Why the Costa Buyout Is Just One Piece of Coca-Cola's Ongoing Transformation

In this segment from Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Daniel Kline take a step back to consider how Coca-Cola's (NYSE: KO) acquisition of Costa fits into management's vision for the future and other major initiatives.

A full transcript follows the video.

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This video was recorded on Sept. 4, 2018.

Vincent Shen: Last comments that I'll mention for the deal, unless you have something to add, is around the valuation. In terms of the process for how this deal came together, I've seen both management teams mention that it was a pretty quick process. The price tag paid has garnered a little bit of attention during the investor call. 16X EBITDA. I compare that to another deal recently in the beverage space, which is PepsiCo, because they recently took over SodaStream. Some people have complained, some investors have been unhappy, because that was this huge premium. They bought it at some of the highest prices that SodaStream has been trading at, almost 25X EBITDA. What we're seeing here, definitely some expensive deals in the beverage industry, in terms of the opportunities that the giants are going after.

Dan Kline: I think it's because there are some sharks out there right now. We've done whole shows on JAB, however you want to call them, which is a holding company that owns a billion coffee brands, some you've heard of, some you haven't. They own Panera Bread, they own some equity in what used to be Keurig, that's now Keurig and Dr. Pepper. They were probably a player here. We don't know that, but even if they were just sort of sniffing, it's very easy to go to Coke and say, "If you don't pay our premium, we don't want to sell to these guys, but they're buying." It's very likely that that was out there.

Shen: Yeah. Talking about Coca-Cola more broadly now, just providing some context for how this deal fits into their strategy going forward. There's been a lot of changes with the company. Ultimately, you see Coke pursuing this capital-lite model, where they can be the puppet master pulling the string on brand management and marketing. They've tried to move away from having to deal as much, in terms of the operations, with manufacturing and bottling because of the heavy capital expenditures that that requires and a lot of the other expenses that come with that business. For example, in 2017, Coke completed the refranchising efforts of its U.S. bottling operations. There were also some big efforts in shoring up the bottling operations of big markets like China and Japan.

In addition to those refranchising efforts, there's also some big changes in terms of the product portfolio, to address health concerns, sugar content. They've killed a lot of what they call zombie brands that are just not performing well, and with that, hundreds of SKUs in certain markets. There's been new leadership, with James Quincy as the CEO. They also have a chief growth officer that they've added. A lot of shifts there, as well.

What that ultimately means if you're looking at Coca-Cola as an investor is, their top line is shrinking, no doubt about it, because of these efforts. But at the same time, with this asset-lite business model, their profitability is getting stronger and stronger. There's a give and take there. The way the company sees its product brand strategy is to become the No. 1 or No. 2 leader market or product, because that brings in the most profitability and the best returns for the company. I have a quote from Quincy, the CEO, where he basically says, "It's better to be the leader in half of the world than No. 3 in all of the world from a scale and profitability point of view." This, again, speaks to why they picked up Costa, right?

Kline: It's a big diss to RC Cola.

Shen: [laughs] Exactly. This latest deal with Costa, it makes sense that they have a dominant name in its home U.K. market, and something that's very strong in Europe and is branching out from there and taking that strength and molding it into their system.

Kline: And it's a brand that could plausibly become the No. 2 in the United States in some of these categories. It is not going to be the No. 2 coffee house. It could absolutely be the No. 1 or No. 2 restaurant brand. It could become the No. 1 or No. 2 convenience store brand.

Shen: Ready-to-drink brand, yeah.

Kline: Ready-to-drink, I think, is harder because that is much more, if you're looking at labels, it is about brand name. If you want a nice hot cappuccino and they put this glorious-looking machine in, you're not probably going to think about who made the beans. You're going to think "I want a barista-made coffee, and this is the closest I can get." I worry about their ability, for a long time, to put a Costa bottle next to a Starbucks and McDonald's. You saw the Starbucks-Nestle deal, which is all about ready-to-drink and expanding. This is a space that everybody is targeting. Dunkin' Donuts has rapidly. Those are very big names. Costa has proven it can be a name, but it's going to take a while in the U.S. until it is a name.

Shen: Yeah. The last thing is, the new brand, and with the retail storefronts. A big part of that is the ability to experiment. You mentioned some examples from Starbucks. The chief growth officer position, I think it's really interesting, he talked about experimentation during a June presentation. He said, as of the first quarter of 2018, Coca-Cola has increased its number of experiments 30% with the volume from those products up 32%. Coffee is basically this whole new playground now for them, to see what works, what doesn't.

Again, I think this is a really interesting deal for Coca-Cola. You think about their dominance in these non-alcoholic beverages. It does make sense. You've essentially opened up the entire additional market that coffee and hot beverages provide.

Kline: Coffee has also become a bit like craft beer. I'm not sure how big a coffee guy you are, but I'm a pretty big coffee guy. If a new coffee house opens up in my neighborhood, I am going to check it out, and I'm going to try three or four different things before I make a decision on whether that becomes part of my rotation. There's a certain anti-Starbucks. It's not that you don't like Starbucks, but you've been there 1,000 times. When they're in a market, when they're opening in China, where there's thousands of Starbucks, and a Costa comes in, your coffee aficionado is going to try it in a way that doesn't work necessarily in fast food or other places, just because it's new. And the product is good. It's proven that people like it. That's going to give it an ability to grow in markets where they don't have to supplant someone. They just have to take a piece of the business. Maybe they'll be a strong No. 2 a lot of places that doesn't exist. The U.S. has a whole bunch. There's a lot of fragmentation across the rest of the world.

Shen: Yeah, definitely. That's something they speak to for coffee. I'll leave listeners, the last comment for this deal -- the potential that you always have to remember when you're dealing with a company of this scale and experience, when it comes to beverages, there's a reason why it's the market leader. Coca-Cola has their distribution system, they get about two billion drinks into the hands of customers in 200 countries every single day. Now, you're just adding this new what they consider platform to the mix. I'm really excited to see what not only Coca-Cola is going to do with this, but I'm excited with the other deal, with PepsiCo and SodaStream, to see how that works out. We're definitely going to follow up on this. It's been too long since we've talked about the majors in beverages.

Daniel B. Kline has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of SodaStream. The Motley Fool recommends Dunkin' Brands Group and Nestle. The Motley Fool has a disclosure policy.