February 8, 2012

Investment Recommendation: Market Weight

Henry Fund Research

Beverages (Soft Drinks)

Patrick Roche
patrick-roche@uiowa.edu

INVESTMENT THESIS
(+) International expansion will continue to be the
primary driver of growth for this industry over the
next decade. Rapid growth of the middle class in
emerging markets should provide a new customer
base for the industry.
(+) Many of the companies in the soft drink
industry will continue to be leaders in product
innovation in the future. Some of the largest
companies in this industry have built up incredible
product portfolios over the years from acquisitions
and product development.

Source: www.bigcharts.com

Key Index Statistics12,14

Price

393.52
-0.008%
355.53-405.48
8.07%
320B
15.1
2.7%

YTD % Price Change

52-Week Range
52-Week Range % Change
Market Capitalization (B)
P/E Ratio (Forward)
Dividend Yield

Major Players by Market Cap (B)12,14

Coca-Cola Co.

153.17B

Pepsi Inc.

102.89B

Fomento Economico Mexicano

24.93B

Monster Beverage Corp.

9.36B

Coca-Cola Enterprises Inc.

8.42B

Dr. Pepper Snapple Group Inc.

8.30B

National Beverage Corp.

777.42M

Cott Corporation

663.84M

Coke-Cola Bottling Co. Consolidated

565.13M

Jamba Inc.

106.01M

Primo Water Corp.

72.33M

Jones Soda Co.

21.19M

Crystal Rock Holdings Inc.

18.39M

(+) Brand strength has created incredible

customer loyalty over the years, creating
excellent competitive positions for the leadears in
the industry. We feel this brand loyalty will allow
the leaders to fend off threats from generic
competition and allow them to use their vast
resources to overcome economic challenges.
(+) The incredible consistency of beverage
companies should comfort investors in an
economic environment that remains volatile and
faces many long-term structural headwinds.
Future success will provide the resources
necessary to reward shareholders.
(-) The soft drink industry is a mature industry and
the domestic market is very saturated, which will
make future growth difficult. If slower growth rates
appear permanent, stock multiples may decline.
(-) Extremely volatile currency and commodity
markets are providing a difficult backdrop for
company hedging activities. Gains or losses from
these activities are almost impossible to predict.
(-) A decline in domestic per capita soft drink
consumption attributable to consumers shifting to
new product offerings and healthier choices
appears permanent.
(-) Rising input costs from commodities are
threatening profitability. We feel a weak consumer
will make it difficult for companies to pass on
these rising costs.

Important disclosures appear on the last page of this report.

THE UNIVERSITY OF IOWA

Henry Fund Research

Henry B. Tippie School of Management

EXECUTIVE SUMMARY

very saturated, and companies in this industry face

intense competition. Naturally, one of the greatest
opportunities for growth at the present time is
internationally where many of the emerging markets
were largely untapped until recently. Worldwide soft
drink consumption grew by 2% in 2010 and increased
25,29
by 5.4% in the Asia-pacific region.
Worldwide sales
growth over the next five years is predicted to be 2.7%
25,29
and 5.1% in the Asia-Pacific region.
We feel sales
growth will be around these predicted numbers.
Predicting winners for this large and complex strategic
challenge is a difficult task, but we feel the pie is large
enough for multiple companies to be successful. We
feel that similar to their success domestically, Pepsi,
Coca-Cola, and Dr. Pepper will have huge success
overseas because of the quality of their products,
talented employees, and execution strategies. These
strengths will create advantages over local brands.

The two themes presently driving the soft drink industry

are the focus on operating execution and the race to
expand internationally through market share gains and
increased brand recognition. Consumer staples
companies have been one of the biggest beneficiaries
of the rising trend in corporate profitability over the last
decade, which currently stands at record levels.
Historically corporate profits as a percentage of GDP
35
fluctuate in a range between four and ten percent.
The two economic expansions of the 2000s have been
fueled by incredible corporate profits relative to GDP
that peaked in 2007 around 10% and have since
35
climbed all the way back to near 10%. The record
profits can be attributed to an accommodative stance
on monetary policy taken by the Federal Reserve and
an emphasis on cost cutting measures that has caught
on like wildfire by many of the United States largest
and most reputable companies. Historically corporate
profits as a percentage of GDP have averaged 6.05%
since 1947 and have only reached the ten percent mark
36
one other time in 1951. Moving forward we think that
profitability will soon begin trending down to the lower
end of the range, reaching a low around five in the next
year or two. This will be caused by a number of factors,
including higher input prices and government actions
that may soon need to address the fiscal budget deficit.
At that point we think many of the economic headwinds
and fiscal imbalances will have been addressed and
profitability will find a home around 6.5%. A longer-term
shift in domestic employment conditions represented by
a tighter labor market and increased wage incomes for
the employed will be one of the main contributors to the
reversion back near historical averages.

