How the Soda Industry Plans to Deliver Another Century of Success

Last year, soda sales fell for the 11th consecutive year as the consumption of carbonated sugary beverages fell to their lowest levels since 1985.

In this consumer and retail edition of Industry Focus, Motley Fool analysts Vincent Shen and Asit Sharma take a look at how Coca-Cola (KO 0.63%) and Pepsi (PEP 1.34%) are responding to the declining popularity of their famous products -- by defending against increased regulation, while also diversifying into new businesses, including healthier beverages and other complementary offerings. Also, the analysts take a look at the companies' future plans as management teams in both companies take on a long-term mindset.

A full transcript follows the video.

This podcast was recorded on Jul. 19, 2016.

Vincent Shen: This episode of Industry Focus is brought to you by Harry's. For guys who want a great shave experience for a fraction of what you're paying now, go to Harrys.com. Get five dollars off your first purchase by entering the code FOOL when you check out.  

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It is Tuesday, July 19th, and I am your host Vincent Shen. Joining me today via Skype to talk consumer retail is Fool.com contributor, Asit Sharma. Asit, very happy to have you back. How are you doing? 

Asit Sharma: Hey, it's good to be back, Vince! I'm doing great, thanks for asking. 

Shen: Yeah, no problem. Getting right into it, on tap for this episode we have -- what I like to think of -- an industry in transition. On the one hand this has really surprised me how high this number is, I would bet every person listening to this show, probably nearly everyone or most people in the country for that matter has at one point enjoyed this product. For 2015 per capital consumption in the U.S. came in at more than 41 gallons for the year or over 14 ounces per day, that's everyday, 365 days. 

On the flip side those numbers represent the lowest for the industry in terms of consumption since 1985 and they also marked the eleventh straight year of sales declines. For the listeners, if you haven't guessed it already, we're actually talking about soda. Also might call it pop or Coke depending on which region of the country you're from; ultimately, carbonated soft drinks, if you want to go with the more technical term. 

The industry has given us some of the most iconic companies and brands I think in the business world. Multiple generations of really weaving this product into our everyday lives, but some health risks have obviously made soda not quite so popular among many consumers. Some people see that as a real long term challenge. Today Asit, I just want to talk about the industry. What's been going on there recently, the past few years, some of the challenges they face in addition to the health concerns? If you want to just dive right into it. 

Sharma: Sure. Well, let's start with the health concerns because that's driving the rest of the business for both Coke and Pepsi, the main two companies that we'll talk about today. As you mentioned, what caught my eye earlier this year was Beverage Digest had their -- they do a study every year and they reported that soda volumes, as you mentioned, have declined for 11 straight years. They hit that 30-year low in 2015. 

Well, many of our listeners hold Coke and Pepsi and those dots have done relatively well over the last 10, 11-year time frame, so obviously both companies have combated this trend. How they're doing it, they take different approaches. Really the fast forward to what the issues on the table are for them today, what we're seeing in 2016, the biggest one out there is taxation. 

Those of you that live in New York remember Michael Bloomberg tried to have big sodas or giant sized servings taxed in New York City. That didn't quite go through, but it started a movement and he's participated. He's funded some groups which have now lobbied for in various municipalities these soda taxes. Last month we saw Philadelphia pass a pretty big tax. It's ₵1.5 per ounce on regular and diet sodas in June. 

What that means is for a 16-ounce Coke which sells, let's say for $1.15, you're seeing a 22% surcharge on that drink. That's an enormous tax. It's an enormous hurdle for a company to overcome. One of the things we'll be talking about today is how strategically as this multi-national conglomerate, whether you're Coke -- who's all beverages -- or PepsiCo -- snacks and beverages -- how you combat what is potentially a wave of taxation. 

I'll just mention really quickly Denver, Colorado, San Francisco are also entertaining about measures similar to the one that passed in Philadelphia. These aren't small cities. In addition the entire country of South Africa is now looking at a soda tax which is a pretty vibrant emerging market for both of these companies. 

