Fat Profits Make Beverage Makers A Target

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Long before Big Apple Mayor Michael Bloomberg launched his anti-obesity crusade against large-size sugary drinks in May, soft-drink makers grappled with a marketing truth: Americans are drinking less soda.

But beverage giantsCoca-Cola ( KO ),PepsiCo ( PEP ) andDr Pepper Snapple Group ( DPS ) have kept a close eye on Bloomberg's proposal to ban sodas in containers 16 ounces or larger in New York City, fearing the measure could spur similar restrictions elsewhere.

The companies have so far managed to grow profits despite the junk-food stigma hanging over high-sugar, high-calorie, carbonated soft drinks. One reason: They've avoided price wars in North America as soda consumption falls. "At least for now the cola wars are behind us," said Bernstein research analyst Ali Dibadj.

Internationally, soft-drink giants are packaging soda in smaller-size, higher-margin containers, and expanding further into energy drinks, sports beverages, flavored water and bottled tea.

Carbonated drinks are still the core business. Muhtar Kent, Coca- Cola's chairman and chief executive, calls the Coke brand "the very oxygen of our business."

1. Business

Beverages are sold through nearly every imaginable retail nook in the global economy.

Among the most profitable channels are the fill-a-cup type fountain sales seen in fast-food chains and convenience markets. Fountain drinks bring single-serve prices and forgo the cost of packaging in bottles or cans.

It is also the segment most at risk if measures like New York City's proposed ban on supersize sugary drinks spread to other localities. Coke has the largest exposure, with about 70% of the U.S. fountain soft-drink business, says Beverage Digest.

For soda sold in bottles, cans and other packages, trademark-brand beverage companies such as Coca-Cola or Dr Pepper sell proprietary concentrates to licensed bottlers. The bottlers mix and package the concentrated syrups with carbonated water and sweeteners, to produce beverages.

In emerging markets, concentrate sales continue to earn high margins for Coca-Cola and others, says Bernstein's Dibadj.

Bottlers have lower profit margins, usually ranging from 2% to 4%, wrote Standard & Poor's analyst Esther Kwon in a June report.

In North America, both Coca-Cola and PepsiCo have acquired their major bottling networks. Dibadj says they did so in part because the bottling networks weren't investing enough to innovate in their operations. "They bought the bottlers to fix them," he said.

Unlike fast-growing emerging markets, such as China and India, beverage consumption in the U.S. rose only 0.7% in 2011, says Beverage Marketing Corp. Carbonated soft drinks fell 1.8% from the year earlier.

A sweet spot, of sorts, was low-calorie Coke Zero, which gained market share in 2011 as soft-drink makers continued to fight back with diet-oriented products. Dr Pepper Snapple launched 10-calorie Pepper Ten in October 2011. It plans similar 10-calorie drinks in other brands, such as 7Up, RC Cola and A&W, says Kwon.

In March, PepsiCo debuted its 60-calorie-per-can Pepsi Next -- half the calories of a regular Pepsi.

• Name of the game: Develop thirst-quenching products that cut calories but preserve taste. "Mid-calorie offerings are an attempt to strike a balance between the sugar and calorie content of the drink and its taste," said S&P's Kwon.

2. Market

Noncarbonated beverages are a smaller market, but rapidly gaining share. In volume, energy drink consumption jumped 17.2% in 2011 from the year earlier, says Beverage Marketing. Ready-to-drink coffee rose nearly 10%, sports drinks were up 7.6%, and bottled teas gained 5.6%.

The beverage industry is highly consolidated, says Kwon, with Coca-Cola, PepsiCo and Dr Pepper Snapple representing about 88% of U.S. retail sales.

PepsiCo also owns Frito-Lay and Quaker Foods and is part of IBD's packaged foods group. Despite their size, the soft-drink giants don't rule in emerging categories.

PepsiCo and Coca-Cola own the two biggest sports-drink brands, Gatorade and Powerade. PepsiCo andStarbucks ( SBUX ) partnered in ready-to-drink coffees.

However, Lipton and Arizona are leaders in bottled teas, a market Snapple also pioneered. Privately held Red Bull andMonster Beverage ( MNST ) are the biggest makers of fast-growing energy drinks.

