The Road To Market

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Significant speculation in the beverage industry trade press has focused on future mergers or combinations of the major beer and soft drink suppliers, as well as the possibility of large distributors vertically integrating or partnering with major suppliers.

During 2010, PepsiCo acquired 100-percent control of its two largest franchised bottlers, PBG and Pepsi Americas, paying $7.8 billion for the remaining interests it did not already own. Prior to the acquisitions, Pepsi owned 33 percent and 43 percent, respectively, of its two largest franchised bottlers. The Coca-Cola Company then announced the proposed purchase of CCE’s North American operations, its largest bottler (which was already 34 percent owned by Coke), for $12 billion (mostly by assuming a large portion of CCE’s existing debt). Coke’s deal closed in October 2010.

Combined with the formation of ABInBev and MillerCoors, the beverage industry has changed dramatically in the past two years. As a result, the value of intangible distribution rights has been reaffirmed and the strategic role of the “exclusive” beverage distributor has escalated.

Access to the Marketplace
Pepsi now owns an estimated 80 percent of its North American distribution network and Coke controls an estimated 86 percent of its distribution system (including direct sales through Coca-Cola’s fountain syrup jobber system, which may account for a third of the 86-percent estimate). As a result, the recent billion dollar mega-bottler acquisitions will allow Pepsi and Coke to cut costs, be more flexible on pricing, and offer mega-retailers better and more uniform deals.

These two leading brand owners now have greater freedom to go to market via central warehouse delivery (a serious prohibition in an all-exclusive franchise system), or the traditional direct store delivery method. They also have direct control over any other beverage suppliers who want to access their respective distribution systems.

Over the past decade, new beverage products have proliferated and some key mega-retailer customers have demanded centralized warehouse delivery of franchised beverages. Nonetheless, we continue to believe that the DSD method remains superior for delivering beverage products to consumers at the lowest cost. For this reason, we think that PepsiCo revamped its distribution for Gatorade away from central warehouse delivery, to its franchised bottler system. Also, in this new environment, competing smaller brand owners seeking to “piggyback” on the established major domestic distribution networks most likely will incur additional costs (like royalty payments) and other hurdles in order to gain access to the marketplace.

The vertical consolidations by the major domestic beer and soft drink suppliers will allow the mega brand owners to profit from future attempts by other brand owners to gain access to the marketplace through their systems. In the U.S., independent distributors with exclusive and perpetual rights to sell and distribute trademarked brands historically have represented a brand owner’s sole access to the marketplace. For decades, this road to market has been an efficient means of distribution for beverages of all makes. The lead franchisors now are in a position to capitalize on the indispensable position of the exclusive distributor in the beverage marketplace, possibly at the expense of the smaller beverage companies and craft brewers seeking to expand their own distribution to retailers.

In recent years, traditional domestic beer and carbonated soft drink volume has been soft. Craft beer and non-traditional or so-called “alternative beverages” produced by small companies have accounted for most of the beverage industry’s growth. The road to market for many of these new and innovative products was made possible by “piggybacking” on the established beverage distribution systems that have been in place for generations. Therefore, by acquiring the vast majority of their respective distribution systems, the lead brand owners (a) increase their options to acquire future growth by buying out a competing brand owner seeking distribution, (b) protect their existing market position and portfolio of brands with retailers, and (c) create new challenges for the smaller beverage companies and craft brewers.

The changing dynamics of beverage distribution and the battle over managing and gaining access to the marketplace increasingly will guide strategic decisions for the dominant mega brewers, the smaller beverage brand owners, craft brewers, and distributors. Due to soft drink companies buying bottlers and brewers attempting to increase their ownership of distributors, “access to the marketplace” is a major challenge for many operators and, by far, the most valuable asset for every beverage company competing in the marketplace in the foreseeable future.

