‘With commodity prices remaining relatively stable over the past year, we believe pricing will remain modest in 2010, potentially allowing for a return of U.S. beverage volume growth,’ said Christopher Collins, Associate Director at Fitch. ‘Internationally, U.S. beverage companies should see significant gains due to the weaker dollar.’
Bottler Consolidation – PepsiCo’s Bottler Acquisition Will Shake Up U.S. Distribution:
On Aug. 4, 2009, PepsiCo, Inc. (PepsiCo) announced an agreement to acquire the common stock the company did not already own of its major U.S. bottlers, The Pepsi Bottling Group, Inc. (PBG) and PepsiAmericas Inc. (PepsiAmericas), with an offer of cash and equity. The bid was valued at approximately $7.8 billion, a 30% increase from PepsiCo’s initial cash and equity offer on April 20, 2009. As a result of the first bid, Fitch downgraded PepsiCo’s Issuer Default Rating (IDR) to ‘A+’ from ‘AA-‘; affirmed PBG’s IDR at ‘A+’ and downgraded its PepsiCo-guaranteed notes to ‘A+’ from ‘AA-‘; and upgraded PepsiAmericas’ IDR to ‘A+’ from ‘A’.
PepsiCo’s acquisition of its major bottlers represents a significant shift in the company’s corporate structure and provides opportunities to rationalize distribution operations. However, Fitch is reluctant to conclude it portends a wholesale change in industry structure going forward. The return on bottling assets is lower than the return on concentrate manufacturing assets, which continues to provide an incentive to structure bottling and concentrate manufacturing as two distinct and separate entities.
More Benefits Seen for PepsiCo Acquisition of Its Bottlers than Coca-Cola Acquisition of CCE:
There are a number of reasons why this type of transaction is more compelling for PepsiCo and its bottlers than for The Coca-Cola Company (Coca-Cola) and its bottlers. First, Gatorade is sold in the same channels as products distributed by Pepsi bottlers but is distributed by PepsiCo (with the exception of G2), so PepsiCo has, in effect, duplicate distribution systems for its beverages. Coca-Cola has for the most part maintained distribution of its entire beverage line-up through its bottlers.
Next, the Pepsi bottling system is more fragmented than Coca-Cola’s. More costs can be taken out of a fragmented system through consolidation. PepsiCo’s new bottling entity will now be the size of Coca-Cola Enterprises, Inc. (CCE). Corporate functions performed by both Pepsi bottlers can be rolled up into PepsiCo’s existing corporate structure, but Coca-Cola would only be able to take on CCE’s. By buying the two largest bottlers, PepsiCo is also taking out competitors for purchasing smaller bottlers looking to exit the business.
Third, in a consolidated system negotiations involve fewer players and therefore take less time to gain agreement, which may be why the Pepsi system has lagged in system efficiency efforts. PepsiCo and its bottlers have established a purchasing cooperative to gain purchasing power in buying raw materials. While the Coca-Cola system also has a purchasing cooperative, the Coca-Cola system has undertaken more initiatives, from experimenting with concentrate pricing frameworks to engaging in greater supply chain cooperation. Through a purchase, PepsiCo can effect similar changes but keep a substantial portion of the cost savings (less synergy and control-related premiums paid to PBG and PepsiAmericas shareholders).
Finally, PepsiCo earns a much greater share of its revenues and operating profit from the U.S. market than Coca-Cola does. While PepsiCo has been pursuing international beverage acquisitions, those investments will take time to produce significant operating income. PepsiCo is also running into entrenched competition from Coca-Cola, which has a more established position in a number of countries in which PepsiCo seeks to have a greater presence. A cost-cutting strategy in the U.S., PepsiCo’s largest beverage market, is likely to be more accretive to operating income sooner, because the benefits are easier to forecast and the execution period is shorter. If Coca-Cola is contemplating an acquisition of Coca-Cola Enterprises, Inc. (CCE), Coca-Cola will likely evaluate the outcome of PepsiCo’s transactions to determine whether the synergies justify the acquisitions, delaying any potential acquisition by Coca-Cola until 2011 at the earliest.
PepsiCo Transaction and Branded Water Losses to Lead to Greater Warehouse Distribution:
Fitch believes the biggest near-term industry change in the U.S. will be the potential for greater warehouse distribution. Developments in the bottled water segment, the second largest after carbonated soft drinks (CSDs), have led concentrate manufacturers and bottlers to conclude the most efficient and cost-effective distribution of case-pack bottled water is retailer-owned warehouse distribution.
Sustainable price gaps between private-label and branded products have seemingly narrowed in the most commodity-oriented beverage, bottled water. In 2008, as the recession deepened, consumers switched rapidly to value-brand and private-label bottled water in future consumption channels. Private-label volume increased roughly 15%, which is stunning in comparison to total bottled water volume growth, which turned negative, albeit less than 1 percent, for the first time. Private-label and value-brand bottled water gained more share in 2009, and Fitch expects the trend to continue in 2010 as consumers are expected to remain cost-conscious.
