North American Soft Drink Market Regaining Its Sparkle

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.

Winners and Losers in a Rebounding Soft Drink Industry
The rebound in the beverages market is likely to be characterized by the resumption of growing demand for noncarbonated beverages. The chart below shows that, while total consumption has remained flat over the last decade, carbonated soft drinks have represented a shrinking proportion of beverage consumption, while functional beverages such as bottled water and sports drinks have gained share.

Noncarbonated beverages are priced at a premium, however, and volumes fell 2.8% in 2009, at a faster rate than soda, which fell 2.1%, as consumers both bought fewer branded beverages, and traded down to cheaper categories. The economic recovery will lead to a resumption of the migration to still beverages, in our opinion, and we think Coke and Pepsi are best-placed to exploit this trend due to their leading brands in a wide range of categories. In the long run, we think the vertically integrated distribution model will set in stone Coke and Pepsi's place at the top of the industry, because they will have their finger on the pulse of the consumer's fickle tastes. The bottler acquisitions will allow these firms to more quickly adapt to changing consumer demands for product categories and pack sizes, and they will be able to experiment with new line extensions.

Hansen should also benefit from consumers paying up for premium energy drinks. It reported third-quarter net revenue growth of almost 24% year over year, boosted by international expansion and a rebound in volumes in the convenience store channel.

On the other hand,  Dr Pepper Snapple (DPS) could lose out in the recovery, because its portfolio is skewed to carbonated products. While these performed well in the downturn, we expect Dr Pepper to underperform its rivals in the take-home channels, although revenue from its renegotiated distribution deals with both Coke and Pepsi and growth in restaurant traffic should ease the pain

Emerging Market Exposure Essential
Although the North American market appears to be stabilizing, it is a very mature market with very few growth opportunities, and soft drink manufacturers must look to emerging markets for growth. Again, we like both Coke and Pepsi for their dominant positions in emerging markets. Pepsi is dominant in India, for example, while Coke is ahead of its rival in China. Local brands are still relevant, however, and we expect the beverage behemoths to acquire local brands in Latin America and Asia over the next decade in order to strengthen their portfolios in these important markets.

Ability to Leverage Distribution Best Practices to Snacks Makes Pepsi the Better Buy
Although Pepsi's third-quarter volume appears to justify our belief that the bottler consolidation was a sensible strategy to improve flexibility in manufacturing and distribution, the firm's competitive advantage may be short-lived because Coca-Cola is hot on Pepsi's heels in integrating its own bottler. We expect the integrated Coke system to provide stiffer competition going forward, particularly in emerging noncarbonated categories. Having said that, we think this is fully reflected in Coke's market value, while we believe Pepsi is around 10% undervalued, as the market is failing to recognize the opportunity to leverage best practices from the integrated system across the snacks business.