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Summary

  • Coca-Cola's CSD sales continue to face headwinds.
  • Healthier alternatives provide major obstacles to overcome.
  • Branding issues and partnerships weigh on the company's future growth opportunities.

It has been well-reported that the beverage industry is continuing to undergo dramatic changes in consumption habits. What may have once been thought of as a fad in the beverage industry has turned into a seemingly never-ending trend away from traditional carbonated soft drinks. This trend is nearly a decade in the making and has caused cracks in the foundations of the major soft drink providers such as Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP) and Dr Pepper Snapple Group (NYSE:DPS). Last year's CSD volume sales continue to outline that the consumer is choosing healthier alternatives to traditional soft drinks. If investors haven't taken the time to read through Coke's or Pepsi's quarterly reports and transcripts, Beverage Digest's recent newsletter paints an ominous picture for the soft drink industry.

Beverage Digest Recently reported that the rate of CSD volume declines now puts the category back at 2003 levels, having lost more than a billion cases in volume sales over the last 10-year period. The major players in the category all lost CSD volume sales in 2013 as the rate of decline steepened YOY in the category. As the chart indicates below, Coca-Cola's CSD volumes fell 2.2% in 2013 while PepsiCo's volume declined 4.4% and Dr Pepper's volume declined 2.4% last year. Overall, the CSD category showed volume declines of 3% in 2013 after falling 1.2% in 2012 and 1% in 2011. Last year's results showed the 9th consecutive year of CSD volume declines, solidifying the reality which points to a direct change in consumption habits.

The silver lining for a company like Coca-Cola is that despite this categorical decline in CSDs, the company was able to increase its total market share. However, it should be recognized that the market as a whole is shrinking, and at some point, it matters very little if a company is growing market share of an eroding market.

Perception, or branding, is a big part of the problem that CSD providers face, and it is magnified by the major cola providers. Coca-Cola is one of the most iconic brands in the entire world, and even Coca-Cola hasn't been immune to the image problem facing traditional colas. With this in mind, and the consumer looking for healthier alternatives to traditional soft drinks, last year the company launched a campaign to highlight its commitment to health and wellness. In the 1980s, Coca-Cola used the advertising slogan "Have a Coke and a Smile" to boost sales. Last year's campaign, however, invited the consumer to have a coke and head to the gym. Why Coca-Cola thought that positioning its product in correlation to the need for exercise was a good idea is beyond this research analyst's scope of understanding, but the proof is in the pudding, and the results showed the campaign was ineffective in generating sales volume decline deceleration. New advertisements simply point out how Coca-Cola has reduced calories in its products over time and scaled down the size of cans; the ad implicitly announces that soft drinks aren't healthy, and that being healthy means drinking less soda. One could say that the ad campaign was the equivalent of marketing firearms at a funeral home. I would think these are not the correlations you want lingering in the consumer's mind about your products.

With Coca-Cola being the largest soft drink provider and most recognized beverage brand around the world, naturally the company bears the brunt of the scrutiny against sugar-sweetened beverages. In the past, the company has denied or deflected reports on the harmful effects from its sugar-sweetened beverages, but now and with a stern warning from the Surgeon General and localized promotional bans, such as the one offered by Michael Bloomberg last year, the company is forced to recognize fears and factual evidence supporting harmful effects from its sugar-sweetened beverages. A letter from a collection of organizations focused on the health and well-being of the average citizen to the Secretary of Health and Human Services, Kathleen Sebelius, in 2012, states the following:

Soda and other sugary drinks are the only food or beverage that has been directly linked to obesity, a major contributor to coronary heart disease, stroke, type 2 diabetes, and some cancers, and a cause of psychosocial problems.

It's not a myth folks. It's not fear and loathing, it's basic science, and all the evidence points toward harm to the human body caused by sugar-sweetened soft drinks.

