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A little history: The Coca-Cola Company (KO) spun off Coca-Cola Enterprises (CCE) in 1986. PepsiCo. (PEP) followed the same course of action when Pepsi Bottling Group (PBG) was formed in 1997. Both bottling groups became “equity investees” because the respective parent companies retained between 20% to 50% ownership of the bottlers. The spinoffs made sense at that time because the bottlers met heightened demand, and expanded into international markets, while PepsiCo. and Coca-Cola focused on innovation and marketing. In addition, the bottling side of the business was more capital intensive and the bottlers were more vulnerable to volatile commodity price swings.

However, of late, both beverage behemoths have decided to buy their largest bottlers, or in the case of Coca-Cola, the biggest segment of its largest bottler, Coca-Cola Enterprises. PepsiCo finalized the purchases of PepsiAmericas (PAS) and Pepsi Bottling Group in a $7.8 billion deal in early 2010. The pending Coca-Cola Company purchase will cost around $15 billion. The near-term impact of these moves may not be too pleasing to investors, as operating margins may well shrink, as integration actions proceed. Also, once the acquisitions are consummated (PepsiCo already has), The Coca-Cola Company and PepsiCo will have to face challenges they previously had not encountered. For instance, the bottlers’ operations are more capital intensive and during the manufacturing process they are more vulnerable to volatile commodity prices. However, both Coca-Cola and PepsiCo. have hedges on the majority of these ingredients. In addition, they are more prone to weak demand and declining volumes due to external factors, such as the recently concluded recession. Coca-Cola and PepsiCo will also inherit the existing debt on the bottlers’ balance sheets.

The beverage landscape has changed. The popularity of carbonated drinks has waned steadily since 2005. The market is saturated and consumer tastes have been gradually shifting toward healthier choices. Therefore, the business has to adapt as well.

Consolidation activities will have vast consequences in the beverage industry. Apart from the aforementioned near-term negatives, there will be positive outcomes too. Both The Coca-Cola Company and PepsiCo will have a dominant position over the distribution channels and the companies will be able to streamline their respective businesses. The actions will eliminate manufacturing redundancies and create a more formidable supply-chain and distribution system. In short, operating expenses will likely be lowered a great deal. The companies will also be able to focus on the growth of non carbonated beverages. At present, bottlers are less inclined to focus on noncarbonated drinks because they carry smaller profit margins in comparison to their bubbly counterparts. Consolidation alleviates conflicts on decision making on such issues.

The respective purchases will affect other companies as well.  For example, Dr. Pepper Snapple (DPS) recently obtained a $900 million payment from PepsiCo.  Dr. Pepper Snapple had a distribution agreement with the two Pepsi bottlers to sell certain DPS products, in specific territories. When the acquisitions became finalized, PepsiCo had to pay DPS for the distribution rights to the tune of $900 million. Similarly, Dr. Pepper Snapple has a distribution arrangement with Coca-Cola Enterprises too, so it remains to be seen how much DPS will gain on that end. Also, Hansen Natural Corporation (HANS) will likely be affected as well as Coca-Cola Enterprises has a distribution agreement here too, which Coca-Cola will have to deal with once the purchase of CCE becomes finalized.

But not all companies will have a big payday. In fact, these consolidations could well be a danger sign for smaller players such as Cott Corporation (COT) and Jones Soda (JSDA). These companies already have small budgets for advertising, promotion and innovation activities. And they already face many difficulties when contending with national brands. The mergers will pose further obstacles for these small beverage manufacturers. Coca-Cola and PepsiCo will rule the majority of the North American distribution channel and will likely heighten competition through pricing and innovation.

Although the impact on the consumer remains unclear, these actions will inevitably chart a new course for those in the beverage industry.  Investors should carefully consider the impact this will have on their holdings in the long term.