The Pepsi challenge for Coca-Cola

When it comes to selling soda in North America, PepsiCo is accustomed to the role of challenger. Year after year, it chases Coca-Cola and the Atlanta-based company’s market-share lead.

But now, it’s PepsiCo that has a head start.

The parent company of Pepsi, Gatorade, Tropicana and Doritos is months ahead of Coca-Cola in one of the most important strategic showdowns in decades: The effort to retool bottling operations to gird for the hyper-competitive North American market.

Call it the Bottle Battle, the latest front in the cola wars.

Coca-Cola plans to buy the North American operations of bottler Coca-Cola Enterprises in the last three months of 2010. PepsiCo closed a similar deal to buy out two independent bottlers in February. For now, PepsiCo has the first-mover advantage -- “a window of opportunity,” said UBS analyst Kaumil Gajrawala.

Why the flurry of moves in the arcane world of bottling? North America is a weak spot in the global drinks business, largely because of the decline of carbonated soft drinks. PepsiCo’s soda volume dropped 5 percent last year, according to Beverage Digest. On Wall Street, there has been “much justifiable concern” about those trends, said J.P. Morgan analyst John Faucher.

The bottler deal is PepsiCo’s method of adapting to a changing environment, Eric Foss, CEO of PepsiCo’s combined bottling operations, told the AJC. “We think this makes us bigger, stronger and faster, while also making us leaner and simpler,” he said.

PepsiCo hopes the newly-merged company can forge tighter links between its beverages and its large snacks business, experiment on new brands more quickly, explore customized ways to deliver drinks, present a unified front to retailers, and streamline its complicated supply chain. All while eliminating a tug-of-war with bottlers over profits.

PepsiCo, which now controls 80 percent of its beverage business in the U.S., Canada and Mexico, touts its newfound flexibility to deliver drinks to retailers in specifically-tailored ways. It could send beverages to big regional warehouses or directly to the shelves of mom-and-pop convenience stores, among other options.

As national retailers demand different delivery methods, the ways PepsiCo and Coca-Cola get their drinks on shelves “needs to be re-examined,” said Bill Pecoriello of Consumer Edge Research.

That flexibility was elusive under the old system, in which PepsiCo would make concentrate for sodas and send it to big bottlers, which would make the finished drinks and distribute them to retailers.

The goal now is to give niche brands more attention than afforded by the previous bottling arrangement, which was built in the days when carbonated soft drinks were the unquestioned engines of the industry.

“Maintaining the flexibility to move with consumers’ changing tastes will give Pepsi an edge over its rivals, at least in the short term,” said Morningstar analyst Phil Gorham.

PepsiCo wanted to put an end to the days in which it wrangled with bottlers over profits and plans for new brands. When Pepsi wanted to try new drinks or package sizes, the requests were sometimes hard for its big, independent bottlers to fulfill at the pace Pepsi wanted, said Gorham. That highlighted one of the central tensions: Bottlers thought Pepsi was too demanding, and Pepsi thought bottlers didn’t move fast enough. Big decisions between PepsiCo and its large bottlers too often became tug-of-wars over revenue, sales volume and profits.

“With one system, you eliminate that,” said Foss. “The benefit of one system is that it really aligns the interests that weren’t aligned before.”

PepsiCo also wants a unified front when it approaches retailers, which have consolidated and grown more powerful in recent years.

In a time when big-box chains arguably have as much power as food and beverage companies -- witness CostCo’s threat last year to stop selling Coca-Cola over a price dispute -- PepsiCo seeks more negotiating leverage with the likes of Wal-Mart, CostCo and Sam’s Club.

PepsiCo bills itself as one of the top contributors to retailers’ profits and cash flow. PepsiCo controls about 30 percent of the soda market in the U.S., as well as 39 percent of the U.S. "savory" snack market. (That category includes offerings such as salty chips, cookies, crackers, nuts and popcorn.) With nearly $60 billion in revenue, PepsiCo is now the second-largest food and beverage company in the world, behind Nestle, and the largest in North America.

