Functional Solution

Bottled water has matured as a category – and it’s got the headaches to prove it. Retailers, take heart, though: a little flavor and some vitamins will keep the pep in your step.

Last summer, concerns over the use of non-renewable resources in the manufacture and shipping of PET bottles from as far away as the South Pacific, the lack of comprehensive recycling programs for those products, and the “revelation” by PepsiCo on its Aquafina bottles that it comes from public water sources all combined to put the bottled water industry in an uncomfortably hot spotlight.

Recently, the city of Chicago began considering a five or ten-cent sales tax on bottled water. Other municipalities have stopped buying bottles for their employees altogether. Nationally prominent restaurants have dropped bottled waters from their menus, despite the bill padding those sales provide. For consumers, the “Sigg” refillable water bottle was one of the chic purchases of the summer.

The bad publicity hasn’t halted bottled water’s growth, but it has slowed it down considerably – while the category had been growing at more than 15 percent annually, to more than 8 billion gallons last year, according to Beverage Marketing Corp., Nestle Waters USA CEO Kim Jeffery recently revealed that he projects sales growth ending up 7 to 8 percent this year.

That kind of growth is still nothing to sneeze at, especially given the sorry state of products like CSDs. But the bloom is off the rose: the bad publicity put the industry on the defensive for much of the year, and Jeffery and his cohorts have taken a pugnacious tone with the industry’s critics (although they have also pointed out improvements in packaging that will decrease the category’s environmental impact).

And the environmental impact issue is only the least of their concerns: the most devastating is the idea that the product may be no purer than the water that comes out of most municipal taps. While the industry’s growth has come largely at the expense of CSDs, and not from tap water, now that consumers are drinking more water, if they decide to source that water from their taps rather than retailer coolers, it could drastically hamper the bottled water industry in the years to come.

But if pure bottled water is on the ropes, at least the adulterated stuff is running toward the ring. Well, “adulterated water” might not be the best name for it, but what’s in a name, really? You can call it “Enhanced water,” “Value-added,” “Flavored,” “Complex” or “Functional.” What you’re really talking about is some sugar, or coloring, or flavoring, or nutritional additions. And these products, ranging from Glaceau’s Vitaminwater and its West Coast doppelganger, Function Water to products like Fruit2O and AromaWater, are hot.

Even better, because of the addition of these other elements, enhanced waters are insulated from the sticky accusation that the same product could be poured out of the tap at home, and it sells at an even higher premium than plain old bottled water, which is often thrown down on pallets as a value-pack loss-leader, anyway. On that financial front, Beverage Marketing Corp. has predicted that “value-added water” will take more than 22 percent of single-serve water dollars by 2011 – an increase of close to 50 percent. While part of that estimate must take into account the

higher ring of enhanced products, there’s also the potential that the growth will be greater because the product hasn’t yet hit all over the country. But it’s coming.

STILL SPREADING

Upon a recent visit to Manhattan, Frank Harrison, CEO of Coca-Cola Bottling Co. Consolidated, which covers much of North Carolina and its adjacent states, got a glimpse of what the future could be. Vitaminwater – the prize enhanced water that the Coca-Cola Co. landed for $4.2 billion earlier this year, was everywhere, he said, comparing its presence in New York City to that of Coca-Cola’s flagship Coca-Cola Classic in his home territory.

“In the Southeast we don’t have any kind of penetration yet,” Harrison said of Vitaminwater. “It’s doing extremely well but there’s low per- caps and poor distribution.”

Both Coke and PepsiCo chased Glaceau, even though Pepsi already had thrown its own version of Vitaminwater, SoBe Lifewater, onto store shelves.

Since PepsiCo, which has now positioned Lifewater as a value alternative to Vitaminwater, lost out on the company, however, its reaction has served to underscore its understanding of the importance of the functional segment. PepsiCo has come back with a portfolio-based approach, trying to build deeper inroads into the functional arena off its Gatorade platform. While Propel fitness water has arguably been the strongest non-Glaceau performer in the category, its tight association to workout culture makes it hard to extend the brand off the athletic field. So the company has launched G2 – a Gatorade drink with half the calories, intended for the casual user.