We have a market weight recommendation for the soft

drink industry. This industry remains a large player in
the global economy, but faces challenges in the coming
years. The biggest challenge facing the industry is the
steady decline in per capita soft drink consumption in
the United States. Per person consumption in the
United States has fallen from 50.6 gallons per year in
7
2006 to an estimated 46.9 gallons per year in 2011.
This shift is a result of an increased awareness and
acceptance towards a healthier lifestyle in the U.S.
Domestic consumers have switched some of their
consumption habits away from soft drinks into coffee,
energy drinks, sports drinks, tea, and fruit and
vegetable based alternatives. We think the decline in
domestic per capita soft drink consumption will continue
for the next three years before leveling off. At this point
a balance between a healthier lifestyle and traditional
taste will be found, as we still see soft drinks
Source: http://moneymamba.com/corporate-profits-percentage-gdp/
representing a major part of beverage consumption. We
feel that the switch to alternative beverages will put a
small dent into the leading companies in the soft drink
industry. However, product innovations and acquisitions
will keep the current leaders at the top of the beverage
industry regardless of the mixture of sales. Pepsi and
Coke have already begun to take advantage of their
deep financial pockets and talented employees,
bringing new products into the market and rolling out
new products under their prestigious brand names. We
like Coke and Pepsi in this industry as we feel the
strongest brands will do well, while the generic brands
may steal some market share at the expense of the
middle and lower quality players. Coca-Colas business
has outperformed Pepsis recently, but we think the
better performance in Cokes stock already reflects this
information. Because of this, we feel there is more
The second well-known focus of these companies is the upside in the common stock of Pepsi, as we feel they
attempt to grow their business overseas, especially in will raise the level of their performance soon.
emerging markets. The domestic soft drink market is

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Henry Fund Research

Henry B. Tippie School of Management

INDUSTRY DESCRIPTION

share will remain the same in the future. We feel Pepsi

will gain back a small amount of market share from
Coke, but they may both a experience a small decline
in market share at the expense of private label brands
in the future. During the most recent recession, we saw
a number of consumers switch to cheaper carbonated
7
soft drink brands. We think that this trend will reverse
itself in the long term as companies stop raising prices
and consumer savings levels are replenished.

Companies in this industry make, market, and sell soft

drinks, while some larger players also produce other
10
beverages and snack foods. To produce soft drinks
these companies add sweeteners, still water, and
11
sparkling water to concentrates and syrups. Finished
products are sold in glass bottles, plastic bottles, and
aluminum cans. Industry per capita soft drink
consumption in the United States stands at around 46.9
7
gallons per year. This industry is controlled by the
three major players including: The Coca-Cola Company
holding 41.2% market share, PepsiCo Inc. holding
33.6% market share, and Dr Pepper Snapple Group
7
Inc. holding 15.4% market share.

Source:
http://clients.ibisworld.com/industryus/ataglance.aspx?indid=285

The top five brands in the industry account for almost

7
fifty percent of the market. The leading brand Coke
holds a 16.7% share, followed by Pepsi-Cola at 9.2%,
Diet Coke at 9.1%, Mountain Dew at 6.5%, and Dr
7
Pepper at 6%. Other brands that make up the top ten
include: Diet Pepsi, Dr Pepper, Sprite, Fanta, Caffeine8
Free Diet Coke, and Diet Mountain Dew. Recently Diet
Coke has been making a run for the number two spot
as Coke has been taking market share from Pepsi. We
feel the current health conscious trend will continue to
help diet beverages gain share from regular beverages.
However, we do not think this will change company
market shares, as we see Diet Coke drinkers switching
from regular Coke and Diet Pepsi drinkers switching
from regular Pepsi. We feel that most of this switch has
already occurred and believe that in the future
consumers looking for more healthy options will switch
to alternative beverages. Therefore, we believe regular
Pepsi and Coke will remain at or near current market
share levels and the rise in diet drinks will slow.

Source:
http://clients.ibisworld.com/industryus/ataglance.aspx?indid=285

The battle for market share in this industry is rigorous

and tends to see continuous fluctuations back and forth
between different companies. In 1984, struggling with
39
debt and declining sales, Dr Pepper went private. This
move turned out to be a game changer for the
company. The company used this opportunity to
restructure some of its debt and sell off some of its non39
performing assets.
Following these successful
strategic moves, the company merged with the Seven39
up company in 1986. This turned out to be another
successful maneuver and has paved the way for the
successful increase in market share from 6.9% in 1983
39
to 15.4% today. Recently Coca-Cola has been taking
small gains in market share at the expense of Pepsi.
Some people feel that Pepsi has spent so much effort
on their Frito-Lay division and searching for new
products that they have lost focus on their core brand.
Regardless of the cause, we feel the small market
share losses are a part of normal fluctuations in the
industry, although we feel it must be monitored closely.
Pepsi will be making a concerted effort to refocus on
their core Pepsi brand through additional marketing and
advertising. We think Dr Pepper Snapples market

