Coca-Cola Plays Copycat

These days, Coca-Cola (NYSE: KO  ) is striving to catch up with rival PepsiCo (NYSE: PEP  ) . Not in stature -- Coca-Cola remains the global leader in nonalcoholic beverage brands -- but rather in strategy.

Late last week, Coca-Cola announced that it will acquire the North American operations of Coca-Cola Enterprises (NYSE: CCE  ) , the world's largest bottler of Coca-Cola-owned beverage names. That revelation came just a day before PepsiCo reported that it had finalized the long-pending merger with two of its key bottlers, a deal that the company first floated way back in April 2009.

PepsiCo has spilled considerable ink describing the benefits of its bottler hookup, including substantial cost savings and improved speed to market. Coca-Cola is naming all the same advantages, headlined by an expected $350 million in eventual synergies (following one-time costs of $425 million). Yet as recently as December 2009, CEO Muhtar Kent asserted that his company had "no need for a vertically integrated system."

So what gives? Although described as "substantially cashless," this is a sizeable transaction, which involves Coca-Cola assuming $8.8 billion of CCE's debt along with $580 million of employee benefit obligations. Moreover, the bottling business is a significantly lower-return operation: CCE's trailing-12-month return on capital (ROC) is 11%, compared to a stout 15.9% for Coca-Cola.

This couldn't really be just about cost savings, could it?

In my opinion, it's not. Moreover, although Coca-Cola management appears to have waffled, I don't believe the move represents a global shift from the independent bottler model. Instead, this looks to me like a last-ditch attempt to fix the ailing North American business in particular, precipitated by the competitive advantages that PepsiCo, bottlers now in hand, is about to reap.  

Essentially, owning the North American bottling business boils down to flexibility -- both in product innovation and pricing. On the latter, U.S. consumers are losing their taste for soda specifically, and packaged nonalcoholic beverages in general. With the supply chain fully under its own control, Coca-Cola should be able to more quickly adjust to shifting consumer preferences.

On the conference call, Kent was quick to point out that the structure of the North American business -- where Coca-Cola splits the manufacturing and sales of specific finished and concentrate products between itself and its bottlers -- is distinct from international operations. A merger will realize cost synergies, which, as analysts have speculated, would allow Coca-Cola to pass along savings in the form of lower prices, all without compromising margins. Notably, companies such as Unilever (NYSE: UL  ) have similarly capitalized on lower costs of a different variety.

The bottom line, however, is that Coca-Cola's North American efforts may fall short. Consumption could continue to spiral downward, leading to ever more lethal price wars. At the same time, certain costs could rise. For one thing, Coca-Cola may have to negotiate a new contract with Dr Pepper Snapple Group (NYSE: DPS  ) , which currently distributes its products through CCE.

Warren Buffett, whose Berkshire Hathaway (NYSE: BRK-A; NYSE: BRK-B) holds Coca-Cola shares, recently gave the deal a nod of approval, while noting that "there's a lot of execution problems in doing anything like that."

We'll see how the Oracle of Omaha's cautionary words play out over the coming years.

Berkshire Hathaway and Coca-Cola are Motley Fool Inside Value selections. Berkshire Hathaway is a Stock Advisor recommendation. Unilever is a Global Gains pick. Coca-Cola, PepsiCo, and Unilever are Income Investor selections. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. The Fool has a disclosure policy.


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  • Report this Comment On March 03, 2010, at 5:05 PM, XMFTheATrain wrote:

    The CCE bottling assets and distribution system are critical to making Coca Cola products as ubiquitous as air. Wanting full ownership of these assets makes sense for Coca Cola, especially as the company needs more flexible distribution for lower volume non-carbonated beverages. When Coca Cola did the spin off of the bottling assets in the 1980s, that decision was driven more by financial engineering than by the needs of the core business. While more than 20 years has passed, I think this is Coca Cola fixing a past mistake.

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