Shen: Yeah. I actually was living in New York when Bloomberg tried to pass the ... when he tried to tighten the serving of the ... I think it was 16 ounces or more at restaurants, movie theaters, stadiums. There was quite a bit of uproar over that. I remember just walking past a 7-Eleven, they had signs on the sidewalk outside the door basically mentioning this and how it's like we don't need to be a nanny state so to speak. 

That ended up ultimately getting shut down by the courts I believe, but you mention Philadelphia recently had some success with that tax specifically and also I wasn't aware of the South Africa developments, the South African developments, but in Mexico overall I believe it was back in January or ... I think it was January 2014, they passed a one peso per liter tax essentially. That raised prices there approximately 10%. 

Results seem to have been generally successful or maybe a little bit more mixed, but obviously this is a trend that has picked up. The companies, both Pepsi and Coca-Cola have lobbied quite a bit against regulations like these obviously hurting their bottom line. I saw in the Wall Street Journal that the industry overall has spent over $100 million since 2009 battling similar tax proposals in more than two dozen cities at least within the U.S. The steam is picking up and the company is having to spend quite a bit of money to try and fight that trend. 

Sharma: That's true and this is, what's maybe a sign of ingenuity in each of these companies, is they have this split brain, left brain, right brain. One side of the brain says we've got to fight the regulation. The other side of the brain says we've got to cope and we've got to find ways where we can still obtain the margins that we need out in the marketplace. 

You mentioned Mexico. Coke and Pepsi had a little bit of lead on that. The actual tax passed I think in October of 2013 and then as you mentioned, Vince, at the beginning of 2014 they had to sell with this tax in place. What we've seen is that both companies took sort of an immediate hit in Mexico, but they're selling more juices which are borderline and can escape the tax. They are working with their margins in Mexico to see if they can be a little bit more profitable there and absorb some of it. They're also looking to introduce new labels wherever possible.  

They have this template that you'll see in evidence in Philadelphia and other cities. Mexico is sort of the test case. It's worked out for the groups who were able to lobby the Mexican legislature because consumption of soda has declined somewhat in Mexico of a result of that tax, but Pepsi and Coke haven't taken so big a hit there. They are gradually gaining back the margins and organic sales that they had. 

Shen: Okay, so not just with regulations, but we had talked about a little bit more, but something else that they're kind of fighting off is just the little bit more of their labeling in terms of their ingredients and on the back of the bottle and the back of the can when you turn it, that's with GMO stuff, right? 

Sharma: Yeah, that's true. There's a lot of legislation in the works or potential legislation I should say, both on the federal and the state level to require labeling. It's called mandatory GMO labeling. It will show on any product if you're using genetically modified ingredients. On one hand Coke and Pepsi are adamantly against this because corn and corn syrup obviously is a big part of sodas. They really want to defeat these on a state level before they reach the federal level. 

They weren't successful in Vermont which just passed a law. Coke has actually said: "Hey, we're going to have to lower volumes temporarily because of this law, because some of our less profitable stuff, it's almost not worth it for us to go thought this long ramp of relabeling." They're looking through their inventory in Vermont and seeing what can be done there. 

What's really interesting to me is if you look at what they've spent, Coke and Pepsi, last year, were the third and sixth biggest lobbying spenders to defeat this GMO labeling on the state and federal level. They spent $14 million -- that was Coke -- and about $9 million -- that was Pepsi. They are leaders in trying to repel this legislation, but at the same time, again, left brain, right brain, Pepsi last year introduced snack machines called Hello Goodness which they vend out Naked Juice, they vend out hummus. 

The marketing push is very much: we're going to offer healthy alternatives. This year they're coming out with organic Gatorade and they're also coming out with a line that will emphasize that Tropicana orange juice doesn't have genetically modified ingredients. 

