Coke's Future Remains Uncertain, While Pepsi Continues To Thrive

| About: The Coca-Cola (KO)

Since The Coca-Cola Company (NYSE:KO) announced earnings on October 15 its stock has traded higher by 1.7%, more than tripling the performance of the Dow Jones. Based on this fact, the market must have liked what it saw. Yet, Coca-Cola gave us absolutely nothing to create optimism. Instead, the company's earnings further proved that new regulations on sugar intake and its heavy reliance on sugar is slowly-but-surely killing the beverage giant. With that said, competitor Pepsico (NYSE:PEP) is better prepared for what's becoming a paradigm shift.

A Bad Story Brewing

Over the last five years, Coca-Cola has been the quintessential mirror of the Dow Jones, both experiencing a gain of 74%. While this looks good on the surface, Coca-Cola has traded flat over the last year. Meanwhile the Dow has increased by 15%. Then reason lies in fundamentals, as Coca-Cola has performed poorly in its last four reports, and especially in its last two quarters.

So, what is it that has been so "bad" about Coca-Cola's last two quarters? Well, the answer is growth. Coca-Cola is no longer seeing growth; it is a distant memory. The company continues to expand throughout the globe and into emerging markets. Yet YTD, the company's case volume has grown just 2%. Moreover, the company has had to become competitive with pricing; thus net revenues have declined, including 3% in this most recent quarter.

For a non-cyclical company with nearly $50 billion in annual revenue, Coca-Cola should always grow at the rate of GDP, or at least with the rate of population. Instead it's declining-- and the reason has absolutely nothing to do with taste or competition, but rather a more health conscious globe that is taking a stand against sugar. This paradigm has the world's largest beverage company, and one of the most recognized brands, cautious with its guidance and in trying to predict future performance.

What Are the Sugary Problems?

There are several sugary problems facing Coca-Cola and the entire industry as a whole:

  • The federal government is limiting calories in school vending machines. Consequently, this eliminates most Coca-Cola products, which also removes the company from one of its largest consumer bases (teens).
  • Our country's largest city, New York, attempted a large soda ban, and many believe that other large cities will follow suit. This would clearly alter the company's volume.
  • Coca-Cola does not have the ecosystem in place nor has it invested in an alternative to sugar. The U.S. is heavily structured to produce sugar/HFCS as a sweetener, but alternative sweetener growth is still in its infancy, with land being precious.

In addition to these fundamental issues, analysts and economists have begun to identify this growing problem for the beverage giant. Credit Suisse Research Institute published a paper earlier this month entitled "Sugar: Consumption at a Crossroad". CNBC then followed the report with their own piece, "Sugar: The food industry's tobacco moment"?

The point made is that sugar is today's tobacco of the late-90s, which is a point I made in my previous article. Furthermore, Credit Suisse concludes that a structural decline in sugar consumption is well on its way due to the identified health risks associated with the sweetener. In addition, it was found that the largest of beverage companies are at a crossroads (including Coca-Cola), a point where they must innovate or face a very uncertain future.

Additional Problems Arise

In addition to problems that have already been addressed, and those widely known to the public, there are also a slew of new developments, and other reasons to be pessimistic.

  • Believe it or not, the U.S. is not the number one market for consumption. The U.S. had 401 8oz drinks consumed per capita in 2012, which actually ranked fourth globally. Panama and Chile both rank ahead, but Mexico is the largest market with 745. This is relevant because of Mexico's imposed tax on sugary drinks - eight U.S. cents per liter - passed last week by Mexico's lower house of Congress.
  • Soft drink consumption overall is at a 26 year low. Over the last two decades, consumption has been volatile, but in recent years, we have seen a steady decline.
  • In regards to Coca-Cola specifically, syrup and concentrates represented 54% of the company's total operating revenue in 2008. In 2012, it represented 38% of operating revenue, clearly a decline. The reason for this decline is both diversity and changes in consumption. Still, 38% is a large chunk, and one has to wonder how this number changes if Coca-Cola implements new ingredients to make its products more healthy.
  • Juice has seen a steady decline for the better part of five years. In 2007 U.S. consumption per capita was 39.9 liters of juice, but last year that number declined to 35.5 liters. Much like soda, juice is high in sugar, and has been affected by the new healthy consumer. Moreover, Coca-Cola's sales of Minute Maid have declined 11.5% in this period to $1.3 billion.

