recent hearings on competition policy in the 21st century, Georgetown professor Steven Salop urged greater scrutiny of vertical mergers. He argued that regulators should be skeptical of the claim that vertical integration tends to produce efficiencies that can enhance consumer welfare. In his presentation to the FTC, Professor Salop provided what he viewed as exceptions to this long-held theory.

Also, vertical merger efficiencies are not inevitable. I mean, vertical integration is common, but so is vertical non-integration. There is an awful lot of companies that are not vertically integrated. And we have lots of examples in which vertical integration has failed. Pepsi’s acquisition of KFC and Pizza Hut; you know, of course Coca-Cola has not merged with McDonald’s . . . .

Aside from the logical fallacy of cherry picking examples (he also includes Betamax/VHS and the split up of Alcoa and Arconic, as well as “integration and disintegration” “in cable”), Professor Salop misses the fact that PepsiCo’s 20 year venture into restaurants had very little to do with vertical integration.

Popular folklore says PepsiCo got into fast food because it was looking for a way to lock up sales of its fountain sodas. Soda is considered one of the highest margin products sold by restaurants. Vertical integration by a soda manufacturer into restaurants would eliminate double marginalization with the vertically integrated firm reaping most of the gains. The folklore fits nicely with economic theory. But, the facts may not fit the theory.

PepsiCo acquired Pizza Hut in 1977, Taco Bell in 1978, and Kentucky Fried Chicken in 1986. Prior to PepsiCo’s purchase, KFC had been owned by spirits company Heublein and conglomerate RJR Nabisco. This was the period of conglomerates—Pillsbury owned Burger King and General Foods owned Burger Chef (or maybe they were vertically integrated into bun distribution).

In the early 1990s Pepsi also bought California Pizza Kitchen, Chevys Fresh Mex, and D’Angelo Grilled Sandwiches.

In 1997, PepsiCo exited the restaurant business. It spun off Pizza Hut, Taco Bell, and KFC to Tricon Global Restaurants, which would later be renamed Yum! Brands. CPK and Chevy’s were purchased by private equity investors. D’Angelo was sold to Papa Gino’s Holdings, a restaurant chain. Since then, both Chevy’s and Papa Gino’s have filed for bankruptcy and Chevy’s has had some major shake-ups.

Professor Salop’s story focuses on the spin-off as an example of the failure of vertical mergers. But there is also a story of success. PepsiCo was in the restaurant business for two decades. More importantly, it continued its restaurant acquisitions over time. If PepsiCo’s restaurants strategy was a failure, it seems odd that the company would continue acquisitions into the early 1990s.

It’s easy, and largely correct, to conclude that PepsiCo’s restaurant acquisitions involved some degree of vertical integration, with upstream PepsiCo selling beverages to downstream restaurants. At the time PepsiCo bought Kentucky Fried Chicken, the New York Times reported KFC was Coke’s second-largest fountain account, behind McDonald’s.

But, what if vertical efficiencies were not the primary reason for the acquisitions?

Growth in U.S. carbonated beverage sales began slowing in the 1970s. It was also the “decade of the fast-food business.” From 1971 to 1977, Pizza Hut’s profits grew an average of 40% per year. Colonel Sanders sold his ownership in KFC for $2 million in 1964. Seven years later, the company was sold to Heublein for $280 million; PepsiCo paid $850 million in 1986.

Although KFC was Coke’s second largest customer at the time, about 20% of KFC’s stores served Pepsi products, “PepsiCo stressed that the major reason for the acquisition was to expand its restaurant business, which last year accounted for 26 percent of its revenues of $8.1 billion,” according to the New York Times.

Viewed in this light, portfolio diversification goes a much longer way toward explaining PepsiCo’s restaurant purchases than hoped-for vertical efficiencies. In 1997, former PepsiCo chairman Roger Enrico explained to investment analysts that the company entered the restaurant business in the first place, “because it didn’t see future growth in its soft drink and snack” businesses and thought diversification into restaurants would provide expansion opportunities.

Prior to its Pizza Hut and Taco Bell acquisitions, PepsiCo owned companies as diverse as Frito-Lay, North American Van Lines, Wilson Sporting Goods, and Rheingold Brewery. This further supports a diversification theory rather than a vertical integration theory of PepsiCo’s restaurant purchases. 

The mid 1990s and early 2000s were tough times for restaurants. Consumers were demanding healthier foods and fast foods were considered the worst of the worst. This was when Kentucky Fried Chicken rebranded as KFC. Debt hangovers from the leveraged buyout era added financial pressure. Many restaurant groups were filing for bankruptcy and competition intensified among fast food companies. PepsiCo’s restaurants could not cover their cost of capital, and what was once a profitable diversification strategy became a financial albatross, so the restaurants were spun off.