Despite the competition, the soft drink industry remains

more profitable than the average industry in the
consumer staples sector at 14.9% of revenue versus
7
9.2% of revenue. Pepsi, Coke, and Dr Pepper enjoy
the largest profitability, as they are able to charge
7
higher prices due to the quality of their brands. Much
of the advantage in the cost structure can be attributed
to the purchase of raw materials where the soft drink

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Henry Fund Research

Henry B. Tippie School of Management

industry enjoys a 42.3 to 58.8 percentage of revenue

advantage over other industries in the consumer
7
staples sector. Coke, Pepsi, and Dr Pepper take
advantage of economies of scale to help reduce costs
7
by purchasing materials in bulk. Labor costs have
benefited the industry as they have fallen from 13.9% of
7
revenues in 2006 to 12.2% of revenues in 2011. We
think that in the future profitability will decline slightly
and average around 14.5% of revenues due to higher
raw material and labor costs.

believe economic problems may resurface in a year or

two.
The CocaCola Company released quarterly earnings
15
on February seventh. Revenue came in at $11.04
15
billion, versus expectations of $10.99 billion. Earnings
per share excluding one time items came in at 79 cents
15
versus expectations of 77 cents per share. Results
were helped by volume increases in foreign markets
15
and market share gains in some product categories.
Sales volumes grew four percent in Latin America,
Eurasia, and Africa, five percent in the Pacific, and one
15
percent in Europe and North America. Pepsi Co.
released quarterly earnings on February ninth, reporting
earnings of $1.15 per share on revenues of $20.16
15
billion. This exceeded analysts expectations of $1.13
15
per share.
Over the past year, Monster Beverage Corp. and
Formento Economico Mexicano have been the two best
performing stocks in this industry with gains of 85.19%
12
and 36.11%. Monster Beverage has been the leading
12
performer in the soft drink industry over the past year.
The company has experienced a big turnaround in
business since the 2008 recession with earnings
improving from $1.11 per share to $3.11 per share in
15
2011. The company produced a 35.5% increase in
15
earnings growth in 2011 from 2010. This earnings
growth was one of the main contributors to the stocks
outperformance over the past year. Other factors
contributing to the increase in stock price were a return
on equity of 31.96% last year and a growth rate of
14
21.1% over the past five years. Going forward we
expect the growth rate to slow to around 15%, but this
will still be above Coke and Pepsis growth rates of
14
around seven percent. While 15% is an impressive
growth rate, the stock has had a nice move and we feel
the valuation might be a bit stretched at these prices.
The second best performing company in the industry,
Formento Economico Mexicano also saw a big jump in
15
earnings per share in 2011 to $2.78. This was an
15
increase of 21.9% year over year. Similarly, this stock
is priced as a growth stock and we believe the high
valuation does not offer an attractive entry point for the
future. We feel these companies are priced for
perfection and feel that even with impressive growth
rates, there are be better opportunities elsewhere.

Source: www.ibisworld.com

RECENT DEVELOPMENTS
The depth of the most recent recession and the
volatility in the markets over the last couple of years
has played an important role in the movement of the
stocks in this industry. With interest rates near zero in
2011, yield hungry investors moved into consumer
staples names, including soft drink companies. These
stocks provided a defensive investment in a volatile
market environment as these companies operated well,
provided a solid dividend yield, and received a boost
from foreign currency translations on international
profits because of a weak U.S. dollar. For the year, the
12
Dow Jones U.S. Soft Drinks index was up 5.6%. This
beat the S&P 500, which finished the year flat with a
12
zero percent gain. In early 2012, improved signs of
growth for the domestic economy have resurfaced. The
Dow Jones U.S. Soft Drinks index has lagged the
12
market as a whole. Investors have increased their
appetites for risk and moved into more economically
sensitive sectors. Moving forward, as the economy
expands, we think soft drink producers will again
underperform the market. We advocate a market weight
position to the portfolio because of the recent pullback
and the ability to select the companies most likely to
outperform their peers. Looking out in time, we feel the
current economic cycle has some room to run, but we

Pepsi and Coke are ramping up their efforts to

overcome the decline in domestic per capita soda
consumption. Pepsi and Coke seem to have hit the
mark with their acquisitions of Naked Juice and
16,17
16
Odwalla.
In 2007, Pepsi acquired Naked Juice.
This Santa Monica, California based company
produces 100 percent fruit and vegetable juices and
16
smoothies.
Recently, the popularity of these
beverages has grown exponentially. Evidence of this is

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Henry B. Tippie School of Management

supported by displays throughout supermarkets,

discount retail stores, natural foods stores, and the
beverages we see people drinking every day. Similarly,
17
in 2001 The Coca-Cola Company bought Odwalla Inc.
This Santa Cruz, California based company produces
17
fruit and vegetable juice, smoothies, and food bars.
We feel these were both good acquisitions and their
products will be a big part of each of these companies
product portfolios. Moving forward these acquisitions,
along with organic growth, should help these iconic
brands deal with the decline in domestic soda
consumption and help fend off competitors.
Additionally, PepsiCo and Coca-Colas brand loyalty,
economies of scale, and innovative spirits should propel
them forward as the dominant players in the beverage
industry.

