Is Coca-Cola Outsmarting PepsiCo or Mortgaging Its Future With Pricing Strategy?

Coca-Cola (NYSE: KO  ) outperformed rivals PepsiCo (NYSE: PEP  ) and Dr Pepper Snapple Group (NYSE: DPS  ) in what turned out to be an awful 2013 for the soft drink industry. Coca-Cola continues to outperform its peers in 2014, largely due to heavy promotions across its soft drink portfolio. The strategy boosts Coca-Cola's beverage volumes in the short run, but it could damage the company's pricing power if consumers come to expect permanent promotions. Here's what you need to know about Coca-Cola's pricing strategy and what it means for Coca-Cola, PepsiCo, and Dr Pepper Snapple shareholders.

Promotions drive volume increase
A recent survey conducted by Wells Fargo's (NYSE: WFC  ) research department found that soft drinks were the most heavily promoted beverage in convenience stores over the Memorial Day weekend (ended on May 26). Promotions come in the form of lower prices, two for the price of one, and other deals that allow consumers to go home with more soft drinks at a lower-than-normal price.

According to the survey, discounting reached its highest level in more than a year, with Coca-Cola leading the way as the heaviest promoter of colas over the holiday weekend. Wells Fargo's team estimates that the promotions drove 2% sales growth for Coca-Cola in the second quarter compared to just 1% each for PepsiCo and Dr Pepper. Clearly, the promotions are working for Coca-Cola.

Short-term fix for a long-term problem
Unfortunately, Coca-Cola's heavy discounting is a short-term solution for a long-term secular decline in cola consumption. Soft-drink sales in developed nations face significant headwinds as a growing number of substitutes compete for consumers' stomach space. Since people are unlikely to significantly increase their overall beverage intake, beverage industry sales are relatively fixed -- growing only as quickly as the population. As a result, soft drinks will lose out to coffee, tea, and energy drinks unless something makes them more appealing to consumers. Coca-Cola is making them more appealing via price discounts.

However, there are a few problems with that approach. First, Coca-Cola's actions could spark a price war with PepsiCo and Dr Pepper. The pressure that health concerns and rising substitutes put on soft drink volumes makes pricing discipline imperative. If PepsiCo and Dr Pepper were to match Coca-Cola's discounting, its volume advantage would shrink and all three companies' margins would fall. The result would be disastrous for the soft drink industry.

The second reason Coca-Cola's discounting is dangerous is that consumers may come to expect lower prices. Consumers expect to pay more for a Coke than for an RC Cola. However, a sustained period of discounting could change consumer expectations, making it more difficult to raise prices in the future. This would impair Coca-Cola's brand value.

A better way forward
Fortunately, there is a better way to get consumers excited again about soft drinks. Innovation in the at-home carbonation channel and in soda fountains is already creating consumer buzz about soft drinks.

PepsiCo is the first major entrant in both channels. It teamed up with Bevyz on a beverage maker that could be just one of many platforms that PepsiCo exploits in the at-home channel. The company also introduced an exciting new soda fountain that rivals Coca-Cola's Freestyle.

Coca-Cola Life could restart U.S. cola consumption. Source: Coca-Cola.

For its part, Coca-Cola has already partnered with its own at-home carbonation platform and continues to bring new cola products to market. The company is having success with Coca-Cola Life, a mid-calorie, reduced-sugar version of Coke with a refreshingly green image. Coca-Cola Life has drawn lapsed South American soda drinkers back to the category and could soon be introduced in the U.S.

Dr Pepper has struggled to innovate after the failure of Dr Pepper TEN -- a 10-calorie version of its flagship product aimed at attracting men to the diet soft drink category. However, following its peers into the at-home carbonation space could change Dr Pepper's fortunes.

Foolish takeaway
Coca-Cola's recent promotions are driving sales gains in the quarter, but the tactic could backfire in the long run. In order to avoid tarnishing their brands and sparking a costly price war, Coca-Cola, PepsiCo, and Dr Pepper need to innovate their way out of the current industry malaise. Fortunately, all three companies show signs that innovation and consumer excitement are top priorities. As a result, investors should not fear a price war unless Coca-Cola maintains its promotions through the summer. This is good news for shareholders of all three companies.

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