Trouble for Big Soda

In our newsletter two weeks ago we highlighted the comments of Coke’s new CEO James Quincey at a recent analysts conference. For those not yet aware he established a new strategic vision for the company - a shift in focus from the core soda brand and a stronger focus on becoming what he referred to as a “total beverage” company. Former CEO Muhtar Kent was famous for always stating the Coca-Cola was all about its main soda product. Its evident that the company has realized that times are changing.

Forefront in the mind of the company, and their main competitor Pepsi, is the effect of a soda tax in Philadelphia. The city implemented a 1.5 cent tax for every ounce of soda sold in each product. For the average 591mL drink this amounts to only an additional 20 cents in additional cost to the consumer. The remarkable part of this tax has been the effect on the sales of soda in the city. Coca-Cola has reported that sales volumes in the city have dropped 30 to 50% and Pepsi is saying their sales have declined 40%.

It no secret that sugary drinks are bad for us. People have known for a long time. However, it took just a small tax for people to change their habits. Many cities around the US have seen the success of this plan in Philadelphia and are discussing implementing similar taxes in their jurisdictions.

People are finally changing their attitudes and their habits surrounding sugary drinks. In fact, according to the New York Times (link), soda sales have declined 25% in the US in the past 20 years and it is expected that bottled water will overtake soda as the largest beverage category. This stagnation can be seen in the total revenues of both companies below.

The soda makers have noticed this shift, as evidenced by the comments of James Quincey. That same New York Times articles suggests that children are consuming 79 fewer calories from sugary drinks from 2004 to 2012. This was before the tax began changing consumption people's minds. When the next generation of potential soda drinkers are changing their habits, it is important for the companies to change along with them.

What is in the realm of possibility for these companies? The problem is staggering, for Coke in particular, which has 73% of its sales volume from carbonated beverages according to Forbes. Pepsi, although has stronger sales diversification, is in the same boat. In hopes of answering these problems, both of these companies have been trying to diversify their sales. Pepsi owns brands like Gatorade and Tropicana; Coca-Cola owns Powerade and Minute-Maid. This is where the future is.

But theses investments come at a cost. New brands don’t possess the same economies of scale as traditional soda brands. They also required a larger per unit marketing budget. Both of these things are weighing on the operating margins of both companies - as shown below.

So what does this mean for investors?

No it is not the end of the world for investors. Coke and Pepsi are still going to be around for years to come. What it should be is a wake up call. The status-quo will not cut it anymore. The former fortress of profits that was the soda industry is slowly being destroyed by changing consumer tastes. Taxes on sugary drinks are unlikely to become widespread in the near future. Some places may add taxes in the near future, but the real worrying part is changing consumer perception.

Investors in these companies should expect suppressed profits in the coming years. Switching the focus from soda to other new beverages is expensive and these markets are competitive. For the most part Coke and Pepsi cannot enter the market and have the same success as soda. It takes time to establish a market leading possession.

In all likelihood profits are going to continue to on the downward trend. But these expenditures are likely to be successful. The marketing power of both of these companies allow them to assert their brands on the masses. In the long-run things are likely to on the upward trend for shareholders, but some near-term uncertainty should be expected.