It seems as though no matter what the major soft drink providers try in creating a healthier beverage, they still can't get the formula right, as ingredients in diet soft drinks are proving to be just as harmful as full calorie soft drinks, maybe even more harmful, as studies are now showing. The consumer is taking notice of these health risks associated with diet soft drinks as well. The latest results from Beverage Digest show severe declines in the diet soft drink category, with Diet Coke volume sales falling 6.8%, Diet Pepsi falling 6.9% and Diet Mt. Dew falling 3.1% in 2013. The ingredient most often cited as causing consumer aversion to diet soft drinks is aspartame.

With 2013 in the rear view mirror and the consumer trend in place, what is it that a company like Coca-Cola is doing to offset its declines in traditional soft drinks? Moreover, is there anything the company really can do in the long run, seeing how recent advertisements of its health and wellness campaign don't seem to be working? Coca-Cola sells Coca-Cola products; they have always been sugar-sweetened because that is what the consumer has largely desired, but a decade-long change has shown Coca-Cola to be ill-equipped to adapt to ever-changing consumer habits.

It's quite clear that Coca-Cola has an image/branding problem that is evidenced or highlighted in its 2013 sales review which shows the company's revenues declined by roughly 2% from the previous year.

If you are Coca-Cola, this is not a position you would want to find yourself in as a company and brand which is more than a century old and for which there is little room for error, as the company's product portfolio leaves something to be desired. A Seeking Alpha contributor, Michael Ranalli, recently highlighted this point of articulation based on recent statistics that show Coca-Cola's waning market share position in the growing sports drink category. According to Forbes, Gatorade commands 46% of the global sports drink market. In 2012, Gatorade's U.S. market share was 75% vs. Coke's 20% from its Powerade brand.

Innovation is a key factor for any company's long-lasting growth strategy, but it seems that product innovation in the beverage industry has been very much overlooked by Coca-Cola since the turn of the century. While the company is taking initial steps to use various different ingredients in its beverage formulas, the task is proving highly difficult and very capital intensive. Stevia has been looked upon as the potential savior for the CSD category, but what many have largely overlooked is its high cost of procurement and relative complexities related to the ingredient's malleability in cola formulations. For these reasons among others, the company has found it difficult to use Stevia in cola beverages and has been forced to pass some of its costs associated with the product onto the consumer. In Great Britain, Coca-Cola introduced newly formulated Sprite with Stevia last year. In June of 2013, Coca-Cola announced it had decided to go through with Stevia to be used in colas, and the result was a 2013 product launch called Coca-Cola Life.

The new Coca-Cola Life product is a mid-calorie offering which is selling only in the Argentinean market presently.

It is quite obvious that these new Stevia-sweetened Coca-Cola beverages aren't targeting Coca-Cola's largest market, which is North America. Admittedly, this is probably a good strategy, as the typical Coke drinker is highly skeptical of any change in Coke's taste as was proven years ago with the failed launch of New Coke in 1985. With roughly 42% of Coca-Cola sales coming from its North American business segment, innovation or taste reformulation to Coca-Cola Classic may be the obstacle the company is unable to overcome. If the company fails to adjust its formulation for Coca-Cola Classic in North America successfully, the trickle-down effect in volume sales will continue for years to come, more than likely. For this reason among others, the company has another trick up its sleeve, but this new trick doesn't seem to be any more reasonable of a strategy than changing the long-standing formula of its Coke brand.

For a number of years, Coca-Cola has tried to address the ever-changing trends in the beverage industry in an unsuccessful way. Each time there has been a shift in consumption habits, the company has proven to be behind the curve. This subjective viewpoint is actually evidenced in its failure to participate in the energy drink category as it rapidly caught fire in the late 1990s. Additionally, the adoption of water and enhanced water flavors proved to be another trend which resulted in the company purchasing Vitamin Water in 2007. Have you ever looked at the ingredients in a typical Vitamin Water offering? The label reads as follows:

Reverse osmosis water, crystalline fructose, cane sugar, less than 0.5% of: citric acid, magnesiumlactate and calcium lactate and potassium phosphate (electrolyte sources), natural flavors, vitamin C (ascorbic acid), gum acacia, vitamin B3 (niacinamide), vitamin E (alpha-tocopheryl acetate), vitamin B5 (calcium pantothenate), glycerol ester of rosin, vitamin B6 (pyridoxine hydrochloride), vitamin B12, beta-carotene, modified food starch, sorbitol.