Rolled out in early December, the returns on G2 are not yet in. There’s little history of success for mid-calorie beverages (i.e. C2) – but Pepsi has to marshal its forces. It’s likely going to be in for a long fight.

The depth of functional waters is such that its growing as fast among children as it has with adults. Glaceau will roll out a “fridge-pak” of 12 oz. bottles next year, furthering its strategy to be an omnipresent lunch box product.

PAIN FOR INDEPENDENTS

The potential growth of Vitaminwater will have its victims, however. Having Coke yank Glaceau into its own distribution system was a haymaker to many independent beverage distributors.

The move “took the profitability out of one-half to two-thirds of the (independent) companies in the system,” Phoenix distributor George Kalil said recently. But what has been lost in blowback has been regained in opportunity – those same distributors are now in search of another hit; someone will have to gain share soon, either in the form of a next-generation functional water product or something from the tea space.

“This could be like a Gatorade situation where the first guy in gets all of the share,” Kalil said. “But basically, a lot of people want to be in it.” And they’ll have that opportunity to get in. For functional waters might be even easier to make than the highly-electrolyzed, purified, Aquafina-type stuff. The line between flavor companies and ingredient providers is narrowing – large service providers like Wild Flavors and International Flavors and Fragrances have ramped up their abilities to provide flavor and nutrition combinations to suit an off-the-cuff line extension – and that preparation lowers the barrier to entry for many new enhanced water products – some of which might even be thematically different enough from Vitaminwater to dodge the dreaded “me-too” syndrome.

That kind of flexibility fits into the build-out of SKU variety that industry observers see as the wave of the not-too-distant future. A recent report from Morgan Stanley’s Bill Pecoriello pointed to the magic number of 1,000 SKUs as the target number for many distributors. That ability to handle variety has to take into account growing fluidity – products quickly coming into and out of the market, a la Japanese beverage culture.

Of course, the makers of straight bottled water are nowhere near close to giving up the business – they understand they should be able to ride the product’s momentum for quite some time. Jeffery has made it clear his company is going to be playing to its strength, which is a portfolio of regional still water brands.

But Nestle has also established itself as the long-term winner of the still water explosion because of its focus on that single product and its innovation in the packaging and pricing sphere. The company appears to have won a six-year, three-way price war with Dasani (Coca-Cola) and Aquafina by continuing to grow its share in the midst of price cuts. And Nestle continues to focus on its arms buildup: “we’ll be building two or three new (bottling) plants a year,” Jeffery told his audience. “Big plants.”

GOING FUNCTIONAL

While the success of Nestle would seem to be an argument for the health of still water brands, it also means that the focus for the other two water giants is changing; Coke has channeled the Dasani label into several new functional areas via names like “Refresh + Revive,” “Cleanse + Restore” and “Defend + Protect” – monikers that can be applied to its intended effect on the brand’s shelf space as easily as they can to any biological outcome. In Vitaminwater, the company has the product that can enhance the rest of its functional and flavored portfolio, one that also features an expanded presence from Coke’s other recent pickup, Fuze Beverage Co.

PepsiCo’s approach with Aquafina, still the world’s top-selling water brand, is less geared toward the functional arena so far, but the company does continue to tinker with new flavors for Aquafina Alive, its functional offshoot, as well as Aquafina Flavors and Aquafina Sparkling. And with that Gatorade-based portfolio, as well as its SoBe products, the company has plenty of irons in the fire.

Even Cadbury Schweppes – soon to be Dr Pepper/Snapple Beverage Group – is showing signs of life, releasing a new water product line via Snapple that promises various functions and flavors.

Meanwhile, focusing on the advances of the “Big Three” as they slug it out in the functional arena ignores an existing infrastructure of companies (note Brand News in the following pages) that have been in the business for significant lengths of time. With the loss of Glaceau, many new functional waters have been – or can expect to be – snapped up by other distributors, while others are likely to enter the scene in the coming year. High function nutriceuticals like Borba Skin Care Water and Vitamin + Fiber Water are also due to arrive, and protein and appetite-suppressant products are continuing to thrive.

So there you have it. At the end of the year, functionals are functioning. Flavors are getting pretty tasty. Protein and fiber are satisfying, and vitamins are making for a healthy bottom line. The future might not be so clear, after all.