What About PepsiCo?

In my opinion, Coca-Cola has a great risk to experience significant revenue and stock depreciation. Coca-Cola simply has no answer, and as legislation tightens the company does not have the innovation present to deal with whatever changes take place. Last year, soda accounted for nearly 70% of the company's total sales, leaving the company very vulnerable to these changes.

The company is testing a stevia-based product called Coca-Cola Life, imitating regular Coke in Argentina, but no data has yet been released. The company is still far from worldwide penetration with this product and others like it.

Dr. Pepper (NYSE:DPS) is also at great risk, as total sales declined 1% in its most recent quarter. Moreover, its Dr. Pepper brand saw a 4% decline in volume, as did the company's other brands. Unfortunately for Dr. Pepper, all of the company's brands are beverages, most of which contain sugar. This fact makes for a tough transition to healthier products and makes the possibility of tighter government policy a real threat to its business.

On the other hand, PepsiCo is clearly affected by the change in sugar demand, but not to the same degree as Coca-Cola or Dr. Pepper. The reason is because PepsiCo is not only a manufacturer and distributor of beverages, but also of food products.

While Coca-Cola relies solely on its beverage business, PepsiCo's American beverage business was only 33% of total sales. Moreover, PepsiCo has a massive food and snack industry, including 22 different brands that all earn more than $1 billion in annual revenue. The company has several brands in chips; it also sells Aquafina water and Quaker oatmeal. While the company still has Pepsi, Mountain Dew, Gatorade, and other sugary brands, the company is well protected by its diversity in the space.

During this last quarter alone, sales of its American foods rose 5% year-over-year to $6.1 billion. As a result, global growth in the food industry offset weakness in the beverage industry, allowing PepsiCo to grow while Coca-Cola's overall revenue declined. Therefore, even with industrial challenges, PepsiCo remains an interesting investment opportunity. Once it solves the problem regarding its beverage business, it will become an even better investment opportunity.

What Must Happen with Soda (My Opinion)?

While PepsiCo's business remains strong, right now we are at a crossroads-- a waiting period - and the state of the entire soda industry is at stake. In my opinion the combination of falling sales and volume, more health conscious consumers, and tighter regulations over sugary drinks will lead to Coca-Cola and Dr. Pepper's downfall. While I am not predicting a colossal collapse with either company, or an 80% decline in stock valuation, I think we could easily see a 20%-30% correction if these two companies don't start making significant changes to adapt with a new consumer. Historically, all large companies must adapt (e.g., tobacco industry or IBM), and for those Coca-Cola/Dr. Pepper bulls who think a 20%-30% correction is impossible, then simply think back one year to Apple at $700.00 and you'll better understand that when minor problems are realized by the market, large losses aren't far behind.

In my opinion, there is only one solution to the problem that carbonated beverage companies face: They must find a replacement for sugar that is equally sweet but all-natural. The only possible product is stevia, which is 200 times sweeter than sugar and is all-natural with zero calories. Furthermore, Coca-Cola's decision to launch Coca-Cola Life earlier this year in Argentina (contains stevia) and PepsiCo's partnership with Whole Earth Sweetener Company to produce a stevia product might be proof that this is the direction that such companies are headed.

However, replacing sugar with stevia is not an easy process, especially for large global beverage companies with billions in quarterly revenue. First, these companies already have well-established ecosystems of farmers, bottling facilities, and fields that are dedicated to sugar production on a global scale. Hence, it would take at least a year to replace that harvest and grow stevia, and even then there are problems.