In 2011, Red Bull generated about $6 billion in revenue, making it roughly three times the size of Monster. Austria-based Red Bull's sports-related marketing has been a big driver of its growth, analysts say.

Monster, which gets roughly 14% of sales outside North America, aims to expand in Europe, Latin America and Asia. Its international operations have been losing money but may soon turn profitable, says Goldman Sachs analyst Judy Hong. Still, Monster faces a tough rival in Red Bull, whose goal is doubling its revenue in five years, says UBS analyst Kaumil Gajrawala in a research note.

One strength of Coca-Cola, PepsiCo and Dr Pepper Snapple as competition intensifies is their ability to push multiple brands. Coca-Cola has more than 500 brands across the globe, including Diet Coke, Sprite, Dasani water, Full Throttle energy drinks, Minute Maid juices, Odwalla smoothies and Powerade sports drinks.

"If you want to be a big company in the refreshment beverage industry today, you really have to be in multiple categories; you can't be a one-trick pony," said Gary Hemphill, a senior vice president at Beverage Marketing.

3. Climate

Coca-Cola denied in May that it was in talks to buy Monster. Still, the Atlanta-based giant has used takeovers to get a foothold in emerging niches.

In 2007, Coca-Cola acquired Vitaminwater maker Glaceau for $4.1 billion, a price tag some analysts thought too high. In 2009, China's government blocked Coca-Cola's $2.4 billion bid to acquire China Huiyuan Juice Group, the country's largest juice maker.

The company has upped its stake in British smoothie maker Innocent to 58% and last year acquired organic seller Honest Tea.

"With more than $20 billion in free cash flow generation likely in the next three years," S&P's Kwon says, Coca-Cola "will continue to look to bolster its position in the noncarbonated arena worldwide."

CEO Kent has told analysts it may pursue small "bolt-on" deals, similar to Honest Tea, but plans to focus on internal product development.

Beverages, like most food products, are a heavily regulated industry. The caffeine content of energy drinks as well as health claims for noncarbonated drinks are scrutinized by consumer groups.

In 2010, Coca-Cola was sued over Vitaminwater. The same year, the Food and Drug Administration warned Dr Pepper Snapple over food labels on green tea.

In May, a federal judge ordered the makers of POM Wonderful to cease making claims over the benefits of pomegranate juice.

4. Technology

Research and development is focused on producing low- or no-calorie drinks that use natural sweeteners instead of artificial ones like aspartame. Beverage companies aim to use natural sweeteners in both carbonated and noncarbonated products.

The industry has had big hopes for Reb A, a zero-calorie sugar substitute derived from the stevia plant, native to South America.

At PepsiCo, zero-calorie SoBe Lifewater; G2 Natural, a new Gatorade product, and Tropicana's Trop 50 orange juice, use stevia, says Kwon. Coca-Cola uses stevia-based sweeteners in Sprite, Vitaminwater, Odwalla juice and many other products.

However, Coca-Cola has yet to roll out a big-volume Coke product using stevia. It might be holding off, analysts say, because stevia sweeteners are said to have a licoricelike after-taste, which may put off some consumers.

5. Outlook

Overseas expansion is key. Latin America overtook North America as Coca-Cola's volume leader in 2007, notes Dibadj. Last year, the company pledged to spend $3 billion in India within three years. In June, it boosted its commitment in India to $5 billion through 2020, and the company still sees room for growth in Africa and Indonesia.

Monster, meanwhile, has just started marketing or will soon launch in Japan, South Korea and Hong Kong, as well as Chile, Peru and Ecuador in Latin America.

• Upside: If the economy improves, the profitable fountain business would benefit.

Companies may tap new consumer taste preferences, such as coconut-flavored water.

• Risks: C ambridge, Mass. is mulling a soda ban similar to New York's proposal. Other cities may follow. New York's ads showed gelatinous fat oozing out of a soda bottle.

Regulation of energy drinks or taxation of sugared products are also possible, analysts say. Soft-drink makers need to put up defenses, says Tom Pirko, an analyst at Bevmark Consulting.

"Brands are so iconic," he said. (Soft-drink makers) have been fighting back effectively. They don't want big soda to look like big tobacco."



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: DPS , KO , MNST , PEP , SBUX

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