Consumption of fizzy drinks in developed economies has been declining at a steady pace over the past few years. The situation in the U.S. is a key example of this trend – per capita consumption of soda peaked around 1998 at about 54 gallons a year. Today, the figure stands at around 44 gallons a year.  A major reason behind this has been the heightened consumer awareness about negative health impacts of sweet and fizzy drinks. This certainly is bad news for major cola companies Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP), both of whom have been reporting declining volume sales of fizzy drinks in developed markets for a few years now. But this trend also promises new opportunities for the beverage giants. Instead of sticking to their traditional sugar and fizz mixes, they can now try to earn more by providing healthier alternatives to consumers.
So what are consumers looking for these days?
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The two categories that have been substituting fizzy drinks are juices and sports drinks. Both PepsiCo and Coca-Cola have been attacking these segments quite aggressively over the past decade – rolling out newer brands, experimenting with new flavors, trying out new sweeteners to entice the calorie-conscious and, of course, increasing their marketing focus. This has helped them cope with volume losses from fizzy drinks to some extent in the recent past.
But it turns out there is a third category that is becoming far more popular with everyday consumers and is now posing a big threat to beverage companies’ profits — plain water.
The Trouble With Plain Water
At the peak of soda’s popularity in the U.S. in 1998, the average American consumed 44 gallons per year. This figure has now gone up to 58 gallons – a clear indicator of the switch consumers have been making. So what does this mean for the beverage giants? They certainly do have another window of opportunity here in the form of bottled water. In fact, out of the 58 gallons of water being consumed, more than 21 gallons are bottled. That’s nearly twice the volume of bottle water being consumed on a per capita basis in 1998.
Both Coca-Cola and PepsiCo have very recognizable brand names in the bottled water segment (Dasani and Aquafina respectively). Each brand controls around 10% of the US market, and as more consumers make the health switch in the coming years, we expect demand to surge at a fairly rapid pace in the next 5-6 years. But the trouble with the bottled water segment is that it is very difficult for the players to create any real differentiation. With nothing like taste or number of calories to back up a marketing message, pricing and availability ultimately become the defining factors for consumers. And that means the threat from smaller competitors is much more real in this segment as opposed to traditional fizzy drinks. The competitive pressures ultimately mean lower price realizations for Coca-Cola and PepsiCo and therefore lower profitability.
Flavored Water Offers A Solution
PepsiCo and Coca-Cola have been increasing their focus on the flavored or fortified water segment as it is offers greater differentiation while leveraging the trend towards increasing water consumption. The segment includes products such as PepsiCo’s SoBe Lifewater, which contains fruit flavors, vitamins, and herbal extracts. Coca-Cola’s counterpart is called Glaceau Vitaminwater, which the company recently started flavoring with the natural low-calorie sweetener Stevia in the UK.  In late 2012, Coca-Cola also launched Dasani Drops, a flavoring agent which allows consumers to modify the way their water tastes. (“With Dasani Drops, Coca-Cola Looks to Flavor its Global Water Business“, September 2012, Brandchannel.com))
We expect the two companies to keep on innovating in this segment to maintain their edge over smaller competitors who depend on plain bottled water. However, investors should keep in mind that bottled water currently contributes around 10% of total sales for both companies and any growth here won’t have a big impact on their total valuations in the short term. Over the short-to-medium term, juices and sports drinks will continue to be the companies’ key growth drivers in developed markets. Growth in the two companies’ traditional soda segment will have to largely come from emerging markets where consumption is growing at a fairly steady pace.
We estimate a $37 price for Coca-Cola, which is slightly below the current market price.Notes:
- “Water becomes America’s favorite drink again“, March 2013, USAToday.com [↩]
- “Coca-Cola Whets Thirst for Vitaminwater with Stevia in UK“, December 2012, Brandchannel.com [↩]