What the Rise of Bottled Water Means for Your Investments in Coca-Cola and PepsiCo

Coca-Cola (NYSE: KO  ) and PepsiCo (NYSE: PEP  ) are in trouble. Sugary beverages are under fire in the United States for their role in the obesity epidemic and the soda giants need a solution -- and fast.

Many Coca-Cola and PepsiCo investors are holding out for a breakthrough low-calorie sweetener to replace sugar and artificial sweeteners that are driving sales declines. Although some variations of existing sweeteners are showing promise, the beverage industry has yet to introduce a sweetener that reverses consumers' negative perceptions of the category. In all likelihood, the future for soft drink companies is a beverage that is already in every home in America.

Water: America's favorite beverage
In the 1980s, soft drinks became America's favorite beverage. The hundreds of millions of marketing dollars that Coca-Cola and PepsiCo had spent had finally paid off. The soda hysteria lasted for more than a decade and peaked in 1998, with per capita annual consumption topping out at 54 gallons of soda versus only 15 gallons of bottled water. Since then, rising public awareness of the health effects of sugary beverages has dampened soft drink sales; each year, Americans now drink 44 gallons of soda and 21 gallons of bottled water. 

Beverage Marketing Corp. predicts that sales of bottled water will exceed those of soft drinks within the next decade. This represents a major opportunity, if not a forced avenue for shelter, for Coca-Cola and PepsiCo.

Coca-Cola already controls 13% of the bottled-water market. Its leading brands include Smartwater, Vitaminwater, and Dasani. PepsiCo represents 10% of the market with brands such as SoBe Lifewater, Aquafina, and the soon-to-be-launched Qua. Both are far behind the market leader, Nestle, which has a 32% share of the U.S. bottled-water market.

Not all bottled water is exactly the same. About 40% of bottled water is just purified tap water; this includes brands like Dasani and Aquafina, which compete on price. Premium brands such as Smartwater, Fiji, and Evian sell for higher prices because of some novelty. For instance, Smartwater is distilled tap water with electrolytes added for flavor and health purposes. Fiji is sourced from an aquifer on the Pacific island of Fiji. Evian is sourced from naturally filtered spring water in the heart of the Swiss Alps.

Premium water has the same cachet as Coke and Pepsi. Coca-Cola charges more than double the price for its premium water, Smartwater, than it does for its purified tap water, Dasani. A 24-pack of 16.9-fluid-ounce Dasani retails on Amazon.com for $21.50, or $0.05 per fluid ounce. A 24-pack of 25 fluid ounce Smartwater currently retails on Amazon for $63.98, or $0.11 per fluid ounce.

Market opportunity
Consumer behavior in the bottled water market is similar to that of the soft drink market: branding is key. Americans are obsessed with brands, even if those brands do not confer significant benefits over private-label products.

Coca-Cola and PepsiCo have already convinced Americans that it is better to pay more for a Coke or a Pepsi than to suffer through an RC Cola. Both companies already have the distribution networks and relationships in place to get their premium water on shelves across the U.S. Now, all that is necessary is good marketing -- like they did for Coke and Pepsi.

The bottled water market is about half the size of the carbonated soft drink market as measured by volume, but dollar sales of bottled water are only one-fifth that of carbonated soft drinks. The difference is due to ridiculously cheap prices of store-brand water, which sell for as low as $0.08 per bottle.

The bottled-water market could grow much bigger in terms of dollar sales as premium water, flavored waters, and other enhancements to plain old tap water make their way into American households. Assume the premium water category grows to one-fifth the size of the U.S. soft-drink market (including energy drinks) on a dollar sales basis. That puts the premium water market size at $15 billion. Coca-Cola and PepsiCo have 34% and 26% of the U.S. liquid-refreshment beverage market, respectively. If each captures the same share of a $15 billion U.S. premium water market, then premium water would represent $5 billion in sales for Coca-Cola and $4 billion in sales for PepsiCo.

Coca-Cola and PepsiCo already derive $1.95 billion and $1.5 billion in revenue from bottled water in the U.S, respectively. If each hits the targets outlined above, it would represent 15% of Coca-Cola's 2012 North American sales and 11% of PepsiCo's 2012 Americas beverage sales.

 Company Market Size Est. Market Share Current Revenue Additional Revenue Potential Sales Growth
Coca-Cola $15 billion 34% $1.95 billion $3.15 billion 15%
PepsiCo $15 billion 26% $1.5 billion $2.40 billion 11%

What it means for your investment
Coca-Cola and PepsiCo are changing. Both have to adapt to changing consumer attitudes about their beverages. The future is uncertain. It is not clear whether soft drinks will continue to decline or if per capita consumption will level out at some point.

However, Coca-Cola and PepsiCo are positioned for whichever scenario plays out; if soft-drink sales never recover, premium water and other soft-drink alternatives serve as a safety net for investors. So, concerned investors should not panic; Coca-Cola and PepsiCo are still great businesses and will continue to dominate the beverage market for the foreseeable future.

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