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Are Carbonated Soda's Doomed?

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Sales of carbonated soft drinks in the United States have declined for years as consumers switch to alternatives. The conventional wisdom is that Coca-Cola (NYSE: KO  ) , PepsiCo (NYSE: PEP  ) , and Dr Pepper Snapple Group (NYSE: DPS  ) need only develop a good-tasting all-natural sweetener to stop declining sales. However, comments from convenience-store operators and strong sales of Monster Beverage's (NASDAQ: MNST  ) energy drinks suggest otherwise. If these trends persist, the soda giants may never recover market share in the United States.

Millennials reject soft drinks, embrace energy drinks
The millennial generation, the oldest of which are now reaching their 30s, is the most important cohort in determining the direction of the beverage industry. As the largest generation since the baby boomers reaches adulthood, its members' purchasing power will shape the industry's landscape.

Unfortunately, milliennials' influence on the beverage industry may not favor Coca-Cola, PepsiCo, and Dr Pepper Snapple. Bonnie Herzog, an equity analyst at Wells Fargo, conducted a survey of convenience-store operators and received several worrying replies:

I just think it's a natural shift. Energy is what the younger consumer identifies with as well as health offerings. I anticipate [a carbonated soft drink] sales decline...

As the group that was brought up on energy drinks gets older, carbonated soft drinks become less and less a part of their daily intake.

[Energy drinks have] become as important as a morning cup of coffee and the younger generation seems to want caffeine all day long, whereas the older generation only got caffeine in the morning to jump start the day.

In essence, convenience-store operators have noticed a definite trend away from soft drinks and toward energy drinks. Millennials' consumption patterns are different than their predecessors -- they want caffeine all day long and they prefer higher doses of caffeine than is available in a soft drink. PepsiCo's convenience- store sales are estimated to have increased 1.1% last quarter mainly due to sales of its Kickstart energy drink and Frappuccino drink sold through Starbucks -- evidence that corroborates convenience-store operators' observations.

Moreover, Herzog said that most convenience-store operators said they will stop carrying Dr Pepper's TEN line of low-calorie sodas when they reassess their product lines this spring. This follows diet soda sales declines that have outpaced the declines of other categories. Although diet soda has fewer calories than regular soda, consumers' rejection of artificial sweeteners -- viewed by many consumers as unhealthy and un-tasty -- has led to a 6.8% decline in dollar sales for the diet category compared to a 2.2% decline for regular soda since November 2012.

Coca-Cola and PepsiCo are working hard to develop alternative sweeteners that consumers might accept, but even a healthy and good-tasting sweetener may not save the category. Finding an all-natural sweetener was once considered the holy grail of the soft-drink industry, but Herzog's contacts believe that consumers have left the category for good. If this is true, then the only thing soft-drink makers can do is change their product mix to emphasize growing categories.

Energy drinks are the future
Among the many alternatives that are gaining share in the beverage market -- including bottled water and fruit juice -- energy drinks are the most disruptive. Monster grew sales at nearly 20% per year from 2008 to 2012 and now sells more than $2 billion worth of product each year. Retail margins for energy drinks average 40% compared to just 30% for carbonated soft drinks. As a result, energy drinks will likely gain shelf space in convenience stores over the coming years. This will only make it more difficult for soft-drink companies to stave off declining volumes.

Bottom line
Coca-Cola and PepsiCo may have global operations, but each relies on the United States for a significant portion of beverage sales; the U.S. ranks fourth in terms of per capita consumption of Coca-Cola beverages. Dr Pepper Snapple relies almost exclusively on the United States for its sales. Even if carbonated-soft-drink sales stabilize upon the introduction of new and better sweeteners, these companies will need to invest in other businesses -- bottled water, juice, and energy drinks -- in order to grow in the U.S. Otherwise, investors could be left holding the stocks of companies that are fated to shrink in the U.S.

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Ted Cooper

Ted Cooper is a value investor based in Texas. He does not ride a horse to work.

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