What the Increase in Water Consumption Means for Soft-Drink Makers

Coca-Cola (NYSE: KO  ) is heavily levered to the carbonated-beverage space. This means that a large part of its revenue is generated via soft-drink sales, unlike PepsiCo (NYSE: PEP  ) , which has a large snacks business. The next great race for the soft-drink companies will be in bottled water, considering that the broader trend is that consumers are trading away from soft drinks.

The move toward bottled water should continue as consumer preferences change due to a increase in health consciousness and the threat of new taxes/regulation on carbonated sugary drinks. With the way things are going, bottled-water sales will outpace soda sales within the next decade.

Coca-Cola owns the Dasani brand and PepsiCo the Aquafina brand. However, the bottled-water market is very competitive and isn't as profitable as carbonated beverages.

That said, there could be money to be made in water, with beverage companies flavoring and carbonating their water to give it a "premium flair." As a result, Coca-Cola has introduced sparkling Dasani and Fruitwater, with PepsiCo rolling out Aquafina FlavorSplash. SodaStream (NASDAQ: SODA  ) has also been making a splash in the sparkling-water market.

SodaStream makes home-carbonating machines and flavored syrups, allowing people to create their own sparkling waters. Unfortunately, shares of SodaStream fell off a cliff earlier this month, falling by more than 20%, after it lowered its fiscal 2013 guidance.

Now, SodaStream trades below both Coca-Cola and PepsiCo at only 15 times forward earnings. However, SodaStream doesn't pay a dividend, and its return on equity is half of the two major beverage companies.

Why Coca-Cola could be a great investment for 2014
Coca-Cola has one of the most recognized names in the beverage market. It offers more than 800 beverage options and owns four of the world's top-five beverage brands. The beverage company managed to meet third-quarter earnings, with its operating margin rising 90 basis points to 23.5%.

During the third quarter, Coca-Cola saw a 3% year-over-year increase in volumes for its still-beverage category, which includes Minute Maid and POWERade. More specifically, packaged water grew 5%, and sales of ready-to-drink tea grew 5%.

Beyond just beverage sales, Coca-Cola also has a robust distribution network, giving the company an impressive competitive advantage. About 15% of its revenue is generated from bottling investments.

Although Coca-Cola is already an international company, with less than half of its sales coming from North American beverage sales, it is turning to emerging markets for faster growth. A few of its key markets include India, China, and Latin America. Coca-Cola plans to invest upward of $4 billion in China over the next three years. This should be a big positive, as the country sees growth in its middle class. A higher level of discretionary income among Chinese citizens should mean more money to be spent on soft drinks. 

As far as downside protection, Coca-Cola has a solid cash position that will help the company continue its dividend payments and share buybacks. The company has upped its dividend for more than 50 consecutive years, and it repurchased more than $3 billion in shares in both 2012 and 2013.

Bottom line
Coca-Cola trades at 20 time earnings, and its forward dividend yield is 2.9%. Meanwhile, PepsiCo trades in a similar fashion, at just below 19 times, and its forward dividend yield is at 2.8%. However, Coca-Cola has the greatest exposure to the beverage market, and although it has the most to lose from the shift toward water, it also has the most to gain.

Coca-Cola is looking to take advantage of the fast-growing emerging markets. Investors should buy this iconic brand with the idea that the sale of more profitable variations of water and its investments in emerging markets will drive cash flow growth. And this cash flow will ultimately return to shareholders via dividends and buybacks.

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