Carbonated Soft Drinks Face Challenges And Critical Partnership Decisions

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 |  Includes: DPS, GMCR, KO, PEP, SODA
by: Seth Golden

Summary

Traditional CSDs face challenges to competing with healthier alternatives.

New sweeteners could bring consumer back to CSD category.

Partnerships in the home carbonation category could prove critical for major CSD providers.

When investors look at the carbonated soft drink (CSD) they recognize a troubling trend that appears to be gaining negative momentum for the major soft drink providers. Coca Cola (NYSE:KO), PepsiCo (NYSE:PEP) and Dr. Pepper Snapple Group (NYSE:DPS) all witnessed further declines in CSD volumes last year and for the 3rd straight year as consumers seek out healthier alternatives to their core brands.

The consumer is slowly but surely coming to recognize the high sugar, sodium and caloric ingredients in CSDs and they have continued a shift away from these major brand names. In the latest reported quarter, Dr. Pepper's core CSD brands proved that the trend of consumers seeking healthier alternatives will likely continue. Let's take a look at what Dr. Pepper reported in Q4 2013:

  1. Dr. Pepper volume decreased 1%.
  2. Core 4 brands, which include TEN, declined 4% as a high-single digit decrease in 7UP and mid-single digit declines in Sunkist soda and A&W were partially offset by a mid-single digit increase in Canada Dry.
  3. Squirt and RC Cola both declined mid-single digits.
  4. Sun Drop declined double-digits.

The CSD results don't get any better when we look at PepsiCo's Q4 2013 results. PepsiCo Americas Beverage organic revenue was even in the quarter driven by an organic volume decline of 2 percent and the negative impact of concentrate shipment timing, offset by effective net pricing of 3 percentage points. Latin America beverage volume declined 1 percent in the quarter. In North America, non-carbonated beverage volume increased low-single digits in the quarter, and CSD volume declined mid-single digits in the quarter. For the full year, organic revenue declined 1 percent driven by an organic volume decline of 3 percent, partially offset by 3 percentage points of effective net pricing.

Coca-Cola was the only company of the major three CSD providers which showed YOY growth in the category although the growth in its CSD products slowed by 2 full percentage points from 3% in 2012 to just 1% in 2013. Much of this reduced growth rate came from its largest markets in the Americas region. In North America, sparkling beverage volume fell 2%, largely due to softer Diet Coke volume. The company has implemented a multi-faceted approach to address category headwinds and the various "misperceptions that fuel them". Keep in mind that even with an increase of price mix of 2% during the year, the CSD business produced operating income which fell short of Coca-Cola's stated goals for the year. It is alarming how callously the company's CEO Muhtar Kent describes the consumer's sentiment toward diet sodas which is in sharp contrast to most medical studies performed on these products.

The American College of Cardiology recently reported that studies do show an increased risk of heart issues with constant consumption of diet sodas. Women who drink the most diet sodas may also be more likely to develop heart disease and even to die, according to a new study published Saturday.

Researchers found women who drank two or more diet drinks a day were 30% more likely to have a heart attack or other cardiovascular "event," and 50% more likely to die, than women who rarely touch such drinks. "Our study suggests an association between higher diet drink consumption and mortality," said Dr. Ankur Vyas, a cardiovascular disease expert at the University of Iowa Hospitals and Clinic, who led the study. It's not an extreme risk," he added.

The major carbonated soft drink providers have been fighting this healthier-for-you beverage trend with the consumer for the last several years as CSD volumes show steady declines in volume. With the growing awareness as to what the consumer is putting into their bodies coupled with the additional taxes which are being levered against sugar sweetened drinks around the world, the problems facing the CSD category going forward seem insurmountable.

Artificial sweeteners have been a way in which the major beverage providers have tried to offset the trend of the consumer avoiding higher calorie CSDs, but as noted earlier, these artificial sweeteners come with health risks. By and large, the strategy isn't working well although beverage companies continue to look toward technological improvements to bring the consumer back to the CSD category.

Most recently, Senomyx has developed an artificial sweetener that has been declared safe for the consumer by the U.S. Food and Drug Administration. PepsiCo has the exclusive rights to the highly coveted product developed by Senomyx called Sweetmyx. "The new Sweetmyx flavor ingredient will enable the creation of lower-calorie beverages and foods that have reduced sweeteners without sacrificing taste," John Poyhonen, President and CEO, Senomyx said in a statement recently. In a memo on Senomyx from May, 2013, Bonnie Herzog, Managing Director, Beverage, Tobacco & Convenience Store Research, Wells Fargo Securities wrote that "if [PepsiCo] is able to address the changing consumer needs with lower calorie beverage offerings through technology, we think it could indeed help reinvigorate its CSD platform and potentially offer incremental growth opportunities." Herzog noted that Sweetmyx (which, at the time, was called S617) "offers the potential ability to reduce [high-fructose corn syrup] up to 35% and sugar up to 50% in beverage products without any effect on taste." While Sweetmyx offers PepsiCo hope for its declining CSD sales, it remains to be seen as to whether or not the consumer will adopt it in mass quantities.

In addition to technology breakthroughs, the major CSD providers are looking to diversify their revenue channels. The most recent developments surrounding these efforts are aimed at offering the consumer more choice through at-home carbonation. The at-home carbonation is being led by SodaStream International LTD (NASDAQ:SODA). around the globe. The SodaStream system allows the consumer to carbonate water at-home through its soda maker machines. The company also delivers on a number of other benefits for the consumer including offering a healthier alternative to traditional store-bought sodas, an eco-friendly benefit through reduced bottle and can waste and the functionality of a system that allows the consumer to make the beverages according to their very own specific tastes.

