Coca-Cola’s Carbonates Offer Growth Despite Unfavorable Market Trends

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KO: The Coca-Cola Company logo
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The Coca-Cola Company

Carbonated soft drinks (CSD) have declined for nine straight years in the U.S. as consumers continue to restrict calorie consumption and switch to more natural means of quenching thirst. This category forms around 43% of the country’s liquid refreshment beverage market by our estimates, and is mature, with Coca-Cola, PepsiCo and Dr. Pepper accounting for almost 90% of the industry-wide volumes. With more and more consumers choosing to avoid sugary soft drinks, the leader of this market, The Coca-Cola Company (NYSE:KO), also witnessed a 2.2% fall in CSD volumes in the U.S. last year. [1] Coca-Cola derives close to 20% of its sales from the domestic market, and with volume growth in core carbonates remaining flat to negative in recent years, the beverage maker has looked to further expand into emerging markets and invest in growing beverage segments such as bottled water, ready-to-drink tea, sports and energy drinks. However, defying current market trends, Coca-Cola’s CSD portfolio in the U.S. could be headed for growth, not only in terms of margins, but also volume-wise.

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Coca-Cola’s stock has risen by only a modest 3% so far this year, reflecting how the investors believe that the company could continue to report stable but only slight organic growth. The company has locked in its share in the fast growing energy drinks market, by buying a 16.7% stake in Monster Beverages, and in the at-home beverage market, by raising its stake to 16% in Keurig Green Mountain. These equity investments will ensure steady income growth, even if Coca-Cola’s own beverage operations fail to grow at expected levels. But the company seems to have found a way to sustain growth in its core carbonates business in the U.S. as well, banking on new launches, higher marketing expenditure, and by using innovative means to re-establish customer bonds.

Can Coca-Cola manage to squeeze-out growth from the ailing CSD market in the U.S.? We give reasons why we think the beverage giant might just be headed in the right direction.

Volumes Grow On The Back Of Share-A-Coke Campaign

Coca-Cola has looked to spur sales of its most popular and namesake cola drink Coca-Cola and its low calorie versions through experiential marketing, which aims at creating an emotional connect with customers. According to the chief marketing and commercial officer at Coca-Cola, Joseph Tripodi, the company spends over $4 billion on marketing around the world. Coca-Cola spent $3.3 billion on advertisements in 2013, representing 7% of its net sales, more than the $2.4 billion spent by chief rival PepsiCo, only 3.6% of its net sales. But the world’s leading beverage company and already one of the most recognizable and valued brands doesn’t plan to stop here. In February, Coca-Cola announced its plans to save an incremental $1 billion in productivity by 2016, which would be redirected to media investments. In line with this productivity savings plan, the company plans to save $550-$660 million this year.

Coca-Cola launched the “Share a Coke” campaign in the U.S. this year, and has seen a rise in U.S. soft drink volumes since. The company labeled Coca-Cola, Coke Zero and Diet Coke bottles with common names of individuals, hoping for customers to buy these personalized bottles and cans and then promote this activity later on through social media. By forming an emotional connect with customers and leveraging present day trend of self expression on social platforms, Coca-Cola managed to grow U.S. CSD volumes and sales by 0.4% and 2.5% year-over-year in the twelve weeks through August, while both PepsiCo and Dr. Pepper Snapple witnessed declines in both volumes and revenues. [2] Coca-Cola is rolling out its Share a Coke campaign in over 80 markets this year, and could very well extract growth in the CSD category, and that too in the ailing cola segment. The drink Coca-Cola, which generated close to $11 billion in revenues last year, grew by 1% last quarter. The flagship drink could end the year with positive volume growth in the U.S., reversing the 0.5% volume decline of last year.

Small-Sized Packages Back Health Initiatives And Margin Growth

Apart from a possible rise in volumes, Coca-Cola now aims to derive higher profitability by leveraging consumer health concerns that have for long subdued CSD consumption levels. Coca-Cola, alongside PepsiCo and Dr. Pepper, announced its aim of reducing calorie consumption through soft drink offerings by 20% by 2025 in the U.S. These companies plan to achieve this through promotion of low-calorie substitutes and smaller packs, which provide lower cumulative calories in one go. Fighting alongside health activists could help these beverage makers not only to spur positive consumer perception but also expand margins, as smaller packs are relatively more profitable. Over three-fifths of the 1% volume growth for the brand Coca-Cola in Q2 was bolstered by double-digit percent increases in smaller packages, including 7.5-ounce mini cans and 16-ounce immediate consumption packages. [3]

Demand for small-sized offerings has risen, despite the mini cans containing the same calorie count per ounce as the regular 20-ounce bottles, as customers look for lesser cumulative calorie consumption. According to Euromonitor, while sales in the overall U.S. CSD market remained flat last year, mini can sales rose 3%. The smaller 7.5-ounce mini cans have higher pricing per ounce, as compared to the 20- and 24-ounce packages, thereby boosting net pricing for companies. Fueled by growth in small-sized packages, Coca-Cola’s net pricing in the sparkling category grew 3% in North America in the second quarter. [4] Owing to the higher unit prices of smaller quantity cans, margins for Coca-Cola could also expand going forward. Beverage makers will aim to attract impulse buyers with their mini cans due to their lower prices and fewer cumulative calories, adding incremental volumes and also simultaneously boosting margins as these mini cans have higher price-per-ounce.

New Product Launches Could Attract Customer Traffic

Much hype already surrounds the launch of the naturally-sweetened Coca-Cola Life in the U.S. this year. The stevia-sweetened drink enters the U.S., Mexico and the U.K. this year, after boosting volume growth in Argentina and Chile last year. Apart from a potential winner in the ailing low-calorie soda segment, Coca-Cola could also have another sugary soda hit in the making. The beverage giant brought back its popular citrus flavored drink Surge, heeding to continual demand by consumers on online portals, this month. Surge was launched on Amazon.com, selling at $14, plus shipping, for 12 packs of 16-ounce cans. The initial demand for Surge remained high, with the drink temporarily selling-out twice on September 15. Gauging the encouraging consumer response to Surge, Coca-Cola might even launch the drink in retail channels in the future, which would then bring the drink in direct competition with PepsiCo’s flagship drink Mountain Dew.

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With dollar sales of  nearly $668 million in measured convenience store channels in the U.S. last year, Mountain Dew was the highest-selling CSD, beating even the popular cola-flavored drinks Coca-Cola and Pepsi. [5] Surge was debuted in 1996, but was pulled after sales didn’t catch-up, and the drink failed to compete with Mountain Dew. However, with initial online sales reflecting strong demand, Coca-Cola might once again launch Surge in retail stores, adding another option in the CSD category, which has been ailing amid health concerns and lack of alternatives.

Due to expected volume growth on increased marketing initiatives and new product launches, in both diet and full-calorie segments, and margin expansion owing to higher sales of smaller packages, Coca-Cola’s CSD portfolio could be headed for growth in the U.S. We currently estimate gross margins for Coca-Cola’s entire CSD portfolio to remain relatively flat through the end of our forecast period. However, if the figure gradually rises to 64%, there could be a 3% upside to our current price estimate for Coca-Cola.

We estimate a $41.86 price for Coca-Cola, which is roughly in line with the current market price.

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Notes:
  1. U.S. beverage results for 2013, beverage-digest.com []
  2. Share a Coke credited with a pop in sales, wsj.com []
  3. Coca-Cola earnings transcript []
  4. Coca-Cola 10-q []
  5. Beverage data, cspnet.com []