Shen: Okay, so these are obviously two of the challenges the companies are facing, but I want to remind listeners, you mentioned in the beginning of the episode that at least for the two bigger players, Pepsi and Coca-Cola, the fact is their stock has been performing quite well. I was looking at their 5-year price charts before we started recording and they're both been pretty consisting with their gains, with a nice up into the right -- that you like to see in a chart like that. But overall they are also definitely kind of changing their approach-you mentioned some things like Hello Goodness -- but we have a lot more to discuss coming up here in terms of how the companies are approaching their products and their strategy in the future.   

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Touching on the future of Coke and Pepsi after we've touched on some of the headwinds previously, Asit, what are these companies doing if we're really diving into it in terms of setting themselves up for future success? 

Sharma: Coke is a thirsty company right now. They're thirsty for brands which are not carbonated sweetened beverages which are what they call stills. That is non-sparkling beverages. They're on the hunt to acquire minority interest or outright purchases of brands which are perceived as healthier by the consumer which have potential to grow. Some names which our listeners will be familiar with are Fairlife milk which has recently become available in grocery stores. Suja LLC is another company they've taken an interest in. Aloe Gloe water. 

You can see these are very nontraditional brands for a company like Coke, but this is something that Coke has really been thinking through for the past several years. Investors perceive Coke as a cash cow. One of the strongest things about Coke is the fact that it's got this great predictable cash flow for decades and decades that's been on the back of carbonated beverages. 

What they're doing is they're transferring that predictability by acquiring smaller brands. Still today about 75% of Coke's global unit volume is sparkling beverages. [The following] statistic counterbalances that. There's this idea that we have to move into stills has taken hold of Coke's management team and now 14 out of 20 of Cokes billion dollar brands are actually still beverages. 

The other thing that Coke's doing has been to launch a multi-year productivity initiative. They're seeking to find $3 billion in annual cost savings by the year 2019. Why are they doing this? They know they can't grow their organic revenues fast enough as soda volumes are falling, so they're sending a message to investors that while we solve this puzzle we're going to deliver the earnings to you and I think that's really helped prop the stock up over the last 12 to 18 months. 

Shen: Yeah, if you don't mind if I jump in really quick, Asit, too. 

Sharma: Absolutely. 

Shen: What you mentioned in terms of that stability is the fact that for a lot of investors, they love the fact that Coke pays a pretty healthy dividend. I think it yields around 3% now, a little over 3% last I checked. Hopefully we can get into this later, but with some of those acquisitions that you mentioned, remind me if I don't touch on this, but they have a whole business unit essentially dedicated to those. I'll let you keep going and we can jump back into that. 

Sharma: Absolutely. We'll circle back to that in a second. Another thing that Coke is doing to reinforce this idea that we can deliver earnings is packaging innovation. A few years ago executives decided that if we can't beat them, join them. In other words if we can't convince people to drink liter bottles of Coca Cola, let's make the packages smaller and I think that's been a huge success for them. 

Our listeners are familiar with seeing the 7.5 ounce mini-cans on the shelves. For many folks that's a great way to enjoy Coca-Cola. It's a reduced guilt type of moment that you can take off in little bits. Buy a six pack and just pull it off. It's relatively guilt-free. For Coke it's a premium packaging innovation. What that means is they've got a higher margin on those smaller cans than they do on the bigger sodas. Everybody wins in that sense.  

The last thing I wanted to talk about in terms of Coke's strategy for dealing with this gradual decline of sodas is they want to become a smaller and more profitable company. This will take many of our listeners by surprise because it's the goal of every multi-national conglomerate to become bigger, right? 

Well, Coke is actually going the other way. They're going from a 120,000 employee company to roughly 40,000 employees. They are going to go from a $43 billion company perhaps all the way down to a $28 billion company. This is going to be a sea change. It will be a bigger story next year and in 2018. 

Essentially what Coke is doing is they're selling off all of their bottling operations to their global bottling partners. They're going to become a more nimble company, a company which markets more than it manufactures. They'll hold onto their concentrates business and in becoming smaller, again, they'll have the ability to grow more quickly again. I think that's a brilliant stroke on the part of management. It shows a lot of long term thinking on their part and I think that this will be a success. 