Just to give investors an understanding of how fast this category is growing, NPD reported recently that in 2013, soda maker units grew 30% with at-home syrups and carbonators more than doubling sales year-over-year in the United States. Four years ago, when SodaStream first brought the home soda maker systems to North America from Europe, people thought it would amount to just another fad item which would eventually die out. What has proven to be the most capitulating aspect of the product and the new category, however, are the healthier alternative ingredients used by SodaStream which result in offering the consumer 2/3rds fewer sugars, calories and carbohydrates and the fun factor.

The machines are popular with consumers because they offer the convenience of customizing beverages on demand, while saving money and helping the environment, said Debra Mednick, home industry analyst for NPD. Increased sales of the CO2 carbonators, which more than tripled in 2013, are a good indication that consumers are continuing to invest in, and use, soda making machines, the firm said. "This has momentum," Mednick said in a phone interview. "It has a fun factor. It's so customizable that you can even choose the level of carbonization." Beverage makers can offset the decline in overall consumption of traditional soda by introducing new products that capitalize on the at-home trend, Mednick said. For retailers, the consumer's need to repeatedly buy the accompanying products drives traffic into the stores, she said.

With near 5% household penetration in many European markets and over 4% in some Asia-Pacific markets, SodaStream is rapidly becoming the alternative to traditional store bought sodas and the major beverage providers have taken notice. Kraft was the first company to co-brand with SodaStream back in 2012 and since that time Campbells (NYSE:CPB), Ocean Spray, Del Monte, Sunny Delight, Eboost, Welch's, Skinny Girl, Whirlpool (NYSE:WHR), Samsung (OTC:SSNLF), Breville and Hamilton Beach have partnered with SodaStream. SodaStream's focus is clearly on healthier for you beverages as the flavor syrups they use contain real cane sugar and no high fructose corn syrup which is widely used by the major CSD providers.

Coca-Cola and PepsiCo have already understood the shift by consumers to these at-home carbonation systems and have strategically partnered with companies to diversify into this new revenue channel. Coca-Cola chose to invest over $1bn in Keurig Green Mountain (NASDAQ:GMCR) and their development of a Keurig Cold platform aimed for release in fiscal 2015. This announcement sent shares of GMCR soaring on February 5th as many believe the Keurig Cold will offer these two partners strong revenues for years to come. It is hard to understand how Coca-Cola sees offering the same decelerating growth by offering the same product, but in a different delivery method to the consumer, will be anything more than a short term fix, if that. Instead of offering the consumer a healthier product, it is simply offering the same product, but through a different form factor. I'm not sure the consumer will be willing to pay $150-$200 for a machine that makes the same Coke it can get for $1.45 a liter across the United States currently. There's no real fun factor in a machine that isn't designed to allow the consumer to make the beverage the way they like either. I've looked at the convenience factor also, not having to carry cases of Coke or two liter bottles from the grocery store to the home. But when I look more carefully at this notion, I understand there is no relative convenience to single-serve Coke through a brewer system when compared to simply opening a bottle or popping a can. So why do I need to spend so much money? This doesn't seem like a well-thought out plan, but the consumer will ultimately make the final decision.

PepsiCo has also partnered with a home carbonation manufacturer. PepsiCo has an equity stake, much like that of Coca-Cola's with Keurig Green Mountain, in a company called Bevyz Global. Bevyz has created a multifunctional beverage maker which dispenses hot, cold and carbonated beverages for the home. What we have come to learn, however, through conversations and product sampling/testing is that the Bevyz machine will launch later this year in select retail locations in the United States at a retail price of $299. The product will carbonate beverages the same way offered in a SodaStream system, by way of a carbonating cylinder. The Bevyz cylinder is a one-way cylinder that needs disposal and will come at a premium to that of the SodaStream system carbonating cylinders. Unfortunately, the Bevyz Fresh machine will not produce a Pepsi as the carbonation levels cannot achieve those required by traditional cola flavors. The Bevyz system, much like the proposed Keurig Cold system, doesn't allow the consumer to make a beverage which best suits their respective tastes. The consumer can't change the level of carbonation, the consumer can't dose syrup to the level they wish and the consumer will need a constant electrical current to make the beverage. One benefit of the Bevyz system is that some of the flavor choices are all-natural. Some say that another benefit is the Bevyz Fresh eliminates the need for multiple machines to produce beverages. But when we consider the cost of the average Keurig coffee maker and SodaStream soda maker combined, we come to accept that the Bevyz Fresh machine will still require the consumer to spend an additional $70 to get into the Bevyz Fresh system. For the aforementioned reasons we come to consider that Pepsi is merely a stake holder in Bevyz Global, but then again, so is Keurig Green Mountain. At a $299 price point and the expectation to sell units in the 10-15,000 range next year, the Bevyz Fresh is not a mass market system and this likely means that PepsiCo is still looking at its options. This speculation is fitting with Indra Nooyi's, PepsiCo's CEO, latest comments during the 4th quarter conference call with analysts in which she states the following:

"There's going to be one technology today that's functioning, but it's based on a system that's very different than what GMCR is thinking about launching. But we have to make sure that we align with partners who we are sure will commercialize the product. So we are working with multiple people. Stay tuned."

It is evident that the consumer is looking for healthier alternatives to traditional sodas and that the home carbonation category is where many consumers around the world are finding this alternative. From an investor's standpoint, it remains to be seen how effective these partnerships taken by Coca-Cola and Pepsi prove to be in the future. We would not be taking new positions in PEP or KO based on current partnerships until results from new technologies and partnerships prove to either offset weakness in traditional channels or show fruitful results in newly developing channels.

Disclosure: I am long SODA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.