Thus, it seems more reasonable to conclude PepsiCo’s exit from restaurants was driven more by market exigencies than by a failure to achieve vertical efficiencies. While the folklore of locking up distribution channels to eliminate double marginalization fits nicely with theory, the facts suggest a more mundane model of a firm scrambling to deliver shareholder wealth through diversification in the face of changing competition.

Eric Fruits

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Eric Fruits, Ph.D. is Chief Economist at the International Center for Law & Economics and Economics International Corp. He is the Oregon Association of Realtors Faculty Fellow at Portland State University. He has written peer-reviewed articles on initial public offerings (IPOs), the municipal bond market, real estate markets, and the formation and operation of cartels. His economic analysis has been widely cited and has been published in The Economist and the Wall Street Journal. Dr. Fruits is an antitrust expert who has written articles on price fixing and cartels for the top-tier Journal of Law and Economics. He has assisted in the review of several mergers including Sysco-US Foods, Exxon-Mobil, BP-Arco, and Nestle-Ralston. He has worked on many antitrust lawsuits, including Weyerhaeuser v. Ross-Simmons, a predatory bidding case that was ultimately decided by the United States Supreme Court. As an expert in statistics, he has provided expert opinions and testimony regarding market manipulation, real estate transactions, profit projections, agricultural commodities, and war crimes allegations. His expert testimony has been submitted to state courts, federal courts, and an international court.

One response to Vertical Mergers: Fast Food, Folklore, and Fake News

  1. 

    Researching the story of Pepsi’s acquisition of KFC sent me down a deep, deep rabbit hole regarding the rebranding of Kentucky Fried Chicken to KFC in 1991.

    The wildest explanation has been circulating for a long time. I first heard it from a friend when I was in grad school in the early 1990s. According to the story, Kentucky Fried Chicken had been selectively breeding chickens to get larger breasts (some stories say it was to get more legs, others said the birds were beakless and/or featherless). This genetic engineering led the Food and Drug Administration to determine these mutant birds were no longer chickens. Since Kentucky Fried Chicken was no longer selling chicken, the company changed its name to KFC to avoid the wrath of regulators and class action lawyers. The rumor had legs and in early 2000, KFC added a page to its website debunking the Frankenchicken fake news.

    Around the same time, “fact checking” website, Snopes.com trolled the Internet with a false story of the “real” reason for the switch from Kentucky Fried Chicken to KFC (yes, the emphasis is in the original):

    “It sounded good, but the *real* reason behind the shift to KFC had nothing to do with healthy food or finicky consumers: it was about money — money that Kentucky Fried Chicken would have had to pay to continue using their original name. In 1990, the Commonwealth of Kentucky, mired in debt, took the unusual step of trademarking their name. Henceforth, anyone using the word “Kentucky” for business reasons — inside or outside of the state — would have to obtain permission and pay licensing fees to the Commonwealth of Kentucky. It was an unusual and brilliant scheme to alleviate government debt, but it was also one that alienated one of the most famous companies ever associated with Kentucky. The venerable Kentucky Fried Chicken chain, a mainstay of American culture since its first franchise opened in Salt Lake City in 1952, refused as a matter of principle to pay royalties on a name they had been using for four decades. After a year of fruitless negotiations with the Kentucky state government, Kentucky Fried Chicken — unwilling to submit to ‘such a terrible injustice’ — threw in the towel and changed their name instead, timing the announcement to coincide with the introduction of new packaging and products to obscure the real reasons behind the altering of their corporate name.

    . . .

    “Update: In November 2006, KFC and the State of Kentucky finally reached an undisclosed settlement over the former’s use of the trademarked word ‘Kentucky,’ and the restaurant chain announced it would be resuming its former name of ‘Kentucky Fried Chicken.’”

    Snopes claims the reason it creates false stories or “Lost Legends” is to teach the world not to succumb to false authority. By that measure, they have failed. Even the senior editor of the venerable Harvard Business Review fell for it:

    “In 1990, Kentucky Fried Chicken changed its brand name to KFC — already in common use — reportedly to avoid new licensing fees the Commonwealth of Kentucky planned to levy on anyone who used the state’s name.”

    The University of Kentucky did trademark “Kentucky” in 1997, but that trademark only applies to things like apparel and sports bottles. It never applied to fast food or fried chicken.

    While not as fun as the fake news of Frankenchickens or rent-seeking state governments, the more mundane explanation for rebranding is the correct one. And, it’s the explanation KFC gave in the press release announcing the change:

    “[I]n keeping with its more contemporary menu and expected move into non-fried chicken, its signs and packaging will prominently feature the initials “KFC.” Also, the company’s traditional red stripes have been completely redesigned to convey a “faster, sleeker look.”
    . . .
    The announcement came just two weeks after KFC became the first national restaurant chain to introduce a skin-free chicken, lower in fat, calories, sodium and cholesterol than its traditional fried chicken.”