Last year was an interesting one for non-alcoholic beverage companies. In the hard-fought cola wars, the world shifted on its axis when The Coca-Cola Company’s (KO - Free Coca-Cola Stock Report) Diet Coke surpassed PepsiCo.’s (PEP) Pepsi, to become the second most popular carbonated soft drink in the United States. PepsiCo.’s stumble to third place has been partly attributed to poor advertising strategies. The beverage titan spent $3.4 billion in advertising last year (this includes spending on its snack portfolio) versus $2.9 billion the prior year. However, many in the beverage world are of the opinion that the “Refresh Project”, which focused on charitable projects, did little to appeal to the consumer in 2010, and that PepsiCo. should revert to more traditional advertising methods in order to recapture consumer interest. We expect the company to shift gears this year back to the old days of “product attribute marketing”. This would enable PepsiCo. to focus on the positive characteristics of the brand itself, which we believe would be a more effective way of regaining consumer loyalty.

But there is a bigger picture to this story. The underlying fact is that soft-drink consumption in the United States is on the decline. Statistics from Beverage Digest highlight that U.S. carbonated soft drink consumption (CSD) slipped by 0.5% in 2010, and both Coca-Cola and Pepsi suffered volume declines. Although the decrease was less severe than the 2.1% drop in 2009, the CSD category is falling short of historical levels. The peak of CSD consumption was in the 1990s when this market grew at an average annual rate of 3%. Further, per capita consumption experienced its zenith in 1998, with about 864 eight-ounce servings per consumer. The most current per capita consumption statistics are from 2009, which show about 736 servings a year. Although the United States still holds the top spot for soft-drink consumption, continuing volume declines are concerning to Coca-Cola and Pepsi alike, not to mention other CSD manufacturers, such as Cott Corporation (COT) and Dr Pepper Snapple (DPS).

Arguably, the main drag on soft drinks is the bad reputation they have earned over the past two decades, or so. Growing concerns over obesity levels have become embedded in the American psyche. This scenario is exacerbated through the media and a myriad of health groups. Unlike times gone by of ignorant bliss, nowadays scientific and medical research have discovered evidence of the harmful effects of high fructose corn syrup and preservatives, key ingredients in soft drinks. And the cold hard facts of obesity, cardiovascular disease, and hypertension (to name a few) have not gone by unnoted.

In fact, it is quite evident that consumer tastes have shifted toward healthier beverage alternatives. U.S. consumers are turning away from soft drinks in favor of bottled water, energy drinks, ready-to-drink teas, and sport drinks. The popularity of bottled water is old news. But the other products are fast becoming regular staples in U.S. households. And, although carbonated offerings will remain an integral part of beverage companies’ businesses, these operators have embraced changing consumer preferences with open arms. In fact, this scenario is beneficial because sales of these more premium offerings enhance profit margins.

Beverage behemoths Coca-Cola and Pepsi continue to expand their beverage portfolios, evident since the two titans have hundreds of these products in their lineups. They have obtained these through active innovation pipelines as well as acquisitions. For instance, Pepsi acquired the highly popular Gatorade franchise in 2001 after acquiring the Quaker Oats Company, which, itself, bought Gatorade in 1983. Its margins also have been lifted by the acquisition of SoBe Lifewater in 2001. Meanwhile, Coca-Cola has followed the same type of action through the acquisition of the highly popular Vitamin Water franchise, which it bought in 2007 for a hefty $4.1 billion. Other companies have also benefited from changing consumer tastes. For example, Hansen Natural Corporation (HANS), manufacturers of Monster energy drinks currently holds sixth place in the U.S. beverage market. This position has been achieved by the growing popularity of energy drinks, as well as the company’s distribution partnerships with The Coca-Cola Company and Anheuser-Busch InBev (BUD).

That said, carbonated offerings are not being ignored as beverage companies, large (Coca-Cola, Pepsi, and Dr Pepper Snapple) and small (Cott Corporation) alike know that their core offerings will likely always experience high levels of demand in the United States. In order to appeal to the health-conscious consumer, beverage companies also have been actively pursuing healthier options to traditional sodas, such as less harmful sweeteners and artificial ingredients. For example, PepsiCo. is currently collaborating with Senomyx Inc. (SNMX), a flavor-enhancer company that seeks to discover sweetener compounds that reduce sucrose content in food and drink products. And Coca-Cola has a similar arrangement with another company. Furthermore, Coca-Cola and Pepsi, fully aware of the saturation of CSDs in the North American market, are both making efforts to penetrate high-growth overseas  markets, such as India, China, and Brazil because the low consumption levels in these countries create  ample growth opportunities .

At the time of this article's writing, the author did not have positions in any of the companies mentioned.