prices, 42% rise in plastic, and the 43% rise in crude oil
39
over the previous year. Most of the price increases
have come from the top three competitors Coke, Pepsi,
7
and Dr Pepper. Many of the smaller, less recognizable
brands, are unable to pass along price increases
because of substitute products and the competition
7
from generics. Although the economy has come out of
recession, we have been a little surprised at the
success of the price increases because of a weak
consumer with little discretionary income. We feel that
because of the continued rise in commodity costs, the
top brands will continue to look to raise prices, but the
implementation of these increases will depend on the
speed of the economic recovery in the U.S.

Another interesting development that is taking place is

the momentum of personal soda making machines. For
example, Sodastream International manufactures
beverage carbonation systems and accessories used in
15
your own home.
Sodastreams products allow
individuals to make sparkling water, soft drinks, energy
38
drinks, and iced teas from tap water at home. Flavors
for their products include regular, diet, and caffeine free
cola, as well as orange mango, diet pink grapefruit,
38
lemon-lime, and root-beer. The momentum for this
product appears to be picking up steam lately as
illustrated by the increasing number of Sodastream
products and displays at local stores. The negative
factors that may inhibit increased adoption by society
include the lack of familiar cola taste provided by Pepsi
and Coke as well as the hassles that come with making
the drinks at home. However, consumers are excited
about the elimination of wasteful bottles and cans that
used to be thrown away from normal soft drinks
purchased at the store. It is very difficult to say whether
this will turn out to be another fad or something that is
adopted permanently. We think that as of now the taste
is not good enough to warrant significant market share
from other companies in the soft drink industry. This
technology offers a lot of potential and we will keep a
close eye on the latest developments.

World Price of Crude Oil

Source: www.ibisworld.com

Rising input prices coming from the rising price of

commodities is posing an annoying threat to the
industry. The most popular brands have attempted to
raise prices to deal with this threat, but as commodities
continue higher, companies are running out of options.
As we can see in the chart above, the world price of
crude oil has had a monster run over the last decade
due to a weak dollar and increased consumption
20
worldwide. Oil and natural gas are used in the
production of aluminum and plastics. The world price of
crude oil has moved from $28.23 in 2000 to $103.14 in
20
2012.
Increased demand and higher productions
costs due to challenging extraction locations, such as
foreign countries and deep-sea wells, should keep the
upward trend intact and creates the possibility of future
price spikes. We believe oil prices have the
fundamental backdrop to continue higher and think that
the price is entering a new permanent range between
$75-$140 a barrel.

INDUSTRY TRENDS
Along with cost cutting, price increases have been one
of the central strategies used by the top brands in the
industry. In July of 2011, Coca-Cola implemented plans
to raise prices three to four percent during the second
half of the year, while Pepsi also invoked price
39
increases. The increases were largely a response to
rising input prices from commodities and an improved
39
economy. Coca-Colas two largest bottlers said that
the increases were a response to the 110% rise in corn

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Henry B. Tippie School of Management

World Price of Sugar

advantage over their smaller rivals. As both companies

continue to ramp up efforts to offer healthier
alternatives, they will undoubtedly each have their fare
share of hits and misses. Equity analyst Philip Gorham
noted with consumers in North America migrating from
soda to healthier beverages, we think that owning its
bottlers should allow Pepsi to be nimble in its route to
market and give it the ability to react quickly to shifting
40
consumer tastes.
Soft drink companies have a
history of acquiring and divesting their bottlers, but for
now we feel that the relationship benefits these large
companies and will remain this way for at least ten
years.

The world price of sugar had remained relatively stable

in a range between five to fifteen cents per pound until
around 2005 when the increased use of ethanol caused
18
a spike in prices. Sugar is a crucial ingredient used in
18
the production of ethanol. We feel that part of Sugars
rise was also a result of other economical and political
factors that also led to the rise of many other
commodities. Going forward prices will likely lose some
of their ethanol premium, but the other factors causing
commodities to rise should keep a floor under the price.
We project world sugar prices to average between
fifteen to twenty cents per pound in the future. The
eventual decline in sugar prices will help offset other
rising input costs and provide relief to soft drink
producers. However, until the decline actually takes MARKETS AND COMPETITION
place, the industry will continue to suffer from rising raw
material costs.
Threat of new competition: Low