Through vertical distributor acquisitions, major soft drink companies and mega brewers achieve the following immediate benefits:

manage pricing promotion and brand “investment” decisions
get closer to the consumer to understand trends
improve their ability to react to consumer trends more quickly, changing out shelves/inventory and adjusting pricing accordingly
reduce the number of people involved (i.e., sales people, distributor management team)
reduce the level of franchisor-franchisee interaction and “politics” (i.e., reduced need to deal with family issues or sensitivity of distributor relations)
reduce barriers for direct shipment to mega-retailers and chains.
Beverage Distribution Alternatives
The lead suppliers’ current shift to (a) acquiring distribution assets and (b) influencing access to the marketplace may set limits for some market players—direct and indirect competitors as well as bottler/distributor “partners.” However, the good news for smaller beverage companies is that vertical integrations should not automatically restrict the availability and distribution of alternative beverages. When considering the total refreshment beverage market of alcoholic and non-alcoholic beverages, the majority of markets throughout the U.S. will have at least the following four major distribution networks available to brand owners—Pepsi, Coke, ABInBev, and MillerCoors.

The four major beverage distribution networks now in place will continue to compete aggressively (with comparable assets and financial resources) to offer beverages to retail customers and consumers nationwide. Additional beverage distribution resources also will be available through expanding mega-retailer delivery systems, and by food wholesalers like McLane Company. Thus, existing and emerging beverage segments such as craft beer will enjoy significant competition for their brands and numerous choices for distribution of their brands, especially among independently owned distributors seeking to expand their portfolios beyond the products offered by their principal franchisor.

Furthermore, in light of the heavy capital investment in distribution, it would come as no surprise if Pepsi or Coke were to ”re-franchise” its entire U.S. distribution system in three to five years “to create the next generation of high return opportunities.” The rebirth of franchised distribution three to five years from now could be similar to current Coke and Pepsi systems outside the U.S.—distribution systems owned and operated by large, independent bottlers (though ideally without public ownership of bottlers that may conflict with the interests of the franchisor).

Through the future “re-franchising” and sale of bottling facilities and/or franchise territories they own, Coke and Pepsi could write new distributor agreements with their new business partners and raise a large amount of capital when needed. This is what Coke did in 1986 when it gave birth to CCE. The soft drink leaders would be in a position to choose whether or not to participate via equity investments in new, large, privately owned U.S. anchor bottlers who would be more closely aligned with the demands of a diverse marketplace increasingly dominated by mega-retailers, and the interests of the franchisor. As an alternative, distribution rights for the smaller up-and-down-the-street accounts could be reassigned to independent local distributors for maximum penetration and retailer service.

Value of “Golden Cases”
Interestingly, Dr Pepper Snapple Group (“DPS”), the third-ranking brand owner in the soft drink industry, actually strengthened its access to the marketplace as a result of the 2010 Pepsi and Coke mega-bottler acquisitions. As it turned out, the two mega-bottlers that Pepsi sought to acquire also were licensed franchisees of DPS for a small but significant percentage of their total volume. If DPS were to disapprove the transfer of its brands to the buyer, the loss of the incremental profit contribution to PepsiCo would have reduced value significantly, likely killing the deals.

DPS showed the muscle and value of incremental “golden cases” by entering into a 20-year renewable “Distribution Agreement” with PepsiCo that gave Pepsi the right to hang on to these “golden cases” in perpetuity so long as Pepsi abides by the terms of the distribution agreement. Pepsi paid $900 million to DPS for the exclusive perpetual rights to the DPS brands in the exclusive territories of the two mega-bottlers it purchased. In essence, Pepsi paid twice for the DPS franchise rights of the two bottlers—demonstrating the valuable nature of “golden cases” and their calculated worth. In the beer world, craft beers are the “golden cases.”

DPS gained leverage in this arrangement because it retained termination rights. Also, Pepsi must adhere to DPS performance provisions and maintain a Chinese wall of confidentiality between its Pepsi and non-Pepsi business. The Pepsi-DPS Distribution Agreement also potentially lays the foundation for similar arrangements in the beer industry, by showing that a competitor may handle another brand owner’s brands on an exclusive, perpetual basis without conflict—an interesting twist in distribution. A similar “golden case” agreement and payment by Coke to DPS was made as a result of Coke’s acquisition of CCE.

Financial and Economic Rationale
The cash flow of distributors is stable and predictable. A mega brand owner may be motivated to acquire distributors because it views a distributor as an extension of itself. The stability, predictability, and interdependence of brand owner and distributor reflect low business risks. Therefore, significant prices are being offered for the stable, predictable cash flows of distributors because buyers recognize that the low business risks drive a low cost of capital.

