How Coke and Pepsi Make Profits Sweeter

It has been a difficult year for the soft drink bottlers that serve both  Coca-Cola (KO) and  PepsiCo (PEP). The companies have been affected not only by higher input costs for the raw ingredients and packaging materials used to manufacture their products, but also by rising fuel costs, which adversely affect direct-store-delivery operations. Further compounding the problem has been the fact that carbonated soft drink sales are in secular decline in their more mature markets, where consumers have been forgoing soft drinks in favor of vitamin waters, energy drinks, teas, and juices. It also hasn't helped that economic conditions in the United States and Europe have affected sales of refrigerated single-serve bottles of soda and water--one of the most profitable lines of products in those regions

Although these challenges contributed to the fair value estimate reductions we recently made for four of the bottlers we cover-- Coca-Cola Enterprises (CCE),  Coca-Cola Hellenic Bottling ,  Pepsi Bottling Group , and  PepsiAmericas --we don't want to leave investors with the impression that the bottlers will be OK once they get past these near-term issues. The capital-intensive nature of the bottling business has always made it extremely difficult for the bottlers to generate returns in excess of their cost of capital, and the conflicting needs of Coke and Pepsi to maximize their own profits has made it near impossible. Given the choice between Coke and Pepsi and any one of their bottlers, we'd choose the concentrate providers every time.

A History of the Beverage Giants and Their Bottlers
The soft drink beverage business is unique in the consumer goods universe, in that the companies that own the brands (Coke and Pepsi) have not been the ones handling the majority of the manufacturing and distribution. Much of this goes back to the early days at Coke and Pepsi, where the two beverage giants believed that fountain drinks would be their primary growth vehicle. Both risk-averse and penny-conscious, they sold the bottling rights to individuals who were willing to put forward the capital needed to build and maintain the bottling plants and fleets of trucks required to produce and distribute bottled soft drinks. All Coke and Pepsi needed to do was produce the concentrates and syrups sold to its two different distribution channels.

The beverage giants offered fairly lucrative terms--such as perpetual franchise licenses and fixed concentrate fees--in these initial contracts because they simply did not believe bottling would be that profitable of an endeavor. As time went on, though, supermarkets, convenience stores, and other retail formats started to litter the landscape, and Coke and Pepsi began to realize the true value of these bottling operations. They became eager to adjust the terms of the original deals in order to capture more of the returns. After all, Coke and Pepsi were doing most of the advertising and brand-building for their products, while the bottlers were only paying a fixed rate for concentrate that did little to compensate the beverage giants for all of their hard work.

By about the time the 1980s rolled around, Coke and Pepsi had managed to rework many of the original deals, which in most cases required buying the bottlers outright in order to change the terms. Keeping these capital-intensive operations on the books, though, was detrimental to both profit margins and returns on invested capital. So in the mid-1980s, Coke decided to spin-off its bottling operations in what has come to be known as the "49% solution." By spinning off 51% of its interest in its bottling assets, Coke no longer had to consolidate its bottling operations on its financial statements. This allowed the company to separate its lower-margin, capital-intensive bottling operations from the high-margin business that handles the production of the syrups and concentrates.

Because it costs relatively little to produce syrups and concentrates, Coke's profit margins and returns on invested capital have been significantly higher than those enjoyed by most of its bottlers. We highlight this using results during the last five years, shown in the following two tables:

Operating Margins
Operating Margins (Incl. Restructuring Charges)	2003	2004	2005	2006	2007	2008 (Estimated)
Coke and Its Bottlers
Coca-Cola (KO)	25.0%	26.2%	26.3%	26.2%	25.1%	26.0%
Coca-Cola Enterprises (CCE)	8.7%	7.6%	7.5%	-7.5%	7.0%	6.3%
Coca-Cola Hellenic	9.4%	10.0%	9.7%	8.5%	10.7%	9.8%
Coca-Cola FEMSA (KOF)	18.8%	16.6%	17.3%	16.4%	15.5%	16.1%
Pepsi and Its Bottlers
PepsiCo (PEP)	16.6%	18.0%	18.2%	18.3%	18.2%	17.8%
Pepsi Bottling Group	8.9%	8.6%	8.3%	8.0%	7.9%	7.4%
PepsiAmericas	9.7%	10.0%	10.0%	9.0%	9.7%	9.4%

