Why Is Coca-Cola Paying A Hefty Premium For Costa Coffee?

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

The Coca-Cola Company (NYSE:KO) announced its intention of acquiring Costa Limited from parent company Whitbread PLC for $5.1 billion. This deal, expected to close in the first half of FY 2019, would give the cola giant a strong coffee platform across parts of Europe, Asia Pacific, the Middle East, and Africa. Costa has nearly 4,000 retail outlets, and is a leading coffee company in the U.K. and is scaling its operations in China. Such a move places Coca-Cola in direct competition with companies like Starbucks and Dunkin’ Donuts, in a market that is growing at a fast pace, in contrast with that of its traditional business. Many beverage companies have been undertaking acquisitions recently to be in segments that seem to have better prospects, such as the acquisition of SodaStream by Pepsi, and the merger of Dr Pepper Snapple and Keurig Green Mountain. KO’s chief executive, James Quincey, stated that the primary rationale behind this acquisition is the combination of Costa’s coffee capabilities and Coca-Cola’s marketing and distribution expertise.

We have a $52 price estimate for Coca-Cola, which is higher than the current market price. The charts have been made using our new, interactive platform. The various driver assumptions can be modified by clicking here for our interactive dashboard on Our Outlook For Coca-Cola In FY 2018, to gauge their impact on the earnings and price per share metric.

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Reasons For The Acquisition

1. Coffee Expertise: The purchase of Costa Coffee provides Coca-Cola with strong expertise across the coffee supply chain, including sourcing, vending, and distribution. This will be a complement to existing capabilities within the Coca-Cola system. The management also stated that the coffee company has a brand new roaster with significant additional capacity, giving them significant roasting capacity in the future. The company also has built up a large coffee vending business, with 8,237 Costa Express machines worldwide, located in places such as convenience stores, cinemas, and offices. This may make it easier for Coca-Cola to expand its existing offerings. Since the cola giant has not had experience in running a retail format, it intends to let the existing management handle that part of the business.

2. Diversifying Into A New And Fast-Growing Segment: Coca-Cola is a big player in the non-alcoholic ready-to-drink beverages industry, currently valued at $0.8 trillion. However, when you add the hot beverage market to this, the addressable market size jumps to $1.5 trillion. Moreover, this segment is growing at a fast pace – 6% annually. Costa Coffee is the number one coffee shop brand in the U.K., and has been voted the most preferred coffee store in the region for the past eight years.

3. China Opportunity: Like Starbucks, Costa Coffee is also looking at China to drive its international growth, with the company intending to increase its store count in the country from 449 currently to roughly 1,200 by 2022. China continues to remain a long-term growth driver for the company, as its GDP, projected to exceed $15 trillion by 2021 from $11 trillion in 2014, is expected to fuel a massive increase in its middle class. Moreover, the per capita coffee consumption in China is about one-half of one cup per person per year compared to approximately 300 cups per person per year in the U.S. The buy-out of Costa’s joint venture partner in South China, gave the company full control of Costa’s Chinese operations outside of Beijing, which should be another factor that may result in an increase in revenues from the region.

4. New Revenue Sources For Costa: Coca-Cola has the capability to expand the coffee company faster and more economically than Whitbread. Moreover, Coca-Cola has plans to launch RTD cold and hot coffee, and at-home options, such as roast and ground beans, and pods, for the Costa Coffee brand. The cola giant already has experience in providing bottled and canned coffee in a few markets, such as Georgia coffee in Japan.

5. Synergy Possibilities: The company says it anticipates revenue synergies, possibly through the sale of Costa products through its distribution network, and through the sale of its products in Costa Coffee shops or vending machines. Currently, it does not expect any cost synergies, although we feel there is a likelihood of a reduction in SG&A costs for the combined company.

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