If history is any indication of the future, the threat of

new competition is low. Pepsi and Coke are two of the
strongest brands in the entire economy, making entry
into this market very difficult. The brand strength and
size measured by the incredible sales volumes of these
competitors allows for tremendous economies of scale
and great efficiency in their distribution networks. The
success of each of these companies patented soft drink
recipes has allowed them to be two of the most
successful companies in American history. While
another great beverage formula is always possible, no
one has been able to match these two juggernauts
since their inception. We believe one of the biggest
threats to these companies, which remains mostly
under the radar, is generic brands from supermarkets
and warehouses such as Costco. If one of these large
companies were to create a product that tasted similar
to Coke or Pepsi, they could pose a real threat with
their pricing power and marketing ability. High
profitability and rates of return on equity exhibited by
the top three players in this industry does create the
incentive for new entrants.
Also, the American
consumer is quick to adopt the next fad, which leaves
the door open to the threat of a new brand. However,
similar to past centuries we believe in the end the taste
of Pepsi and Cokes products will prevail. Additionally,
they are just as likely, if not more, to take advantage of
their competitive position and resources to create the
next great product.

Source: www.ibisworld.com

Each of the industrys two largest players, Coke and

Pepsi, have now purchased bottling operations from
their bottlers in order to realize cost synergies from the
acquisitions. In 2010, Pepsi closed on the acquisition of
its bottlers Pepsi Bottling Group Inc. and
23
PepsiAmericas Inc., costing 7.8 billion dollars. In the
first quarter of 2010, Coke announced it was taking
over its North American bottler operations from its
23
bottler Coca-Cola Enterprises Inc. These operations
account for approximately seventy-five percent of CocaColas U.S. bottler delivered sales volume and the
majority of its Canadian bottler delivered sales
23
volume. Pepsi has realized over six hundred million in
cost savings since its acquisition, and Coke expects to
save three hundred fifty million over the first four years
23
after the transaction. These acquisitions should help
Pepsi and Coke realize cost synergies and make their
distribution systems more efficient. We believe these
acquisitions will also play an important part in the
creation of new products, creating yet another

Threat of substitute products: Moderate to High

This is the most critical long-term threat to the industry,
and an area that has been gaining steam as of late.
Price and quality are mostly a non-issue to substitutes
as soft drink prices remain at or below most substitutes.
In fact, consumers have even shown the propensity to

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pay a premium for some of the newer substitutes on the

market. Additionally, Coke and Pepsi continue to
consistently produce the great taste that Americans
have been savoring for decades. The foremost reason
for the recent rise in substitutes is the health conscious
consumer, along with increased product offerings.
Energy drinks are one of the newest substitutes to gain
traction, especially with the younger generation. Many
young people are drawn to energy drinks because of
the cool factor associated with these products. Other
substitutes, such as fruit juices and variations of bottled
water, are growing in popularity because of their health
benefits. Finally, coffee has gained favor with some
individuals, as they have become more likely to
consume this drink in the afternoon. We believe that
Pepsi, Coke, and Dr Pepper will continue to be the
dominant players in the industry due to organic growth
and acquisitions. CNBC recently highlighted Pepsis
research and development push to find healthier
ingredients, covering an international trip with multiple
stops where company researchers explored new
healthy ingredients from plants and trees all over the
15
world.

or Coke products must decide between the two. One of

Pepsis attractive qualities is its snack business, which
can be marketed to businesses along with the
companys beverages. While there are many options in
the beverage world, this is something that the industry
has been dealing with for a long time. Unless Pepsi and
Coke get caught in competition and get out of line, we
do not see this having much impact on future
performance.
Intensity of competitive rivalry: High
The epic rivalry between Coke and Pepsi continues to
go on as heated as ever. Price adjustments, marketing
campaigns, and new product offerings are a constant
between the two with each constantly shadowing the
others latest move. One could argue this rivalry has
kept these two companies at the front of the pack and
has contributed to their great success. Pepsi has
ventured into the salty snack business in an attempt to
gain a leg up in this ongoing battle, but Coke remains
the industry leader in soft drink market share.
Throughout the beginning of the decade, Pepsi made a
strong push for this title as it enjoyed enormous
success, surprising many with the degree of success,
and raising future expectations. Over the past year, the
stock of Coca-Cola has regained momentum,
outperforming Pepsi as a result of superior execution
and small market share gains. Cokes stock has risen
by 8.89%, while Pepsis stock has risen by 4.68% and
14
Dr Peppers by 8.23%. Dividend yields are 2.8%,
14
3.10%, 3.3% for Coca-Cola, PepsiCo, and Dr Pepper.
Over the past decade we see that Pepsi outperformed
12
Coke for the majority of the time. Moving forward we
expect all three of these companies to be leaders in
their industry and provide the safety that some of the
smaller players in the industry are lacking. We feel
there may be an opportunity for Pepsis stock to play
catch up and outperform its competitors.

