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Stock Strategist

North American Soft Drink Market Regaining Its Sparkle

Bottler acquisitions bolster dominance, but we think Pepsi's the better buy.

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The deals that led to the vertical integration of both the  Coca-Cola (KO) and  PepsiCo (PEP) bottlers in North America have both now closed. From the moment Pepsi announced initial offers for both Pepsi Bottling Group and PepsiAmericas, we were strong supporters of the strategy, and we predicted in our research piece, "Bottler Consolidation: The Real Thing?" that Coke would follow Pepsi's lead and acquire  Coca-Cola Enterprises (CCE). In February 2010, Coke announced that it was to acquire CCE's North American business. While it is too early to give bottler integration the thumbs up, the early signs are positive. We think the acquisitions will cement Coke and Pepsi's place at the top of the soft drink industry for many years to come.

The North American market is a challenging one for soft drink manufacturers. Although it is one of the most profitable markets in the world, total consumption in North America is flat, and tastes are shifting from mass produced sodas to healthier noncarbonated drinks. These trends are disrupting the business model that has worked in manufacturers' favor for decades, causing complexity in the route-to-market. The recession threw another spanner in the works, with the retreating consumer spending more cautiously in the grocery store. The trade-up to noncarbonated beverages slowed, restaurant sales declined as more consumers ate at home, and fewer impulse purchases of single-serve soft drinks negatively impacted the convenience store channel. However, evidence from the third quarter points to an improvement in North America. Manufacturers' volumes stabilized in the quarter, and trading up to premium beverages resumed, although we think this is more likely the result of the economic recovery, albeit a tepid one, rather than bottler consolidation.

Volumes Stabilize in the Third Quarter
After several consecutive quarters of weak volumes, there were indications in the third quarter that consumption is rebounding in North America. PepsiCo has suffered three consecutive years of volume declines in its Americas Beverages segment, but reported flat volumes in North America in the third quarter, while Coca-Cola reported a second consecutive 2% increase in North American volume. These results are cycling weak comparables, however, as total liquid refreshment volume declined by 2.4% in 2009. However, they do indicate that the worst of the volume declines may be behind the beverages industry. Both PepsiCo and  Hansen Natural  (HANS) reported an improvement in the convenience store channel, indicating that consumers are making more impulse purchases for on-the-go consumption. However, with the unemployment rate still stubbornly high at 9.6% in the U.S., we think the rebound in the convenience store channel will remain anemic until the job market improves.

Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.