The blue-ribbon investment bankers who rendered the fairness opinions of value in the two Pepsi mega-bottler deals calculated a cost of capital in the range of 7-8 percent. This is a very low hurdle rate compared to the risk-adjusted return on investment of most industries in the U.S., and reflects the relatively safe and stable nature of beverage distribution.

Paradoxically, investments in the distribution side of the beverage business always have generated a lower return on capital than investments in “pure” franchising (which consists mainly of tax-deductible marketing expenditures). This conclusion is supported by the underperformance of PepsiCo’s stock price relative to the S&P 500 in the months following its announcement of the mega-bottler acquisitions. Nonetheless, a franchisor’s pursuit of distribution assets in the well-developed U.S. beverage industry is perfectly rational economic behavior, because the lower returns available from distribution still exceed the 7-8 percent minimum returns required by the franchisor’s shareholders.

In most of the world outside the U.S. (where Coke generates most of its profits), the locally owned, independent, exclusive franchise system publicly advocated by Coke is in full swing. The “contrary” vertical integration of franchisor and franchisee that we presently are witnessing in the U.S. simply may signify that Coke and Pepsi have run out of high yielding investment opportunities in the “pure” franchising business in this country. However, owning their respective distribution systems for now and therefore having the ability to manage access to the marketplace along with low levels of business risk provides the platform for huge future returns. Furthermore, ongoing annual capital expenditure requirements are low compared to the cash flow generated, especially for bolt-on brands or “golden cases.” The large brewers are likely taking note.

The senior management of the mega beverage companies makes strategic decisions based on maximizing “Return on Investment” and “Value Creation” for their shareholders. Therefore, as noted above, three to five years from now we very well may see a return to a franchise system in the U.S. built around different market dynamics that create “the next generation of high return opportunities.”

Outlook for Independent Exclusive Distributors & Small Brand Owners
Independent exclusive distributors, the small beverage brand owners, and craft brewers will undoubtedly encounter hurdles in a turbulent and uncertain future in the months and years ahead. Nevertheless, so long as there remains a mandate for a dynamic three-tier system for soft drinks and beer, we conclude the following:

The industry’s margin pool split for independent exclusive distributors will remain intact because the principal brand owners realize that distributors must operate near current gross profit levels to remain competitive and deliver value-added services to large and small retailers.

The independent distribution platform for beverages is an extremely valuable asset for all brand owners that use it, including small breweries, craft brewers, and small beverage companies, and to risk altering the existing franchise or three-tier system risks permanently damaging the equity of the brand owners.

The outlook for growth, profitability, and reinvestment in the beverage distribution business remains positive for strategic buyers of exclusive distributors as they continue to squeeze out redundancies through the acquisition of willing sellers.

Brand exclusivity and perpetuity are conveyed to distributors by the binding distribution agreements that exist between brand owners and exclusive distributors. Well-drafted agreements will support the premium value of beverage distribution rights and strengthen the balanced partnership between a performing distributor and the brand owner.

The smaller beverage brand owners and craft brewers are seeking and should be afforded relief from some of the state-regulated franchise laws, to enable them to economically divorce themselves from a non-performing distributor. This will encourage greater investment and growth on the supplier side.

Opportunities exist for brand owners and independent beverage distributors holding exclusive franchise contracts to create enterprise value through strategic partnerships and acquisition of “golden cases,” as the beverage industry continues to realign brands and remake itself.

Now is the time for independently owned craft breweries, beverage companies, and distributors to assess strategic options, create new partnerships and alliances, and pursue brand acquisition opportunities to increase overall enterprise value. An exclusive “three-tier” beverage distributorship system, in tune with the demands of consumers and retailers, remains the best business model to create value for distributors in partnership with strong and growing brand owners.

Andrew S. Christon is the president of Ippolito Christon & Co. Since 1986, Ippolito/Christon has prepared nearly 500 appraisals for the purchase, sale, and valuation of closely held businesses in the beverage industry. It also advises clients on the purchase and sale of beverage businesses and brokered the first beer distributorship transaction in excess of $100 million three years ago. Ippolito/Christon is recognized nationally as an expert on the value of intangible beverage distribution rights.