“Pepsi has one advantage over Coke, and that is that it is a food and beverage company,” said Tom Pirko, president of consulting firm Bevmark. “You’re responsible for more of the stores’ revenues, so you have more leverage. You can do some creative things.”

PepsiCo calculates that having tighter control over its drink-distribution system will allow it to “unlock millions of untapped occasions,” as Foss put it -- those times when shopper pick up a Pepsi drink but not a snack, or vice versa.

For years, PepsiCo has used the phrase “Power of One” to describe its goal of being a unified snack and beverage company. With the bottler buyout, the company wants to take the concept further. It vows to increasingly use consumer insights it gleans from its Gatorade, Tropicana and snacks business to help its soda business. It will trim overlap in purchasing, manufacturing, distribution, consumer research and other areas.

PepsiCo now directly controls a North American beverage business encompassing 106 manufacturing plants, 578 warehouses and 78,000 employees.

The company plans to strip out up to $150 million in costs this year and $400 million annually starting in 2012. But top PepsiCo executives say those savings were not the main impetus to the deal. The main goal is to build a more logical structure for its beverage business to win in a North American market in which juice, bottled water, ready-to-drink teas and sport drinks are seen as the growth waves of the future.

PepsiCo has experience with mergers, having absorbed Frito-Lay in 1965, Tropicana in 1998 and Gatorade-maker Quaker Oats in 2001.

“They’ve done a lot of deals,” said Gajrawala. “They have a good playbook.”

As it designed the deal with PepsiAmericas and Pepsi Bottling Group, PepsiCo was “very conscious” of the fact that four out of five mergers fail to deliver value for shareholders, Foss said. Foss attributed that to integration planning that moves too fast or too slowly, cultural differences that are ignored until too late, or cost savings that fail to materialize.

So far, industry observers give the company high marks for smoothly pulling off the deal, despite an initial hiccup: its bottlers last year rejected PepsiCo’s first, unsolicited offer.

“In major acquisitions, price is something that is often the subject of disagreement,” said John Sicher, editor of Beverage Digest. ‘But once agreement was reached, people seemed to work pretty well together.”

For marketing companies such as Coca-Cola Co. and PepsiCo, owning bottlers requires a culture of chasing pennies and embracing “unglamorous and tedious” work, according to Credit Suisse analyst Carlos Laboy. But PepsiCo seems undeterred, and apparently wants to buy more bottlers. Foss told analysts in New York that the company would be an “interested” buyer if smaller bottlers were interested in selling.

Foss acknowledged that the blue-collar, capital-intensive bottling business requires different skills than the marketing and branding expertise cultivated at the parent company. But, he said, “At the end of the day it’s the same business.”

Bottle battle

Both PepsiCo and Coca-Cola Co. are trying to gain control of North American bottling operations after years of working with independent bottlers. Here’s a timeline of bottling moves:

1986: Coca-Cola Co. spins out Coca-Cola Enterprises, which assumes responsibility for making and distributing carbonated soft drinks in the U.S. (and later in Europe)

1999: PepsiAmericas formed from the combination of Pepsi's No. 2 and No. 3 anchor bottlers

1999: Pepsi Bottling Group spun out from PepsiCo in initial public offering

April 20, 2009: PepsiCo announces unsolicited bid for PepsiAmericas and Pepsi Bottling Group

May 7, 2009: PepsiAmericas say PepsiCo' offer "significantly undervalues" the company.

Aug. 4, 2009: PepsiAmericas and Pepsi Bottling Group accept sweetened offer from PepsiCo

Feb. 25, 2010: Coca-Cola Co. announces plan to buy North American operations of Coca-Cola Enterprises

Feb. 26, 2010: PepsiCo closes acquisition of PepsiAmericas and Pepsi Bottling Group

Fourth quarter, 2010: Coca-Cola plans to close deal with Coca-Cola Enterprises

How We Got the Story

When Coca-Cola announced in February that it would take over mega-bottler Coca-Cola Enterprises’ North American operations, reporter Jeremiah McWilliams started researching rival PepsiCo’s similar buyout of two bottlers. He interviewed company executives, as well as equity analysts, consultants, trade journalists and former Coca-Cola employees. He also reviewed company documents and read transcripts of earnings conference calls.