Integration Nation

HOW BIG MERGERS COULD IMPACT RETAILERS.

Leave it to The Coca-Cola Co., Inc. to move last. The world’s largest beverage company recently reinforced its reputation for lumbering like the polar bears that once populated its television commercials when it announced plans in February to acquire the majority of its North American bottling network. Arch rival PepsiCo Inc. announced a similar plan last May – so far ahead of Coke that it completed its acquisition the day after Coke’s announcement.

But, while Coke may lumber like a bear, it also has the strength of one. Its move to vertically integrate its bottling, manufacturing and marketing operations seals the end of the franchise bottler model that has reigned for the last decade and signals potentially seismic changes for consumers, independent bottlers and retailers.

Coke, like PepsiCo and Dr Pepper Snapple Group before it, boasted that integrating its operations would save it hundreds of millions of dollars. But the acquisition’s potential benefits extend beyond finances. Both Coke and PepsiCo noted that their new alignments could simplify retailer relations, and PepsiCo echoed DPSG when the company said it expected greater agility when handling newly developed and acquired brands. All of this could transform the landscape for both ordinary sodas and innovative brands alike. In the long run, this new era of bottling integration may yield to a dynamic where each of the big three embraces a different model. But in the near term, retailers and the rest of the beverage industry will find themselves in the unenviable position of having to wrestle with three massive marketer/bottler hybrids.

Wayne Johnson, president and general manager of Johnson Distributing in Wisconsin, said he expects Coke and Pepsi’s integration to make his job harder. His firm deals primarily in beer, but also handles soft drinks. With the big guys “taking out one whole tier of the distribution system,” he expects their prices to drop by as much as a dollar per case, further squeezing his premium-priced brands. Johnson said he’ll continue to compete through strong independent brands and niche products – he recently added drank relaxation drink – but noted that every brand he distributes could follow the same path as SoBe, Monster and FUZE. In the long term, Johnson said, the emerging dynamic of top-to-bottom integration could seriously reduce his involvement in the non-alcoholic beverage sector.

What Johnson takes for bad news, Bill Eichorn, a beverage category manager for the Big Y supermarket chain in southern New England, said he welcomes. Like Johnson, Eichorn expects soda prices to fall. He also welcomed the opportunity to negotiate solely with Coke and Pepsi instead of also haggling with their bottlers – as long as how they distribute the product doesn’t change. He fears, though that they could “forget about smaller companies.”

That’s something that Coke and Pepsi will have to be careful about, said Kaumil Gajrawala, an equity analyst with UBS Investment bank. Gajrawala, who has watched the beverage sector since 2002, said regional bottlers have had a stronger history of serving regional chains, often through not requiring minimum order sizes.

And he had more bad news for retailers. While he expects Coke and Pepsi to use their top to bottom integration to quicken negotiations and streamline product delivery, he said he also expects them to use it to force higher prices. With salary and operation costs streaming from central offices, Gajrawala said, Coke and Pepsi will enjoy greater strength when dealing with retailers’ last resort on pricing disputes: delistings.

In November, Coke and Costco engaged in an unusually public battle when the wholesaler dismissed Coke from its shelves and informed customers that Coke wouldn’t meet Costco’s commitment to deliver bargains. The standoff lingered until December, when the two sides came to an agreement with no clear winner. Gajrawala said Coke may be able to endure a similar fight longer once it owns its bottlers.

While pricing may be a top goal (Gajrawala noted that “CSDs have lagged inflation for much of the past 20 years”), he expects Coke and Pepsi to make immediate changes in how beverages get to stores. He expects them to meet with retailers and work out the best plan to get product from the bottler to the shelf. Not every beverage product needs to go through direct store distribution, Gajrawala noted, a sentiment that Pepsi Beverage Company chief executive Eric Foss echoed during a recent conference call.

During the same call, Foss and PepsiCo CEO Indra Nooyi boasted the “Power of One” that PepsiCo would wield as a result of the merger. The integration, they said, will allow PepsiCo to dynamically cross-promote and deliver both snack and beverage products. For example, the company recently paired Pepsi Max with Doritos by creating a “Cease Fire” lime flavor of Max and co-promoting it with 1st, 2nd and 3rd Degree Burn Doritos flavors. On a less visible side, CEO Indra Nooyi noted that the company recently accommodated a retailer’s request for a snack and beverage shipment in less than 24 hours, when it could have taken weeks in the past.