In a previous article I highlighted S&W Seed Company's (NASDAQ:SANW) attempt to grow stevia unsuccessfully. The company is predominantly an alfalfa grower, but saw an opportunity in stevia for the reasons noted in this article, and this move took its share price from $5.00 to $11.00. Naturally the company attempted a harvest on just 114 acres of land and then expanded with 150 acres. However, the company then wiped out all but 10%-20% of its crop. Essentially, this experienced grower did not have the know-how or experience for the endeavor, as stevia is not a sweetener that is produced on a large scale, especially in the U.S. Yet, in order for Coca-Cola, PepsiCo, Dr. Pepper, and other food and beverage companies to successfully implement stevia without costing billions, each company needs to grow the sweetener in the U.S.

Given the failures of S&W, large beverage companies simply can't make an executive decision to replace sugar fields with stevia and then hope for the best. They must acquire new acreage for testing and then slowly roll out stevia and implement it into various regions. Consequently, it is not an overnight solution; it is a process-- one that must be executed correctly or it will do more harm than good.

In my last article, I highlighted a number of companies that Coca-Cola might seek to either partner with or acquire. These were companies that had everything that large beverage companies would need in order to make a smooth transition. However, I do warn that these are very small companies, as the majority of such companies are private and those that are public have spent time in research and are not what you would call "momentum stocks" by any measure. However, changes in the food and beverage industry make these unknowns very interesting as large companies are forced into change.

One of the companies that I identify as having what Coca-Cola needs is Stevia First (OTCQB:STVF). Now, there are other privately held companies, but none that investors could easily find or research. There are larger publically traded companies, but all have major weaknesses. In the case of S&W it is an alfalfa grower and clearly not a stevia expert. Then there are others such as Stevia Corp, but its stevia is mostly grown in other countries. PureCircle is the largest grower of stevia but does not own its own land and uses third party farmers in various countries. Lastly, Ingredion might be viable, but is mostly a corn-based company-- unlikely for it to change its entire ecosystem to focus on stevia, a product that may or may not grow on its land.

Stevia First has large sums of land, a fermentation process to refine superior taste, stevia products in development, and has patents and trademarks on its products. In more depth, let's explain why such things are important to Coca-Cola and other large food and beverage companie

  • Stevia First has over 1,000 acres in the agriculturally rich Central Valley of California, which is known for its diverse climate. Like I've already explained, Coca-Cola can't necessarily replace current crops without trial and error. Invariably, land becomes precious-- and in its largest market, Coca-Cola needs local land to avoid high costs and keep margins intact.
  • Stevia First can modify the taste of its stevia via patents and trademark technology. Last week the company announced trademark requests that will further allow it to utilize its technology to create a better commercial product. Moreover, the company is preparing for a commercial launch after months of clinical testing, which is a process that other stevia companies must undergo.
  • Stevia is healthy but naturally has a lingering aftertaste. Part of Stevia First's fermentation process is to produce Reb A, which is a part of stevia that is 200-400 times sweeter than sugar. More importantly, it has the best taste profile without the aftertaste. This process would be crucial to large beverage companies who want to replicate the taste of certain products, but don't want a lingering aftertaste.

Combined, these points could solve most of Coca-Cola's (and the industry's) problems. Now, with that said, I am in no way suggesting that Coca-Cola will acquire Stevia First. However, I do think a partnership with one of the larger food or beverage companies could be a part of Stevia First's future. But also, I think there are several small private companies who offer much of what makes Stevia First interesting; these companies might also be on the acquisition or partnership block.

Conclusion

Essentially, investors should not be satisfied until Coca-Cola makes more of an effort outside of Argentina, and acquires or partners with a company that has extensive research and experience in producing stevia. I have covered this topic before, but since my report we have seen another dismal quarterly performance from Coca-Cola along with a thorough research report from Credit Suisse-- and other analysts have started to take notice of this consumer shift. The report from Credit Suisse highlights the problems facing sugar. And recently JPMorgan called the state of the carbonated industry, "…the worst performance we have ever seen, with volumes continuing to decline despite a falloff in pricing growth."

Combined, it paints a very gloomy picture for the largest of food and beverage companies, which makes the strong performance of PepsiCo that much more impressive. In the end, we must believe that these large companies will innovate and make changes to remain a global power, but that doesn't mean that short-term pain will not exist. If this short-term pain is realized, it might make for a good investment opportunity, but until then, I'd be very wary of investing in either Coca-Cola or Dr. Pepper.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.