Coke deal risk bigger than Pepsi's; should pay off

NEW YORK (Reuters) - Coke may have followed Pepsi's lead with a very similar bottler deal, but the world's top soft drink maker faces greater risk in its unexpected return to the logistics side of its business.

Coca-Cola Co's (KO.N) surprise move to buy the North American operations of bottler Coca-Cola Enterprises Inc (CCE.N) should improve its business in the long term, but it will change the investment profile of the world's largest soft drink maker and dilute some of the reasons for owning the stock in the first place.

That also applies to PepsiCo (PEP.N), which closed its purchase of Pepsi Bottling Group and PepsiAmericas Inc on Friday.

But Wall Street appears be more bullish on Pepsi given its greater potential for cost savings, more consistent performance from its bottler and the headstart it will have in consolidating its distribution system.

"Coke is considered an emerging market and international growth stock -- but this deal takes overseas revenues from 74 percent of total to 54 percent," said Barclays Capital analyst Michael Branca.

Another consequence of the deal is that about half of Coke's revenue will come from bottling drinks, which has slimmer profit margins than its business now of selling beverage syrup.

Coke's "impressive financial metrics," such as operating margin, net margin and return on invested capital, "should all compress," Branca said in a research note. He pulled Coke from his Consumer Staples "Favorites" list, but not PepsiCo.

Coke's deal is not expected to close until October. "In the interim, we believe PepsiCo will begin to reap the rewards of its actions in the very short term," he said.

With food brands such as Frito-Lay, Quaker and Rice-A-Roni, PepsiCo has more ways to consolidate its distribution and cut costs. Plus its footprint was already more concentrated in North America.

At the same time, Coke might be more at risk when it comes to execution, said Edward Jones analyst Jack Russo.

"If you look at CCE's financial results over the last five to 10 years, they've been a lot more inconsistent than PBG," Russo said. PBG's smoother performance is particularly notable in a volatile business exposed to commodity prices for everything from glass and aluminum to fuel.

Over the longer term, however, both Coke and Pepsi should see improved profitability from the bottler transactions, said Bryan Keane, an analyst with Alpine Mutual Funds, based in PepsiCo's hometown of Purchase, New York.

They will also continue to see growth in emerging markets, even if that makes up a smaller portion of revenue.

"The overall topline will slow, but not necessarily the emerging market topline," he said.

Coke shares fell 0.8 percent to $52.72 on Friday, after sliding nearly 4 percent on Thursday, the day it announced the deal. By contrast, shares of PepsiCo rose 5 percent on August 4, the day it announced its sweetened bottler deal, and has gained 6 percent since then until Friday, when the deal closed.

DRAMATIC ALTERATION

Coke's main business involves selling beverage concentrate, or syrup, to a global network of bottlers, who do the capital- and labor-intensive job of mixing, bottling and distributing the drinks.

Coke engineered it this way, by spinning off its bottling business in 1986, a move that took the lower-margin business off its balance sheet. PepsiCo did the same in 1999.

But since then, "fundamental industry forces have dramatically altered the consumer, customer and competitive landscape," said Coke CEO Muhtar Kent on Thursday.

For one, he said non-carbonated drinks like teas, juices and waters have doubled as a percentage of total volume, now making up more than 30 percent. Those drinks have outperformed in recent years as a growing health consciousness turned many consumers away from sugary sodas.

Coke and Pepsi are mostly responsible for bottling those drinks themselves, since they often require more specialized techniques, such as pasteurization. They also carry higher profit margins, a fact that has aided the concentrate companies at the expense of the bottlers.

At the same time, consolidation in the retail sector means more power for a few big-box retailers such as Costco Wholesale Corp (COST.O) and Wal-Mart Stores Inc (WMT.N), which favor a more centralized system of delivering drinks to their warehouses.

Bottlers, however, specialize in delivering directly to a multitude of stores.

With carbonated soft drink sales falling in recent years, competition has intensified.

Both companies' deals -- which together involve some $20 billion in cash, stock, equity and debt -- are expected to cut costs and streamline operations.

For example, they would need only one sales associate to keep in contact with a retailer instead of one from the company and one from the bottler. Plus, having control of their distribution could also speed innovation and new product launches, which analysts say is key to winning more consumers.

Both Coke and Pepsi reported higher-than-expected sales in the recently ended fourth quarter, as strong sales in emerging markets helped blunt the impact of ongoing weakness at home.

EXECUTION IS KEY

Kent said on Thursday he "fundamentally believe(s) that the franchise model in its broadest sense is the best way to win in the marketplace," an oft-repeated phrase many investors took to mean he would not buy the North American bottler, like Pepsi.

But Coke has been looking at buying its bottlers on and off for about five years, said John Sicher, editor and publisher of industry newsletter Beverage Digest. Sicher said the board may have only approved a deal now that "management is strong enough and stable enough to handle a transaction as complicated and massive as this one is."

Coke plans to relinquish its 34 percent stake in CCE worth about $3.2 billion and assume $8.9 billion in debt and other assets and liabilities. Pepsi paid $7.8 billion for the bottlers and $900 million to Dr Pepper Snapple Group Inc (DPS.N) for the right to continue selling its drinks.

Sicher stressed that the deals represent a first step in a major overhaul of the beverage industry.

"I don't think Coke's going to spend $13 billion, or Pepsi $8.5 billion, just to get synergies. You spend that kind of money to make necessary and dramatic change," Sicher said.

But Tom Pirko, founder of beverage industry consultant Bevmark LLC, said he was concerned that resources needed to integrate the bottling businesses will take away from the companies' main functions as brand-builders.

"Stop supporting brand development and feeding your icons because you have to worry about bottling lines, route salesmen, trucks, merchandising in stores, etc. and you may really go awry," he said.

(Reporting by Martinne Geller; Editing by Michele Gershberg and Matthew Lewis)