Coke vs. Pepsi: 2010 Style

Includes: CCE, DPS, KO, PAS, PBG, PEP
by: Morningstar
By Philip Gorham

After months of strenuous denials, The Coca-Cola Company (NYSE:KO) announced in February 2010 that it was to follow in the footsteps of great rival PepsiCo (NYSE:PEP) and acquire the majority of its North American bottling platform. As we outlined in our report "Bottler Consolidation--The Real Thing?" we had expected Coke to make this move because we think owning the distribution network is a sensible strategy for competing in the increasingly complex soft drink industry.

Given its extensive snacks portfolio, we think Pepsi has more to gain than Coke from bottler consolidation, but that the repercussions of the strategy go beyond the two main players. Dr Pepper Snapple (NYSE:DPS) will be affected because Pepsi will now directly distribute its brands, and major retailers such as Wal-Mart (NYSE:WMT) and Kroger (NYSE:KR) will now face suppliers with deeper pockets. Although we suspect many shareholders believe that Coke will spin off its newly-acquired bottling business in the not-too-distant future, we believe this time the strategy is for the long term. In fact, we think that both Coke and Pepsi will increase their grasp on their North American distribution by making further acquisitions of small independent bottlers.

Timeline to Consolidation
Both Coke and Pepsi have long histories of backtracking over the nature of their relationships with the bottlers. Below, we present a brief timeline leading up to the latest round of consolidation.

1899.--The first Coca-Cola bottler is created when Willie Thomas and Joseph Brown Whitehead obtained free of charge the rights to bottle and distribute Coke in the United States, with Coca-Cola selling syrup to the bottler for $1 per gallon. Subsequently, subfranchised sales territories are created throughout the U.S.

1920.--The inflexibility of the original bottling contract had caused tension between Coca-Cola and its bottlers from the outset, but the most notable conflict came after the expiration in 1919 of sugar price controls, set during the First World War. As the price of sugar rose, The Coca-Cola Company suffered significant losses, and in 1920, variable syrup prices were implemented after the firm threatened to tear up the bottling contracts.

1950s.--In the mid-20th century, both Coke and Pepsi opted to consolidate some bottlers in order to ensure favorable contracts and shore-up underperforming distributors.

1986.--Coke spins off Coca-Cola Enterprises (NYSE:CCE) in order to exclude the low-margin bottling and distribution businesses from its books. The firm retains a minority interest in the bottler in order to maintain influence over its activities. Meanwhile, Pepsi follows a different path and continues to consolidate.

1999.--In an abrupt about-face, Pepsi spins out its Pepsi Bottling Group (PBG) and forms PepsiAmericas (PAS) by combining its second and third-largest bottlers.

April 20, 2009.--Pepsi announces an unsolicited $6 billion double bid for its two anchor bottlers Pepsi Bottling Group and PepsiAmericas.

May 4, 2009.--Having just announced solid results for the first quarter of 2009, PBG rejects Pepsi's offer.

May 7, 2009.--PepsiAmericas also rejects the bid, claiming that Pepsi's offer "significantly undervalues" the firm.

Aug. 4, 2009.--PBG and PAS agree to be acquired by PepsiCo for a combined total of $7.8 billion, in a deal that gives PepsiCo control of around 80% of its North American distribution.

Feb. 25, 2010.--Coca-Cola announces its acquisition of the North American business of Coca-Cola Enterprises (around 90% of total North American distribution) for $12.7 billion, and CCE agrees to buy Coke's wholly-owned bottling operations in Norway and Sweden.

Feb. 26, 2010.--Pepsi's acquisitions of PBG and PAS close.

Fourth quarter 2010.--the transactions between Coke and CCE are expected to close.

Why It's Different This Time
The nonalcoholic beverages market has changed significantly since Pepsi spun off Pepsi Bottling Group in 1999. In previous consolidation cycles, the syrup makers--particularly Coke--have acted as a hospital ward for struggling bottlers, acquiring them when they were close to financial distress, recapitalizing them, and nursing them back to health before spinning them off again. However, this time it's different. We think that significant changes in consumer preferences and in the retail landscape are permanent, and as a result, the franchise model will not be as effective in the new decade as it has been in the past.

Over the last decade, the U.S. carbonated beverages industry has been in decline as consumers have switched from sugary, sparkling drinks to sports drinks, energy drinks, water, and juices. As a result, retailers have demanded a broader range of beverage products from manufacturers and non-carbonated categories have become the new battlefield upon which beverage manufacturers compete. Both Coke and Pepsi have launched and acquired a range of non-carbonated brands in recent years. Products such as fortified water, juices, and energy drinks are sold at relatively low volumes because they target smaller market segments. Smaller brands with lower economies of scale are more costly for bottlers to distribute--an unattractive proposition for firms that already generate quite thin operating margins. Furthermore, consolidation in the retail sector over the last decade has shifted more bargaining power from manufacturers to large grocery store chains such as Wal-Mart and Kroger, and those retailers have been demanding more customized route-to-market practices. By owning their distributors and eliminating the tug-of-war over profits, we think both Coke and Pepsi will have the flexibility to become more responsive to the demands of retailers and consumers.

Winners and Losers in the "New Normal"
We think that PepsiCo has more to gain than Coke from bottler consolidation. For several consecutive quarters Pepsi has lost market share to Coca-Cola, and its North American beverage business has been in need of a revamp. Although Pepsi gained a first mover advantage, Coke will already be making progress on integrating CCE in North America, and we expect any advantage gained to be short-lived. Having said that, Pepsi has more to gain from streamlining its route-to-market than Coke, because its snacks business should give it more leverage over retailers. For logistical reasons (primarily the contrasting density and fragility properties of drinks and snacks) we do not expect distribution to be combined across the businesses. However, ownership of the snacks business means that Pepsi is responsible for a significantly larger proportion of revenues in the convenience and grocery store channel than Coke. In its negotiations with retailers, we think bigger will be better for Pepsi, particularly when combined with a flexible delivery system.

Although some investors may justifiably feel deceived by Coca-Cola's apparent lack of transparency during its negotiations with CCE, we applaud the firm for paying a reasonable price for the bottler. Coke CEO Muhtar Kent stated publicly on several occasions that the firm would not be buying CCE because the franchise model was his preferred strategy for success in the current marketplace. It was something of a surprise to the market, therefore, when the firm reversed this position. However, by denying interest in a deal, Coke probably prevented having to pay a premium for the bottler, and at 7 times enterprise value/earnings before interest, taxes, depreciation and amortization, we think the company paid a fair price.

Dr Pepper Snapple will also likely be a winner from the latest wave of consolidation. As part of the deal that allowed PepsiCo to assume the Dr Pepper distribution rights previously held by PBG and PAS, Dr Pepper was paid $900 million in up-front revenue. We think the best use of this cash would be to make tuck-in acquisitions that broaden the firm's portfolio. In the absence of reasonably-priced acquisition targets, we would like to see the cash returned to shareholders in the form of a dividend. In addition to this influx of cash, Dr Pepper is also likely to be a beneficiary of Pepsi's superior route-to-market. More flexible distribution is likely to enhance its brand, although we doubt that Pepsi will be willing to prioritize third-party products at the expense of its own.

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