Soda Makers Wonder: Where Could Growth In U.S. Come From?

The U.S. carbonated soft drinks (CSD) market declined for the tenth consecutive year in 2014. As customers continue to shift away from sugary, calorie-filled sodas to alternatives such as sports drinks, carbonated water, and ready-to-drink teas and coffees, at no time soon is the CSD market expected to rebound strongly. However, the rate of decline fell last year, on increased customer spending on perishable products, amid an improving economic environment in the country, reflecting that there might be some fight left in the CSD category. Why this category is particularly important is because approximately 41% of the industry-wide volumes in the U.S. liquid refreshment beverage market, which stood at 30.88 billion gallons last year, is constituted by CSDs alone, as per our estimates. In turn, this segment in the country’s beverage market is also pivotal for juggernauts The Coca-Cola Company (NYSE:KO), PepsiCo (NYSE:PEP), and Dr Pepper Snapple (NYSE:DPS), which together command 87.6% of the market share. Let’s see why…

43% of Coca-Cola’s net revenues came from the U.S. last year, and CSDs in the country alone form approximately 15% of the company’s net volume sales. On the other hand, 25% of PepsiCo’s last year revenues were from CSDs, and the U.S. alone formed 51% of the net revenues. Coca-Cola and PepsiCo derive a considerable chunk of their sales from international markets, but the domestic market still contributes approximately half of their respective sales. Especially now, when most foreign currencies are depreciating against the U.S. dollar, and with increased volatility in some of the key emerging markets such Russia, China, Ukraine, Venezuela, and Brazil, growth in the home country has become more crucial for these players. Domestic growth is, in fact, the most crucial for Dr Pepper, which derives almost 90% of its top line from the U.S., and 80% of its net volume sales are from CSDs.

We estimate a $44 stock price for Coca-Cola, which is above the current market price.

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The rate of decline of CSDs in the U.S. might have fallen in the last year, but this can be tied to a general upbeat business environment in the country, and higher customer spending capabilities, also boosted by the lower fuel prices. What this statistic also tells is that despite improving conditions in the U.S., the CSD market continued to decline, and couldn’t shake off this decade-long-trend. Introducing low/no calorie sodas has also not gone down well with customers, which is evident from the following table, which shows how the Diet products have fared even worse. This is mainly as customers remain skeptical about the safety aspects of the low calorie drinks, especially due to the usage of artificial substances, such as the sweetener aspartame.

The only slight exception to the worse-fall-for-diets case is Coke Zero. A major win for Coca-Cola in the last quarter was the 5% growth in its diet drink, Coke Zero, which along with the new Coke Life (which uses the natural sweetener Stevia), represents how Coca-Cola might be ahead of its competition in terms of low calorie soda sales. PepsiCo just announced that it is removing aspartame from Diet Pepsi, and replacing it with sucralose, better known as splenda, which has a slightly better customer perception than aspartame. On the other hand, Dr Pepper had earlier in 2014 announced plans of launching its naturally-sweetened 60 calorie sodas in the domestic market, but the products are still being tested in regional markets. The diet category forms roughly one-fifth the net revenues for the overall CSD category, according to our estimates. Revenues for this category are expected to trace a bell-shaped curve through 2000-2020, with the peak in 2009, and decline ever since. In 2015, diets are estimated to decline another 5%. ^[1]

So where could the potential growth come from?

The answer might be effective product pricing and packaging. One notable trend in 2014 was the rise in unit prices of soft drinks, which meant that higher revenues per unit case made up for declining volume sales. Retailers and beverage makers could increase product prices due to the upbeat economic environment in the country. In addition, more emphasis on the higher-price-per-unit smaller packs has also boosted the average revenue per unit for beverage makers.

We estimate a $98 price for PepsiCo, which is above the current market price.

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Coca-Cola put more emphasis on sales of its 7.5 ounce packs, which have higher price per unit compared to value packs. As the company continues to drive top line growth through premiumization of sodas, and higher proportionate sales of small bottles and cans, net domestic revenues grew 6% year-over-year in Q1. PepsiCo also managed to offset the 1% volume decline in PepsiCo Americas Beverages in Q1 due to 3 percentage points of effective net pricing. On the other hand, while Dr Pepper has also gained due to a positive product and package mix, there is still more opportunity for the company to boost its revenue growth, as its pricing is still lower than its peers. A positive mix is what fueled top line growth for the company more than positive pricing. Dr Pepper is not completely in the smaller packages segment, which has been a growth driver for both Coca-Cola and PepsiCo in terms of higher price per unit in recent quarters. This means that Dr Pepper has further growth opportunities when it comes to CSDs, and could emphasize more on the smaller packages and further raise its product prices to spur revenues.

We have a price estimate of $79 for Dr Pepper Snapple, which is above the current market price.

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Coca-Cola not only leads the U.S. CSD market in terms of volumes, but has also shown more growth in recent times. This might be mainly as the company has a lot of wins in terms of product campaigns, and is mostly the first to spearhead pricing initiatives. Dr Pepper has for years been the trailing third in the U.S. CSD market, behind Coca-Cola and PepsiCo, commanding 17.7% market share as per our estimates. But seeing how it is easier for a smaller company to gain share, rather than for Coca-Cola to expand its share to over 50%, and that Dr Pepper also has opportunity to raise its product prices, there is potential growth for the company, too. In all of this, PepsiCo might have relatively weaker CSD growth going forward, which might give more fuel to the agenda of activist investors to spin-off the food and beverage giant’s drinks business.

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