Not many people are talking about it today, but we'll see as those financials change over the next several quarters. You'll see profits go up, but revenues actually declined as it leaves off the bottling revenue that it has right now. 

Shen: Yeah, absolutely. They actually have a slide in their investor presentation from a consumer conference, which was just last month actually, touching on how adjusted for after they do all these refranchising of the bottling operations, which was a huge focus I might add of that presentation. The revenue is falling from 44 to about $20 billion, but you mentioned profitability. Gross margins potentially going up 7 percentage points from 61 to 68% forecasted. Operating margins an even bigger jump, going from 23 to 34%. 

It does sound crazy sometimes for a leading company like this to say hey, we want to be smaller, but obviously there is a lot of incentive to do that on their bottom line. 

Sharma: Sure. Let's circle back really quickly to how they're acquiring those smaller companies. Coke has its own venture capital arm. It's called Venturing and Emerging Brands. This company seeks out really tiny labels, mom-and-pop operations that have innovative products. For Coke, once a product hits about $10 million and $20 million in revenue, it starts to become interested. If it sees that a brand can grow maybe up to $50 million in a year or $70 million or $100 million, then it really takes interest. 

Because for Coke the Holy Grail is to find a brand which they can just run through that enormous worldwide distribution system and if anybody can scale a brand up literally overnight from $50 million to the hundreds of millions or make it $1 billion product, it's Coke. This group, VEB for short, is basically an investor. They're the company that takes minority interests, if you're familiar with Honest Tea, that was a VEB venture and it's now wholly owned by Coke. 

Again, another way that the company strategically addressing how to diversify its overall portfolio and lean more toward these still beverages which have sustainable, natural, healthier bent to them that consumers are clamoring for. 

Shen: Yeah. I'm really glad you brought up Honest Tea as well because I feel like I tried it maybe once a few years ago, but then once they had the investment from Coca-Cola they got the extra leverage with distribution and things along those lines, I see them everywhere now in all the convenience stores, anywhere. A lot of different, for example, restaurants too. That is something on the menu that's available. 

Some other ones that may or may not have been specifically under their VEB unit, but ZICO Coconut Water for example is another one I remember really took off obviously with the partnership that they had. They've also been using some of their acquisitions just to get access to other markets outside the U.S. where the sugary drinks or the sodas aren't still, are doing OK or they're still seeing some decent volume growth. 

Enough about Coca-Cola. Going to the number two here in the industry which is half snack business, half drink business, but obviously drinks still very significant. PepsiCo, what do you think? 

Sharma: Sure. PepsiCo is doing a great job right now transitioning as well. They're a $63 billion company. They have the snacks business so they're actually larger than Coke. Some of the things that they're drawing the lessons are from Coke's playbook that they are also looking for productivity savings. They're shooting for a billion dollars this year in cost savings along. It looks like they'll hit that. 

They're using higher marketing spends to prop up those declining soda volumes. Of course it's a beverage and a snack company. It's got that diversification. Frito-Lay North America itself which is a division of PepsiCo is a $14.8 billion business. It's a $15 billion company on its own. That's provided some support against the soft drink decline. 

Pepsi also employs a strategy of relentless innovation. On their last conference call Indra Nooyi, their CEO, mentioned that about 9% of revenue now, that's $5 billion comes from new products. I'll give you an example of this innovation. The company is coming out with a new type of Mountain Dew called Mountain Dew Black Label. It's sort of a craft version of Mountain Dew if you can imagine such a thing. It features real sugar and herbal bitters in its composition. 

They're marketing this to a younger crowd, millennials obviously, and the CEO pointed out -- Indra Nooyi pointed out -- that this is when Mountain Dew customers want to have their drink with a touch of class. They're really innovative in the sense that they know where the millennial customer is going and for them it's less about these bolt-on acquisitions that Coke does and more about developing new varieties in-house. 