Source: www.sec.gov.compepsiannual

Bargaining power of customers: Moderate

Soft drinks have been and will remain an add-on to
traditional meals, and not a necessity. This creates
some bargaining power for the consumer that can be
witnessed by the low price of soft drinks relative to
other food items. In addition, there are plenty of options
available in the beverage space. Even though the
quality may be inferior to Pepsi and Coke, consumers
have plenty of options from other name brand and
generic soft drink producers. Also, the ongoing battle
between Pepsi and Coke creates even more leverage,
as another quality product is always available. Similar
to the individual consumer, businesses that sell Pepsi Source: www.bigcharts.com

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Henry B. Tippie School of Management

Key Metrics

KO

DPS

PEP

Market Cap
(B)

158.76

8.17

100.43

Forward
P/E

15.69

12.04

14.4

PEG Ratio
(5 yr)

2.68

1.52

2.51

Price/Sales
(ttm)

3.38

1.37

1.49

Price/Book
(ttm)

4.97

3.57

4.77

Profit
Margin
(ttm)
Operating
Margin
(ttm)
Return on
Assets
(ttm)
Return on
Equity (ttm)

18.42%

10.27%

9.69%

23.41%

17.35%

15.6%

experience multiple expansion. As a whole it will be

difficult for these companies to experience significant
multiple expansion moving forward and we see risks to
the downside for Coke if they dont continue to deliver
superior results. Cokes advantage in profit margin at
18.42% to 9.69% for Pepsi and 10.27% for Dr Pepper
14
shows their operating dominance. We believe this is
one-reason investors have rewarded Coke recently and
this trend seems likely to continue. However, there are
significant risks to margins in the future. Recently
companies have been benefiting from a weak dollar,
cost cutting, a lean workforce, and extremely low
interest rates. If these economic variables became
unfavorable for the industry, these companies could
face margin pressures. Coke is also an industry leader
in the return on equity category with an impressive
14
27.31%.
Pepsi and Dr Pepper also have an
impressive return on equity of 30.50% and 25.67%
14
respectively. An excellent industry business model will
likely allow these companies to maintain similar return
on equity numbers, but increases are probably unlikely.

ECONOMIC OUTLOOK
8.91%

7.06%

9.2%

27.31%

25.67%

30.5%

Payout
Ratio

51%

44%

50%

Qtrly
Revenue
Growth
(yoy)

5.2%

3.5%

11%

Gross Domestic Product

In the last couple of years GDP has been slowly
improving, but remains under historical expansionary
rates. Gross domestic product in the United States has
been bouncing around between 1.5% and 3% recently.
Lower GDP rates have less of an impact on the soft
drink industry than many other industries in the
economy. We have seen evidence of this from the solid
sales of many of these companies during the recent
recession. Future gross domestic product readings
remain unusually challenging to forecast because of the
many economic cross currents and recent political
interventions. On one hand, GDP should be buoyed by
low interest rates and a weak U.S. dollar. On the other
hand, the economy faces structural headwinds such as
high unemployment, a weak consumer, and rising
commodity prices. We project gross domestic product
to be between two to three percent for the foreseeable
future. We think GDP will average around 2.7%.
Consistent GDP growth in the high two percent range
should provide a decent, albeit not perfect, environment
for these companies to continue to do well. An uneven
recovery may provide the economic conditions
necessary for abnormal swings in P/E multiples.
Recently institutional investors have been quick to
reposition their portfolios in and out of economically
sensitive sectors. Historically this industry trades at a
slight premium to the market because of its stable
performance. We feel the market as a whole will trade
at a price to earnings multiple around fifteen. Therefore,

Source: www.finance.yahoo.com

The two largest players in the industry are Coke, with a

market cap of $154.63 billion and Pepsi, with a market
14
cap of $104.22 billion. These companies use their
size as an advantage when they can, but their size also
makes high growth rates difficult. Dr Pepper has a
market cap of just $8.29 billion, but has grown
14
considerably over the last decade. Additionally, the
acquisition of Snapple looks like it will turn out to be
very positive for the company. Historically these
companies trade at a slight premium to the market
because of their consistency and high rates of return on
equity. Coke trades at a premium to Pepsi and Dr
14
Pepper, which we think is currently deserved. We feel
there is opportunity for Pepsi to trade at a multiple
similar to Coke if they execute better and investors
reward their results. Dr Pepper will need to show that
they can take market share from the big two in order to

THE UNIVERSITY OF IOWA

Henry Fund Research

Henry B. Tippie School of Management

we feel it is appropriate to expect for the leading soft

drink companies to trade at price to earnings multiples
of sixteen. However, any signs of acceleration or
deceleration in the economy have the potential to
create quick changes in current P/E levels.