“We’re creating the industry’s fastest, most flexible and most efficient food-and-beverage system. We’ll have the ability to more quickly implement and execute marketplace programs, and we’ll be especially well positioned to capture emerging growth opportunities,” said Larry Jabbonsky, Pepsi-Cola North America Beverages’ vice president of communications.

Gajrawala noted that the same scale, properly focused, could allow the Red and Blue systems to better incubate new brands, a problem area for both companies in the recent past. While PepsiCo scored RTD coffee dominance through its partnership with Starbucks, and Coke Zero surged by 20 percent to 116 million cases in 2009, both companies have suffered a number of flat national launches. PepsiCo’s list of stumbles and false-starts includes SoBe sublines Adrenaline Rush and No Fear as well as earlier incarnations of Amp Energy. The company even scrapped an Amp energy shot recently because it failed to capture public attention. The Coca-Cola Co. tripped over Surge and, later, Vault energy soda lines and saw partnerships with Godiva and Caribou Coffee fizzle as it tried to replicate PepsiCo’s pattern for RTD coffee success.

Under the franchise system, Gajrawala said, Coke and Pepsi needed to execute big launches, otherwise the economies of scale didn’t work. Additionally, large bottling systems like CCE could only give a product a few months to prove itself. Through vertical integration, Foss said PepsiCo will be able to test and tinker with brands in individual markets to see if they fit its DSD or warehouse systems. Gajrawala said this process could take years per brand, allowing the big companies to absorb small-scale losses to craft new products that resonate with the public.

Coke has so far avoided extolling the virtues of brand building under an integrated system. Instead, Coke CEO Muhtar Kent and Coca-Cola Enterprises CEO John Brock have kept their focus on nuts and bolts details. Kent and Brock have touted the $350 million in savings expected over the next four years. The pair also said they believed they can increase Coke’s sparkling beverage sales in the U.S. The company has increased sparkling beverage consumption in other developed countries, Brock noted, so why not domestically?

Coke’s silence might have something to do with the stage of the deal, Gajrawala said. PepsiCo has already completed its $7.8 billion bottler acquisition, while Coke only recently announced its own merger plan. The larger beverage marketer has also had to deal with Wall Street whiplash. Kent and other top brass at Coke argued for months that they would stand by the franchise bottler model, but claimed upon announcing the deal that it had been in the works for over a year. That sudden about face, reported the Atlanta Journal-Constitution, may have hurt Coke’s credibility with Wall Street analysts – though it has yet to hurt the firm’s share prices.

The ultimate outcome of these mergers may differ by company. While PepsiCo has trumpeted its “Power of One,” Coca-Cola executives have already murmured in the press about again leaving the bottling business. Gajrawala noted that difference would reflect the organizations’ divergent goals. Coke, he said, wants to be a global marketing organization, while PepsiCo will press its advantage by combining beverage and snack marketing.

In the mean time, DPSG may be the quiet winner in its rivals’ consolidations. The number-three player in the beverage field held distribution agreements with Coke and Pepsi’s bottlers, and their mergers triggered new rounds of negotiations. Already, one new contract resulted in PepsiCo paying DPSG $900 million for the right to continue distributing Dr Pepper and other brands. Gajrawala expects Coke to fork over a similar payment, and noted that the new contracts may have also given DPSG the opportunity to demand more attention for its brands. Additionally, he said, DPSG, with its limited saturation and national distribution, has a lot of “runway” to sell more product in North America, which is still the most profitable market in the world. DPSG even managed to grow its CSD sales by 4.8 percent in 2009, according to a recent survey from Beverage Digest, while Coke and PepsiCo saw declines of 3.9 and 5 percent, respectively.

Ultimately, the era of near-total bottler integration could be short lived, with each of the big three beverage producers favoring slightly different models, but its effects will likely be long lasting. Coke, Pepsi and DPSG could emerge from the other side of this episode with higher pricing and profitability on CSDs as well as greater agility in getting new products to the market. As each plays to its strengths, the new alignment could also result in greater parity.