ROIC
Returns on Invested Capital (Incl. Goodwill)	2003	2004	2005	2006	2007	2008 (Estimated)
Coke and Its Bottlers
Coca-Cola (KO)	27.4%	31.9%	32.4%	28.0%	26.9%	23.4%
Coca-Cola Enterprises (CCE)	5.1%	4.5%	4.6%	5.0%	5.1%	5.1%
Coca-Cola Hellenic	4.9%	5.0%	5.9%	5.7%	8.0%	7.9%
Coca-Cola FEMSA (KOF)	15.0%	12.6%	9.3%	13.8%	11.1%	14.0%
Pepsi and Its Bottlers
PepsiCo (PEP)	29.8%	29.4%	30.6%	28.9%	27.0%	26.2%
Pepsi Bottling Group	7.8%	6.1%	8.9%	10.0%	7.8%	6.6%
PepsiAmericas	6.9%	7.5%	8.1%	7.1%	7.2%	7.1%

Although Pepsi might have been slower to adopt the 49% solution for its own bottlers (it waited until the late 1990s to spin-off Pepsi Bottling Group), it was not as dependent upon beverage sales as Coke was during much of that time. The company had acquired Frito-Lay in the mid-1960s, and it also owned the Pizza Hut, Kentucky Fried Chicken, and Taco Bell restaurant chains until they were spun off to shareholders as Tricon Global Restaurants (now  Yum Brands (YUM)) in the late 1990s.

Why the Bottlers Bear the Burden
By holding a near-majority stake in their bottlers--and in some cases controlling all of the voting rights and/or directors sitting on a bottler's board--Coke and Pepsi have been able to exert a significant amount of control over their subsidiaries. By purchasing nearly half of their raw materials and finished goods directly from their parents, and receiving annual incentive payments from the beverage giants aimed at compensating them for the unequal distribution of costs and profits that exists between the two parties, the bottlers are not entirely in control of their own destinies.

Coke and Pepsi set the price at which concentrate and other inputs are sold to the bottlers, as well as the terms under which they can manufacture and distribute both carbonated and noncarbonated beverages in their territories. With the cost of concentrate, royalties, and finished goods purchased from the two major beverage producers making up nearly half of a bottler's annual cost of goods sold, it takes only a minor shift in the prices to have a major impact on profitability. Bottlers also have to absorb all of the other costs associated with manufacturing, packaging, and distributing Coke and Pepsi products, so it is not difficult to see why rising commodity costs have had such a huge impact on the operating profits during the course of the last year.

Making matters worse has been the fact that the business of bottling itself has become a lot more expensive and riskier today than it was 20 years ago, when bottlers were focused on just a handful of brands sold in only a few different package types. Innovation and the growth of noncarbonated beverages have led to a proliferation in the sheer number of products being produced and distributed to retailers. The complexity of producing hundreds of different offerings in what has become an even more competitive landscape for beverage sales has only increased the cost burden on the bottlers--adding even more strain to the complicated relationship that already exists between them and the beverage giants.

Although the bottlers do have the ability to take pricing increases in order to cover increases in their costs, it is often easier said than done. Unlike many of the packaged food firms, which have relied more heavily on package resizing to push through their price increases during much of the last year, the bottlers have had few opportunities to do the same. Absolute price increases have also been nearly impossible to obtain, especially in an environment where consumers are cutting back their spending on discretionary items in response to rising food and fuel costs.

The structural deficiencies inherent in the bottling business have only been magnified by the recent runup in commodity costs as well as the breakdown in the U.S. economy, and we don't envision the bottlers recovering anytime soon. Although some bottlers are at times better operators than others ( Coca-Cola FEMSA (KOF) would certainly qualify in that regard), we believe that the profitability of the bottlers in aggregate will always be secondary to the overarching profit needs of Coke and Pepsi. We believe this rings even truer today, as the bottlers continue to take the main hit from input cost inflation and the concentrate providers remain relatively insulated. This should certainly serve as an exclamation point to our long-standing argument that when given the choice between Coke and Pepsi and any one of their bottlers, we'd choose the concentrate providers every time.