Coca-Cola Flexes Its Venture Capital Muscle With Purchase of Topo Chico

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Global beverage titan Coca-Cola (NYSE: KO) recently announced the $220 million purchase of Monterrey, Mexico-based Topo Chico, the leading sparkling water label in Northern Mexico, which has also taken much of Texas by storm.

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In this segment from The Motley Fool's Industry Focus: Consumer Goods podcast, the cast analyzes the deal and what it means for Coca-Cola's shift toward marketing, rather than manufacturing beverages. To learn what a $42 billion outfit like Coca-Cola sees in the small, premium drink label, check out the video.

A full transcript follows the video.

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This video was recorded on Oct. 3, 2017.

Vincent Shen: For our next update here, we have two stories. The first is with Coca-Cola. They opened the week with the news that the company would be acquiring Topo Chico for over $200 million. I've never had a chance to try its products myself, but Topo Chico is an imported sparkling-water brand from Mexico that's very popular in select regions of the country, especially Texas, which makes up about 70% of Topo Chico's sales. The brand has a long history dating back over 100 years to 1895, and it seems to be a big part of its allure and popularity with consumers. Asit, this deal is made as part of Coca-Cola's venturing and emerging brands unit. We've talked about this unit before. It's a really interesting part of the company. Can you tell us about this unit within the Coca-Cola umbrella?

Asit Sharma: Sure. VEB, venturing and emerging brands group, functions as a venture- capital arm within Coca-Cola. Their mission is to go out into very far reaches of the soft-drink or beverage world and find companies that are developing brands which Coca-Cola can buy. Now, for Coca-Cola to buy a brand, it really has to have $10 [million] to $20 million in sales. Then it can scale those sales up to $200 million and beyond. But VEB doesn't necessarily have to find companies that are selling that much from the outset. They really take an ear-to-the-ground approach and try to meet with small companies when they're just forming up in start-up phase, and keep in touch with them, as many venture capitalists do with technology companies, in the hopes that they find a brand or label just starting to gain traction, and they have the advantage of the first mover, they have a relationship with the entrepreneurs and can write a big check, acquire the rights, and then scale.

I think this group has been effective. Some of you drink Honest Tea. That was a transaction that the VEB Group consummated. And this week's transaction, also consummated by the VEB Group, they did it with the Mexican bottler ARCA Continental for $220 million.

And this is interesting for those who are wondering how Coke will parlay the strategy of small, tuck-in acquisitions. Previously, Coca-Cola was buying up some small labels and manufacturing product. But the company has sold its bottling operations over the past year to bottling partners in North America and throughout the world. And by next year, Coca-Cola is going to exist more as a marketing company than an actual manufacturer. And this is one of the first transactions we see how great that business model is, because Coca-Cola actually acquired the rights to Topo Chico, rather than buying all of the manufacturing and trying to go bottle this product itself.

Shen: Yeah. I want to mention a few other aspects of how the venturing and emerging brands unit approaches its investments and kind of apply that to this latest purchase that they've made for about $220 million. So the unit was established in 2007, and they're looking for these potential billion-dollar brands. But the thing is, they're focused on products that are outside of Coca-Cola's traditional carbonated soda and sugary beverages, because the business unit claims to think five to 10 years ahead about where the beverage industry is going, and the signs of the leaves seem to point away from some of those traditional Coca-Cola sodas. And you mentioned Honest Tea, for example. This was a pretty early success for the company. They made an initial investment of over $40 million in 2008, when the company had less than 100 employees and just $30 million in revenue. Almost a decade later, Coca-Cola has totally taken over the Honest Tea brand, and the latest number from 2015 puts Honest Tea sales at almost $180 million. So the formula here is, they have phase one, they identify the opportunities. Phase two, they take a venture-capital role and make that initial investment. And that seems to be where we are here with Topo Chico.

The next phase, then, is when they start taking a greater role and usually a bigger investment as the brand grows its reach. This seems to be a pretty standard formula for the company, in terms of what options they have for Topo Chico. It has 70% of its sales in Texas, it has really strong market share there, and management has actually spoken to this idea about re-creating this success and building more Texases, basically growing Coca-Cola's share of the still-growing sparkling water industry, which at this point is still dominated by private-label store brands that you might see at the grocery store, for example. Estimates I found pinned Topo Chico revenue at less than $70 million for 2016. So we know this is not exactly moving the needle for a company this size. Coca-Cola, keep in mind, despite the fact that their revenue is going down because of this restructuring they've done, you mentioned in terms of the bottling operations, they still had almost $40 billion in sales in the last 12 months.

I think, basically, you have to think about what the company is going to be able to leverage, and I think Coca-Cola is legendary in terms of its ability to leverage its marketing machine, and allow Topo Chico to ride that and scale. Even though it's only available in 35 states and regions of Northern Mexico already, the brand is not that familiar outside Texas. And I'm sure Coca-Cola will be working a lot to remedy that. But if you are a Coca-Cola shareholder or you're considering a position in the company and you're trying to adopt a Foolish long-term perspective, I guess the question becomes, do these satellite brands and venture capital-like investments have the ability to eventually offset some of the major declines that are expected with traditional soda consumption? What do you think, Asit?

Sharma: In this case, it certainly does. Very interestingly, as you mentioned, revenues for Topo Chico are 70% in Texas. You can visualize a small band on the map of the U.S. border -- this drink is actually manufactured in northern Mexico, and it's sold in northern Mexico. South of northern Mexico and north of Texas, there's tremendous potential. Some of our listeners may know, Mexico is the second largest market for Coca-Cola outside of the United States, and Coca-Cola has been hit hard by Mexican government tariffs on sugary soft drinks. So this is an excellent way for Coca-Cola not just to take an exciting brand and scale it but to make up for lost revenue. It's exactly what you want to see as a long-term shareholder. What's the strategy to replace the declining revenue? And that is such an opportunity that falls into Coke's hands.

I don't how many of our listeners, maybe you can tweet to us if you've tried it, those of you who are down deep in the South -- I've tried it. I've got my hands on some several months ago from my local Latin American store. It's an interesting drink. It has a very colorful label. Effervescence is a little bit higher than sparkling waters you might buy here, at least to me. It's got a little bit of a salt taste to it. So it's something that offers a different segment opportunity for Coca-Cola, a new brand that they can push out there, and it's beloved by hipsters in Texas. So there's that cachet that we talked about with Tiffany. They may have some hipster cachet that they can expand on. I think it absolutely does fulfill that problem that you mentioned, Vince. We'll watch this one to see how far they can scale it in the next few years, for sure.

Shen: I think it's interesting, that popularity that it has in Texas, has a lot to do, I think, with the heritage of the brand itself, again, dating back over 100 years. The company, in the release, there's a Q&A with some executives from the venturing and emerging brands unit talking about how important it is for them to maintain that heritage and tradition for this brand, despite the fact that they're going to be putting it into the machine and expanding its presence across the country. We'll be watching to see what kind of success they have, whether this can be a next Honest Tea for them. But ultimately, this unit within Coca-Cola has invested in over something like 40 different brands at this point. Not every single one is going to be a major success, but if we know anything about this company, they certainly have the resources and the experience in beverages to experiment and test and find these small labels and help turn them into enormous successes.

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.