Shen: Okay. Mountain Dew Black Label. I have to say I am really surprised to hear someone put the words Mountain Dew and class in the same sentence, but I haven't seen that yet. I'm actually really curious to try it. Some of the listeners might laugh at me, but I still actually enjoy a Mountain Dew every now and then. It's probably one of the few sodas I actually still seek out on occasion. This actually has me really intrigued now. 

Sharma: Sure. Well, I'll tell you what. Maybe they could entice you with another strategy they're using which is the cross marketing of their products. Pepsi, they're doing a great job in convenience stores which is a growing channel for soft drinks and snack beverages of putting the displays together. You'll see Doritos cross market with the Mountain Dew. So, Vince, you can grab some Doritos while you're at it once you pick up your Black Label Mountain Dew. 

This is a strategy that actually was -- they had an active investor, Nelson Peltz who didn't like this idea at all several years ago. He actually wanted to split the company up. He wanted PepsiCo to sell its snack business, it's Frito-Lay and also Quaker Oats to Mondelez which is the company which used to be Kraft in this merry-go-round of brand names, but Indra Nooyi and her executive team resisted. This was about three years ago in 2013. 

What they did was they insisted that "if we market our products together, snacks and beverages, we'll be stronger". In the resisting they actually did grow revenues at a faster rate. Nelson Peltz said: "Hey, if you don't break this company up you're always going to be a number two to Coke. You'll always have lower growth rate and you'll always be valued by investors as not quite as much as Coke is." 

Low and behold three years later by sticking with this better together that is snacks and beverages strategy, PepsiCo now commands a premium valuation multiple to Coke. It's just a bit over Coke's, but they've caught up. That's really interesting to me to see. 

Shen: Yeah. I wasn't aware of some of the history with the active investor. When you brought that up yesterday I thought that was just some really interesting background. In this case I think overall Indra Nooyi generally has a strong reputation with the shareholders and investors and obviously holding out in this case has definitely helped the company. As we wrap up here, Asit, what do you think? Any final takeaways?  

For me for this industry I think I see a lot of people try and kind of similar to fast food, similar to McDonald's, sometimes you hear people writing the obituary for soda. How people, consumers being more health conscious are going to turn away from their products, that maybe a few decades down the line they'll really struggle and won't be around anymore potentially. To me their brands are just too strong. These are huge companies with a lot of resources, I think, to invest in innovative new products or to invest in that upstart drink down the line or that upstart snack down the line. Overall, some people also talk about the potential research that they can do into other sweeteners beyond high fructose corn syrup that can present better health benefits or non-negative health issues. People can still enjoy their Coke or their Pepsi, but any other takeaways from you? 

Sharma: Yeah Vince, I just want to agree with you totally. Both of these companies are too innovative for investors to look away. Investors, stay put! These are two awesome companies with great cash flow. They have sales growth potential ahead of them because of the innovation. They both are reacting very vigorously to this decline in sodas. As you mentioned they are working on lots of different types of sweeteners. 

It may take years, but at some point they probably will be able to replicate what did Coke or Pepsi or Mountain Dew taste like using more natural ingredients. They are fine tuning their distribution, working on global markets, working on global volume. While it may look bleak, at least for Coke and for Pepsi, both of these companies are working on the exact things that you would want them to implement to survive and be the type of strong cash flow returners, great value propositions over the years and total return vehicles. 

Let's not forget that as you mentioned, both supply, ample dividends. My takeaway is the exact same. That innovation will carry these companies forward. Now is a great time to stay invested or invest if you're looking at either of these. 

Shen: Absolutely. All right, thanks a lot, Asit! It was awesome having you on the show again. 

Sharma: Thanks so much, Vince! I enjoyed it. 

Shen: Listeners, that is a wrap for us today, but you can continue the conversation with us via Twitter @MFIndustryFocus or send us any questions or comments via email to [email protected]. You can also enjoy the other great podcasts from The Motley Fool by checking out Fool.com/podcasts. People on the program may own companies discussed in the show and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!