Bottlers have long complained case-pack water is a low margin business. However, maintaining prices to cover the costs of direct store delivery (DSD) distribution has allowed private-label and value-brand bottled water, which utilize warehouse distribution to cut costs and consequently lower retail prices, to pick up significant share in the future consumption channels. With little traditional competition from private-label brands in most beverage categories, concentrate manufacturers, with the exception of the Coca-Cola system’s distribution of POWERade, have been hesitant to try to change distribution. Additionally, bottler disputes over territory, as in the case of POWERade distribution, have made experiments with warehouse distribution untenable. However, PepsiCo’s acquisitions make it more likely the Pepsi system will work out a deal to at least experiment with warehouse distribution for case-pack Aquafina. The Coca-Cola system’s supply chain initiative, Coca-Cola Supply, and fountain sales rationalization efforts, Fountain Harmony, lay the groundwork for greater cooperation across the Coca-Cola system. Fitch expects the PepsiCo consolidation to put pressure on the independent system bottlers to more readily consider agreements for warehouse distribution.
Dr. Pepper Snapple Group – The Victor in PepsiCo’s Bottler Acquisition:
The biggest winner in the bottling consolidation may be Dr. Pepper Snapple Group, Inc. (DPS). Because of change of control provisions in its bottling contracts, DPS is able to renegotiate the distribution of its products through PBG and PepsiAmericas. In certain markets, distribution of Dr. Pepper determines leading market share between a Coca-Cola and a Pepsi bottler, making it valuable to both the Coca-Cola and Pepsi systems. PepsiCo most likely wants to keep Dr. Pepper distribution to keep its new acquisitions as profitable as possible, and Coca-Cola bottlers would like Dr. Pepper distribution to increase cold-fill line utilization, which has been under pressure due to multi-year CSD volume declines.
DPS could potentially extract a sizeable franchise fee for Dr. Pepper distribution. However, DPS faces a difficult strategic choice between Coca-Cola bottlers and the PepsiCo captive bottlers. PepsiCo has stated its desire to have its bottlers focus more attention on growing PepsiCo-owned brands, which could prove detrimental to Dr. Pepper distribution. However, Coca-Cola bottlers bottle and distribute Fanta and would probably decline to bottle and distribute DPS’ competing Sunkist and Crush brands. If DPS keeps its current distribution deals for Sunkist and Crush with PBG and PepsiAmericas, the brands’ importance may be diminished within the PepsiCo bottlers if Dr. Pepper distribution is awarded to a Coca-Cola bottler(s).
Soda Tax – Depending on Size, It Could Be Severely Disruptive But Implementation Remains Unlikely:
In an effort to develop sources of revenue to offset the recent efforts to reform health care, a so-called soda tax, a tax on sugary beverages, was introduced by members of Congress. With the price-elasticity of demand for retail beverages generally believed to be 0.8 to 1.0, any tax would be operationally and financially disruptive. A 10 percent tax would have an 8 percent to 10 percent negative volume impact, and unlike the tobacco industry, beverage industry participants would be unable to raise prices to make up for lost revenue from volume declines due to the relative elasticity of beverages. The Congressional Budget Office estimated a quarter cent per ounce excise tax would raise approximately $50 billion over 10 years. A one cent per ounce tax on sugary beverages, an extreme measure some health advocates have endorsed, could lead to volume declines for some packages that could potentially be in excess of 50 percent. A two-liter bottle that retails at $1.30 with 67.6 ounces would command a 52 percent tax under a one cent per ounce tax scheme. However, in a victory for the industry, the soda tax seems to have been tabled. The beverage companies were not the only ones poised to lose under a soda tax scheme. The farm business lobby’s members were firmly against the tax as it would have hurt its members due to the main caloric sweetener of U.S. beverages being high-fructose corn syrup, a derivative product of corn.
Operations – Volume Comparables Become More Favorable, Weak Dollar to Provide Reporting Boost:
Due to price increases taken to offset commodity input cost inflation in 2008, Coca-Cola and PepsiCo along with their bottlers are reporting North American total beverage volume declines of low to mid-single digits year-to-date 2009; DPS reporting a comparable volume increase of 4 percent is an exception. Consumers also engaged in category trading, looking for value as CSDs outperformed non-carbonated beverages. Fitch expects category trading to continue in 2010 as consumer spending remains constrained. In the U.S., Fitch believes pricing will be modest due to relative stability in commodity prices and bottlers hedging most of 2010 variable input costs. With pricing expected to be negligible, volumes are expected to grow at the long-term rate of around 1 percent.
Outside of the U.S., volume growth is expected as economies rebound from global recessionary lows. Companies’ international segments are poised to post significant reported gains due to a weakening U.S. dollar. Coca-Cola is the greatest beneficiary of a weak dollar, given roughly 75% of its revenues are generated outside the U.S. Allowing for PepsiCo’s acquisition of its bottlers, industry credit measures are expected to remain stable if not improve slightly.
Following is a list of Fitch-rated issuers and their current IDRs:
–Coca-Cola Company (‘A+'; Outlook Stable);
–Coca-Cola Enterprises, Inc. (‘A'; Outlook Stable);
–PepsiCo, Inc. (‘A+'; Outlook Stable);
–Pepsi Bottling Group, Inc. (‘A+'; Outlook Stable);
–PepsiAmericas, Inc. (‘A’+; Outlook Stable).
Additional information is available at ‘www.fitchratings.com’.