Coke Follows Pepsi’s Lead in Changing the Model

Last April, PepsiCo (PEP) announced that it would purchase two bottling operations and gain absolute control over 80% of its North American bottling operations. Speculation swirled as to how Coca-Cola (KO) would respond, and today it announced that after nearly a year of negotiations it would in fact buy the North America bottling operations of its largest bottler Coca-Cola Enterprises (CCE). Both Pepsi and Coke had spun out these capital intensive bottling groups years ago, and the stockholders of KO in particular proved to benefit greatly as a result. However, they both believe that the market is changing as consumers prefer healthier and more extensive options than just carbonated soft drinks. These deals will give the companies much more control and flexibility in the distribution of their products.

Coke’s move reverses a strategy to divest bottling operations that began 23 years ago, although it never totally gave up all interest in CCE as it did still own 34% coming into the deal. Judging by the relative performance of the stocks during that time, it is clear that the strategy had proved its worth. Since CCE began trading in late 1986 it has returned just 249%, while Coca-Cola has enjoyed much faster growth as its stock advanced 1113% over the same period. In terms of average annual return, CCE gained just 4% versus nearly 11% for Coke, as a benchmark, the S&P 500 returned about 5.5%. When looking at the deal through the prism of history, it appears that Coke is trading growth for greater flexibility to address modern challenges. In the case of Pepsi, the opposite is actually true as the bottling stocks outperformed their former parent company.

The deal valued at about $12.2 billion is actually an asset swap that will give Coca-Cola 90% control over its North American bottling, but will decrease its ownership of European bottling. Coke is absorbing $8.88 billion worth of debt held by the bottler, but they say they will save $350 million in costs over the next four years and if the Pepsi deal provides any guidance it could be significantly higher. CCE shareholders will get a $10 per share special pay-out and will receive one-share in the European-focused company.

While Coca-Cola has achieved impressive growth in emerging markets, volume in North America has been in steady decline since 2005. It is still the largest and probably most important market, and Coke and Pepsi are confronting consumers changing tastes head on. Control over bottling operations gives them the opportunity to more quickly shift priorities and strategies as they see fit. However, the bottling operations come with lower margins and higher fixed costs than the old model of producing concentrate and selling that to the bottlers to mix and bottle it.

We had just upgraded CCE to Fairly Valued from Overvalued as of this week’s report, which gives us some concerns over the purchase price Coke is paying for this slower growth business line. However, it is clear that both Pepsi and Coke see a changing environment in North America, and they must proactively seek solutions to new challenges as the cola business evolves. Integrating the supply chain may put a slight drag on growth and apply pressure to margins, but in the end, unless Coke can more aptly serve North American consumers changing tastes, growth would continue to dwindle anyway.

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