Pepsi Gets Back into Bottling

After several months of haggling over price, PepsiCo (PEP) Chief Executive Officer Indra Nooyi announced Aug. 4 that the food and beverage giant will pay $7.8 billion in cash and stock for two of its bottlers, the Pepsi Bottling Group (PBG) and PepsiAmericas (PAS). Together they control 80% of Pepsi's U.S. distribution.

Besides $300 million in annual cost savings, Nooyi and her team are promising the deal will deliver growth, too. That's pivotally important to Pepsi, which has been having a tough 2009. The splashy makeover of its Tropicana and Gatorade brands seems to be lacking some fizz. Two weeks ago, the company reported a 7% revenue decline in its American Beverage business, affected by another quarterly decline in Gatorade sales.

The deal is $1.8 billion more than Pepsi's original offer in April, but the company justified the increase with higher expected cost savings and the fact that the bottlers' businesses have improved over the last few months as the economy has stabilized.

Streamlining Operations Distribution is a capital-intensive business without high margins, which is why both Coke and Pepsi got out of the business years ago. Now, Pepsi is hoping that bringing its bottlers back in-house will help the combined enterprise figure out a more effective strategy to compete in the increasingly fractured beverage market.

These days, consumers are increasingly likely to grab a Red Bull energy drink or a bottled tea or water rather than a carbonated soft drink like Pepsi. Nooyi told investors and analysts on Aug. 4 that the operating model as it stands today cannot support independent bottlers and manufacturers and provide long-term profit growth for both. The merger "will allow us to vertically integrate our business, reduce costs, and focus our system resources on growth and innovation," Nooyi told them. "We believe we are taking a very important step to strategically reshape the North American beverage business."

Mike White, PepsiCo's vice-chairman and CEO of PepsiCo International, became the point person on the deal when the company first started exploring the option last winter. White notes that when PepsiCo spun off its bottlers a decade ago, carbonated soft drinks represented between 65% and 70% of packaged beverages; that share is now down to 45%. A structure where bottlers were focused primarily on high-margin, high-volume product left little room to nurture smaller brands that are now playing an increasingly important role in the market. "The supply chain and distribution need to adapt to a world in which people are as likely to drink a SoBe Lifewater as a Pepsi," White says.

The Rise of Niche Categories "Niche beverage categories have been outperforming the traditional larger categories like carbonated soft drinks and traditional juice beverages," notes Gary Hemphill, senior vice-president at New York industry consultancy Beverage Marketing. "It's really almost that the industry's reached an era of specialization." He predicts that consumers' increasing interest in a greater variety of choices and healthier options will continue the trend to more specialized products.

This is an opportunity for Pepsi to rethink the distribution of all of its beverages, from refrigerated Tropicana juices to Gatorade and whole new product introductions, argues Tim Calkins, a marketing professor at Northwestern University's Kellogg School of Management. "In beverages, there's a lot of interest in innovation from consumers. That puts a lot of pressure on the big companies," says Calkins. "It's a tough balance. They have to maintain the big brands because that's really what drives the business and their financial result. At the same time, you want to nurture innovation."

PepsiCo's White thinks this deal will help. "You need some high-velocity core products that fill up the system, but you also need to be planting seeds for the future," he says. "We have a range of products from premium products with smaller volume like Izzy and SoBe Lifewater to high-volume [products] like core Gatorade and Pepsi. One size does not fit all." Sometimes brands need time to germinate and grow. Having more control over distribution, White argues, will allow Pepsi more flexibility in marketing fledgling products.

Independents Gain a Foothold Traditionally Pepsi and its archrival, Coca-Cola (KO), have been particularly weak in innovation. They've missed many of the big trends in beverages and have ended up having to buy into the successful new categories, as Pepsi did by buying the brands Gatorade and SoBe in 2000, and as Coke did with its $4 billion purchase of vitamin water maker Glaceau in 2007.

But many of the fastest-growing categories of late remain dominated by brands that grew independent of the big cola companies. In recent years, the beverage market in general has grown about 2% a year, although 2008 was a down year, Beverage Marketing's Hemphill says. Last year, sales of energy drinks grew 9%, to $7.8 billion. Just five years earlier, it was only a $1.3 billion business. The dominant brands in that field are Red Bull, Monster, and Rock Star, all products from independents.

Recently Nooyi has put an increasing push on research and development, and PepsiCo's White says the company is not just looking for internal inspiration but is increasingly partnering with outside universities, think tanks. and others to come up with the next great thing. As Kellogg's Calkins notes, a lot of the traditional lines between beverage categories have blurred. Consolidating distribution may help Pepsi erase some of its internal lines as well. "If you had a fruit juice-based energy drink that was carbonated, where would you put that?" says Calkins. "The world of beverages used to be much simpler."

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