Source: Bureau of Labor Statistics

Personal Savings Rate

Consumer spending has made a sharp comeback
following the recession. Savings rates have returned
21
back to around three percent. We are concerned with
the current savings levels and feel that the events of the
last few years have proven that savings rates must rise.
Moving forward we think spending will slowly increase
as a result of rising personal incomes. After a brief
scare during the 2008 recession, consumers have
reverted back to old habits spending now and worrying
about the future later.
At some point we think
consumers will reevaluate and realize its different this
time. We feel that the catalyst for this will likely come
when the government addresses its fiscal problems.
Consumers may begin to get their financial house in
order once the government starts to get its own
financial situation under control. We believe personal
savings rates will reverse from the current trend lower
and begin moving higher. We project the savings rate to
eventually reach four to six percent. The status of
personal savings rates paints a gloomy picture and
reinforces our view that large accelerations in volume
growth will be difficult to achieve.

Source: www.ibisworld.com

Unemployment
Unemployment continues to remain elevated above
eight percent. This is currently having a negative effect
on consumer spending, although less so for the soft
drink industry than many other parts of the economy.
Although loyal customers often consume soft drinks
regularly, high unemployment will keep soft drink sales
from reaching their full potential. Areas where soft drink
sales may suffer include leisurely events such as
parties, friendly gatherings, and company outings and
trips. Unemployed individuals will not be hosting parties
and purchasing the accompanying food and beverage
items that are often produced by the soft drink industry.
Similarly, in a weak economic environment, companies
will be more selective in the activities they plan for
employees. As a result, they will spend less on food
and beverage products. Restaurants are another large
source of business for the soft drink industry.
Carbonated soft drink producers benefit from impulse
purchases that casual diners often make when dining
out. Since the 2008 recession we have seen a decline
in casual dining, hurting soft drink sales. Finally, the
poor economy has severely affected vacations in the
U.S. Americans have cut back on vacations because of
a lack of discretionary income. Soft drink producers are
experiencing declining sales from travel purchases as
fewer people are making impulse purchases on the
road. We think unemployment will decline slowly this
year and end 2012 at 8.0%.

Source: www.ibisworld.com

THE UNIVERSITY OF IOWA

Henry Fund Research

Henry B. Tippie School of Management

Currency Markets
Volatile currency markets have led to exceptionally
large swings in many different currencies around the
globe over the last decade. These moves have had a
distinct effect on profits earned in foreign countries and
converted back into American dollars. Due to
accommodative fiscal and monetary stances from
politicians and central bankers, we have seen a sharp
15
decline in the dollar over the past decade. This has
allowed many large U.S. corporations with international
operations to benefit from foreign currency translations.
Pepsis international sales volumes grew 2% in their
10
snacks division and 10% in the beverages division.
Coca-Colas sales internationally were flat for the year
due to the difficult economic climate in some of these
11
locations. The major challenge of this volatility has
been the difficult hedging environment it has created.
Moving forward we see the dollar relatively flat due to a
slightly strengthening economy, but accommodative
fiscal and monetary policy. There are a few events that
have the potential to again create large swings in the
dollar such as a toughening stance on the budget deficit
or the European debt crisis. If the dollar remains flat or
declines, this industry will continue to benefit from
foreign currency translations.
U.S. Dollar Index

these economies grow and the middle class develops,

there will be an increase in income and spending levels.
Also, as these products gain sales momentum
overseas you should see an increase in acceptance by
local cultures, which should increase the popularity and
performance for domestic brands moving into new
countries. Pepsi and Coke have made note of the fact
that they are focused on these areas for growth by
highlighting their performance and strategic plans
15
across multiple media sources. We believe the large
players will continue to be the most successful
expanding internationally and this will help contribute to
their unexciting, but stable growth in the future.
The second potential area for growth in this industry is
in new products, especially non-carbonated beverages.
The new product offerings under traditional brands may
come from a variety of sources. One trend that is
already taking hold is the addition of new healthier
beverages to the market.
We have seen the
beginnings of this from the current industry leaders as
well as from other alternative beverage companies.
Some examples from current soft drink producers
include vitamin water, fruit and vegetable juices, and
smoothies. We feel it is a likely, though not certain, bet
that the iconic brands of Pepsi and Coke will continue
to win this battle of innovation.
Their abundant
resources should give them advantages in the research
and development department, making them more likely
to benefit from new product creations. In the event that
unknown competitors create the next successful
product, Coke and Pepsi will, in all likelihood, use their
financial position to acquire the new start-ups. Whether
growth by acquisition or organically, Coke and Pepsi
appear correctly positioned to succeed in the future and
to maintain their dominance as industry leaders. History
tells us that new soft drink formulas have an extremely
low success rate, witnessed by all the failures of niche
products in the past. Therefore, Coke and Pepsi are
likely to remain the brands of choice.

INVESTMENT POSITIVES

Source: www.cnbc.com

CATALYSTS FOR GROWTH

Due to saturation in domestic markets, declines in
domestic per capita soft drink consumption, and the
size of the industry leaders, achieving increased sales
growth will remain difficult. The two main areas of
growth for this industry are international expansion and
new product development. First, the most significant
opportunity for growth rests in emerging markets. As

10

Reputable studies have shown that health benefits

2
from soft drink taxes fail to materialize. Studies
show that the taxes will probably not bring in
additional revenue and consumers are likely to
consume other substitutes that are equally as
2
unhealthy as soft drinks. Researchers have found
that calorie reductions from soft drinks are more than
made up for by consumption of other high calorie
2
beverages. These studies should provide support
against additional government taxes.

