Pepsi's Bids for Bottlers Shake Up Beverages Industry
Exploit the changing soft drinks landscape by investing in the category leaders.
Given our outlook for weak consumer spending growth during the next few years, the nonalcoholic beverages industry is a good place to look for investment ideas. Still, even this industry is facing change. In April 2009, PepsiCo (PEP) made offers totaling $6 billion to acquire the outstanding shares of Pepsi Bottling Group (PBG) and PepsiAmericas (PAS), two of its key bottlers. However, the following month, both bottlers rejected Pepsi's approach, claiming that the offer prices undervalued both companies' equity. The ball is now in Pepsi's court, with investors waiting to discover whether the beverage and snacks behemoth intends to raise its offers.
We think that PepsiCo's strategy will shake up the soft drinks industry in North America. In this report, we discuss the background to Pepsi's offers, we indicate why we think the offers are part of a sound shift in strategy by Pepsi, and we suggest ways for investors to exploit the changing landscape in the nonalcoholic beverages industry. But first, here's a little history.
A Brief History of Syrup Providers and Their Bottlers
The separation of manufacturing and distribution in the soft drinks industry has its roots in Coca-Cola's (KO) strategy in the early 20th century. Unwilling to take the risk of investing in bottling plants and a distribution network, Coca-Cola gave away the bottling rights of its popular soft drink, believing that demand for bottled carbonated drinks would not take off. However, the convenience and portability of bottled sodas created a surge in the popularity of Coca-Cola, and in order to expand distribution, the company created many more bottling franchisees throughout the United States, each with an allotted sales territory.
From the very beginning, the relationship between franchisee and franchisor was strained. The original contract between the two parties, signed at the turn of the century, fixed the price of concentrate sold by Coca-Cola to its bottlers. When the price of sugar spiked soon afterward, Coke's profits were squeezed, and the company threatened to tear up the contract. A battle with the bottlers ensued, leading to operational disruptions, until the bottlers blinked and were forced to accept variable concentrate prices. As demand for bottled drinks increased exponentially during the following 40 years, both Coke and Pepsi opted to continue the franchise model to grow the business in the U.S. and abroad, thus managing to exclude the assets of the bottling business from their financial statements. This early clash, however, proved to be the first of several disputes between the syrup providers and their bottlers.
In the mid-20th century, both Coke and Pepsi opted to consolidate some bottlers in order to ensure favorable contracts and to shore up underperforming distributors. In the 1980s, however, Coke spun off 51% of its interest in most of its bottlers, thus maintaining an influence over the firms, but still avoiding the inclusion of the bottlers on its books. In contrast to its great rival, Pepsi acquired more of its bottlers in the 1970s and 1980s, particularly in key North American markets, as it attempted to reverse its market share losses to Coke in the restaurant fountain drink market. Having succeeded to a certain degree by the late 1990s, Pepsi replicated Coke's "49% strategy," and spun off majority stakes in its bottlers.
The nonalcoholic beverages market has changed significantly since Pepsi spun off Pepsi Bottling Group in 1999. During the last decade, the carbonated beverages industry has been in decline in the U.S., as consumers have switched from sugary sparkling drinks to sports drinks, energy drinks, water, and juices. Noncarbonated categories have created a new battlefield upon which beverage manufacturers compete, with both Coke and Pepsi having launched and acquired a range of noncarbonated brands in recent years. Several of these products, such as fortified water and energy drinks, are sold at relatively low volumes because they target niche markets. Fewer economies of scale makes niche brands more costly for bottlers to distribute--an unattractive proposition for firms that already generate quite thin operating margins--and this has been the source of the latest conflict between the syrup makers and their bottlers. In some cases, the bottlers have crushed less profitable fledgling brands by refusing to distribute them.
How to Play Today's Nonalcoholic Beverages Industry
We think that the most flexible operators will be the most effective in the in the 21st century marketplace. Assuming the bids are ultimately successful, outright ownership of the distributors will give Pepsi control of around 80% of its North American beverage distribution and should allow the firm to invest in small or underperforming brands without resistance from the bottlers. This would allow for experimentation with a broader range of package sizes. We also expect the acquisitions to deliver significant cost savings and make Pepsi more responsive to consumer behavior--a valuable competitive advantage over its closest competitor, Coca-Cola. We think Pepsi is currently undervalued and that its stock offers significant upside to its current value whether the deals are closed or not.
Coca-Cola could soon find itself facing a rejuvenated, more nimble competitor if Pepsi can seize control of its bottlers. We think that if Pepsi can execute on the potential synergies and demonstrate that it has gained a competitive advantage in the marketplace, Coke would be forced to follow suit and consolidate its bottlers. Having said that, we still like Coke's long-term prospects, and we think that the firm will continue to generate excess returns on invested capital and wide operating margins for many years to come.
Smaller brands, such as Dr Pepper (DPS) and private label, could find competition for shelf space becoming even stiffer if Pepsi is able to influence retailers to carry more of its brands and give them more prominence in the store. Although we think Dr Pepper has room to grow, we would prefer to buy the stock at a deeper discount to our fair value estimate. For private-label manufacturer Cott (COT), if Pepsi does manage to squeeze out smaller brands from grocery store shelves, the company could find itself on the brink of financial distress, with declining volumes weighing further on the firm's negative operating income. Adding additional concern, Cott has $269 million of debt coming due in 2011 which could lead to financial distress depending on market conditions at that time.
Pepsi might raise its bids for its distributors. However, the original offers were close to our fair value estimates of the bottlers, and with no other suitors on the horizon, we do not expect Pepsi to increase its offer significantly. Furthermore, the original offers valued both bottlers at a 17% premium to their market value just before the offers were made. If Pepsi walks away from the acquisitions, there is a risk that the shares of the bottlers could tumble to their prior levels. At this point, we do not think that the bottlers offer an attractive level of upside for the inherent risk involved in holding the equity. Bottling and distribution is a low-margin, capital-intensive business, and we continue to recommend that investors look to the concentrate providers for exposure to the soft drinks sector. We think that Pepsi looks particularly attractive at this time.
Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.