So, it contains less than 0.5% of a whole large list of ingredients (none of which has anything to do with this particular flavor's namesake fruit, the orange), and thus at least 99.5% water, crystalline fructose, and sugar. Crystalline fructose, it turns out, is an even more processed version of high-fructose corn syrup; it provides a pure jolt of fructose.

The line in the sand has been drawn by the consumer, and now Coca-Cola is looking toward at-home carbonation as its saving grace. But it is using North America's leading single-serve coffee company as its partner for this venture. Keurig Green Mountain (NASDAQ:GMCR) will look to launch a Keurig Cold home carbonation system, and Coca-Cola has decided to take an equity stake and initiate a multi-level partnership with Keurig Green Mountain for this new home carbonation system. When we look closely at what this partnership aims to achieve and the obstacles which lay in front of the partnership and its proposed home carbonation system, we uncover some alarming facts and even more alarming speculations.

The Keurig Cold home carbonation system aims to deliver the same functionality of its Keurig single-serve coffee brewers. Essentially, a Keurig Cold consumer will be able to implant a K-cup of a Coca-Cola beverage into the Keurig Cold machine, and in less than 60 seconds, a Coca-Cola beverage will dispense into a glass at the push of a button. Sounds simple enough, but here's the problem and what most consumers will likely be asking themselves when presented with the product at participating retailers; "Can't I just open the refrigerator and pour from the bottle into a glass? Why do I need to spend $150-$200 on a Keurig to do this?" The consumer knows they need a brewer for a hot cup of coffee, because for a hot cup of coffee, they can't simply open the fridge and pour a hot coffee into a glass. This is obviously not the case for a cold beverage, and especially for a cold Coca-Cola, hence the problem in marketing such a costly system and in correlation to the consumer recognizing they will not likely ever be able to substantiate the cost per serving from a Keurig Cold system against traditional store bought sodas. With the average K-cup costing $.50-$.65 per K-cup/glass, Keurig Green Mountain and Coca-Cola are not only asking the consumer to consider a different form factor for receiving their beverage, but at a sharply higher price per liter.

Remember, the consumer has already well-established their growing aversion to the major brand colas and diet soft drinks, so what is the expectation from GMCR and KO in this product partnership? Are the two companies really saying, "We know you have been choosing the healthier alternatives to our Coke brands, but here is the same beverage, just at a higher price point." This seems like an unreasonable expectation. Unreasonable or illogical expectations are usually met with failure, although time will certainly tell with this new partnership.

As if the aforementioned obstacles aren't sufficiently bewildering, this product partnership has other notable issues to contend with. Once again, Coca-Cola is playing catch-up in a new beverage category called at-home carbonation. SodaStream (NASDAQ:SODA) is the worldwide leader in this category and has a growing household penetration rate that is evidenced with 25% household penetration in Sweden. In just the last 4 years, SodaStream has gained roughly 2% household penetration in North America and will likely close in on 3% in the coming 12-18 months as the company faces little competition in the region to date. SodaStream users, by and large, are the very consumers looking for healthier alternatives to traditional store bought sodas like those of Coke and Pepsi. Additionally, SodaStream users enjoy the simple economic benefits of a SodaStream soda maker's seltzer water function which delivers a liter of seltzer water at roughly $.25 compared to store bought seltzer which is roughly $.75 per liter. With the latest price increases of store bought Coke now at $1.44 for a 2 liter bottle in the United States, SodaStream Cola and like flavors are now effectively cheaper than Coke and Pepsi brand soft drinks, coming in at roughly $1.37 for 2 liters of SodaStream Cola. It should be noted, and with great relevance, that these new home carbonation systems find their greatest use in making plain seltzer water and not flavored soft drinks. It has been estimated that among the home carbonation user base, which is offered by SodaStream to be roughly 8 million users around the world, 70% of those users only use the home carbonation systems for making seltzer water. With this stated observation of the sales data from sales trackers like NPD Group and IRI Group, there seems to be a misunderstanding in the intended usage of these new home carbonation machines by the likes of GMCR and KO.