THE UNIVERSITY OF IOWA

Henry Fund Research

Henry B. Tippie School of Management

Despite recent trends of consumers switching from

soft drinks to alternatives such as coffee, energy
drinks, tea, and fruit drinks, the beverage industry
remains a powerful machine. The 2010 Beverage
Consumer Trend Report found that between 2008
and 2010, every type of beverage grew in incidence
5
on the menus of the nations top 500 restaurants.
In a recent study, 58% of consumers reported
buying a nonalcoholic beverage on their most recent
3
convenience store visit.
The major players in the soft drink industry are
getting out in front of the health initiatives through
new product offerings and the completion of projects
4
in order to keep a solid public image. For example,
the beverage industry has partnered with the
American Heart Association and former President
Bill Clinton to develop national School Beverage
Guidelines, where full calorie soft drinks at schools
were replaced with healthier beverage choices
4
consisting of less calories and smaller portions. The
industry has also taken on the task of including
calorie information on the front of products as part of
their health initiatives.

INVESTMENT NEGATIVES

VALUATION
Stocks in the soft drink industry remain reasonably
valued according to P/E multiples, although Coca-Cola
remains at the upper end of our valuation comfort zone.
Profitability of many of these companies as well as
many other large U.S. corporations remains near
historic highs. This makes margin increases difficult and
creates the likelihood for falling margins in the future.
Companies have benefited for a number of years from
accommodative fiscal and monetary policy. Moving
forward we see profitability likely pulling back a bit and
changes in the price of currencies and commodities
offsetting each other. While domestic per capita soft
drink consumption remains on a steady decline, we feel
the industry leaders such as Coke and Pepsi will
continue to preserve their share of the beverage
market. International expansion remains the best
growth opportunity and it will be interesting to see who
can expand internationally the quickest and most
efficiently. We recommend a market weight on this
industry. We feel that Coke and Pepsi are still the two
companies to own in this industry based on their strong
position and steady performance. Because of
valuations and the recent outperformance of CocaCola, we feel Pepsi offers investors more upside
potential, but acknowledge the recent outperformance
of Coke.

Threats from government regulations may add to the

challenges this industry is facing. During the creation
of the healthcare reform bill, a soft drink tax was
initially included in the bill before being taken out in
1
the end. However, some cities and states are
thinking about enacting similar legislation to tax soft
drink sales in the future, which in the past has
1
caused sales to decline. Raising prices might not
only cause a decrease in consumption, but may also
2
change consumption habits.

Our buy discipline would be triggered should prices fall

back to more attractive valuations, such as P/E
multiples around twelve. Additionally, if we felt the
economy or the market was overheating and a
downturn was likely, we would look to reposition out of
more economical sensitive names into these more
consistent performers with dividend yield support as a
portfolio management tool. Our sell discipline would be
triggered if multiples continued rising toward the upper
end of historic ranges. Other economic factors that
would cause us to reevaluate would be a quick rise in
The focus on healthy alternatives will undoubtedly the dollar, an oil price shock, or a brisk increase in
hurt industry sales. A member of a foodservice interest rates.
industry consulting firm recently said, if you dont
have a blended fruit beverage, youre not in the
5
game right now. Similarly, at convenience stores,
sparkling bottled water is growing at a double digit
3
rate and iced tea continues to do well.
The great recession of 2008 coupled with low
interest rates and the Federal Reserves quantitative
easing programs have ignited a major bond market
rally pushing yields down to historic levels. As the
economy improves and fiscal imbalances are
addressed, interest rates should begin to rise. This
will hurt soft drink companies that use debt financing
because it will raise their interest expense, although
it will also increase their interest income.

11

THE UNIVERSITY OF IOWA

Henry Fund Research

Henry B. Tippie School of Management

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12

THE UNIVERSITY OF IOWA

Henry Fund Research

Henry B. Tippie School of Management

IMPORTANT DISCLAIMER

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This report was created by a student(s) enrolled in the

Applied Securities Management (Henry Fund) program at the
University of Iowas Tippie School of Management. The intent
of these reports is to provide potential employers and other
interested parties an example of the analytical skills,
investment knowledge, and communication abilities of Henry
Fund students. Henry Fund analysts are not registered
investment advisors, brokers or officially licensed financial
professionals. The investment opinion contained in this report
does not represent an offer or solicitation to buy or sell any of
the aforementioned securities. Unless otherwise noted, facts
and figures included in this report are from publicly available
sources. This report is not a complete compilation of data,
and its accuracy is not guaranteed. From time to time, the
University of Iowa, its faculty, staff, students, or the Henry
Fund may hold a financial interest in the companies
mentioned in this report.

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13