Moreover, because of the limited market share for the home carbonation category and the variety of flavored water enhancers on the market today, this data may be misleading. It is highly likely and possible that flavored water enhancers such as Kraft's (NASDAQ:KRFT) Mio, Coca Cola's Disanni Drops and others are being used in this category post the actual carbonation of the water at home by way of a home carbonation device. Given this greater consideration, we would lower the 70% figure by roughly 5 percentage points and allow for margin of error. So what does this mean in the grand scheme of the Coca-Cola/Keurig partnership? Well, it basically suggests that these home carbonation machines need to show value to the consumer and that they are primarily purchased for the use of making seltzer water. Coca-Cola and Keurig are going to have a hard time marketing these machines at $150-$200 vs. a SodaStream at $79.99-$100.00.

I think it is safe to say that the media has less understanding of the home carbonation category and what drives its growth than those leading this category, like SodaStream. Again, when the consumer is looking at purchasing one of these home carbonation products, they are likely asking themselves, "Why do I need this?" As the GMCR/KO product partnership currently rests in development, we know that it will likely ask the consumer to ignore simple facts:

1. Keurig Cold requires the consumer to spend more money per serving for a Coke.

2. Keurig Cold requires the consumer to accept it is still going to be offering the same Coke one can get out of a refrigerator without fumbling around with an electric machine for $150-$200.

3. Keurig Cold requires the average American family of 3-4 family members to assign a person to brew each 45-60 second drink while the others sit at the dinner table.

4. Keurig Cold requires this family to only drink one glass at lunch or dinner, unless of course you want to leave the table and go back to the brewer for another glass; so much for family time.

5. Keurig Cold requires the consumer to ignore the more cost effective and healthier-for-you choices in the SodaStream system.

6. Keurig Cold requires the consumer to accept the same carbonating form factor of zeolites, which are commonly used in fracking and cat litter.

7. Keurig Cold requires the consumer to house another kitchen appliance on the counter top that houses a maintained water reservoir and needs to be plugged in constantly to enjoy a cold beverage on-demand.

8. Keurig Cold's success is predicated on greater usage of the system beyond seltzer water due to the low margin results on the hardware system itself.

9. Keurig Cold skips one of SodaStream's greatest features in its syrup deliver form factor which allows for drink customization to suit specific user tastes.

10. Keurig Cold will not likely be able to offer differing levels of carbonation customization like that of SodaStream's and other home carbonation machines. Essentially, Keurig Cold eliminates choice and evokes the "drink it our way, one way" rule.

If there is a positive to be taken from the Keurig/KO partnership, it is probably to be recognized through historical partnerships involving Coca-Cola and its equity stakes that have been taken in the past. Coca-Cola took equity stakes in Zico Coconut Water and Honest Tea before an entire acquisition was enacted. Should a failed product partnership and equity stake in GMCR be realized, Coca-Cola would likely have a great desire to acquire GMCR at a much more reasonable valuation than where the company's stock price is trading today, and subsequently take back control of its brand. Unfortunately, as is the case with Vitamin Water and Zico Coconut Water, these are good business with gross margins that are unable to overcome sales declines in Coca-Cola's CSD business segment. GMCR's gross margins are substantially higher than those offered in the enhanced water flavor business segment, but sales of Keurig products are now growing at a single digit rate and have slowed dramatically since 2011.

Coca-Cola has a number of obstacles to overcome with respect to its overall business, and it's no wonder that with these obstacles come simultaneous opportunities for others to succeed in the CSD an LRB categories. The question remains, and the answer won't likely be revealed for a number of years, but I will propose the question one last time for readers to consider, "What can Coca-Cola do, at this point, to reverse the direction in its core and most profitable CSD beverage business?" Investors like me would like to know.

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.

Source: Coca-Cola's Decade-Long Struggle To Fix Its Declining CSD Business