Are Sodas Losing Their Fizz?

"Everything is for hydration," said Gailas, a 20-year-old student at New York University.

Gailas is just one example of an industrywide trend. Gone are the days when slaking your thirst meant popping open a can of your favorite fizzy soda brand.

Consumers have gotten more picky about their liquid refreshments. The core 18- to 24-year-old soda drinker is moving away from sugary sodas to energy drinks and healthy beverages.

Over the past decade, the market has moved from one-size-fits-all megabrands to targeted niche products, says Gary Hemphill, managing director of Beverage Marketing Corp., a consulting and research firm.

"We're seeing a vast proliferation of products," said Hemphill. "Companies really can't operate with one brand. They have to have a portfolio of products."

Soft drink companies have extended their lineups to include a vast array of drink categories, including energy drinks (the market's fastest grower), bottled water, juice drinks, sports drinks, and ready-to-drink tea and coffee.

"The industry is moving into an era of specialization where products are finely targeted, whether to a specific demographic group, occasion or to a specific need state," Hemphill said.

1. Business

The beverage industry is really two distinct, symbiotic businesses.

Big drink companies like Coke and Pepsi make a drink's concentrate, or flavored syrup, and manage packaging design and marketing.

Bottlers, meanwhile, mix the concentrate with water and other ingredients, package it and distribute the final product to retailers.

"The bottlers handle the dirty work," said Alton Stump of Longbow Research.

The drink companies' operating margins hover between the high teens to over 20%, he says. Bottlers see margins of around 7% to 9%.

The drink companies make money from effective marketing and by driving higher sales through new products and marketing campaigns.

Bottlers depend on the same drivers, but also make money by being more efficient in distribution and effective with in-store promotions, Stump says.

Collectively, soft drink stocks rank No. 46 out of IBD's 197 industry groups, from 91 three months ago.

The group includes top soft drink companies and bottlers such as Pepsi Bottling Group (NYSE: - ), Coca-Cola Bottling Co. (NasdaqGM: - ) and Hansen Natural (NasdaqGS: - ).

Noncarbonated drinks present not only a revenue growth opportunity but a profit growth opportunity, Stump says.

That's because most drinkers tend to buy them individually from convenience stores and gas stations, where the products are three to four times more profitable per unit than in the six-packs and cases sold at grocery stores.

Health-conscious consumers have driven demand for noncarbonated drinks, says Garima Goel Lal, senior research analyst with Mintel International Group.

Consumers buy low-calorie drinks to stay trim, drinks that have nutritional value to stay healthy, and energy drinks to stay alert and active.

Coca-Cola (NYSE: - ) recently introduced vitamin-fortified Diet Coke Plus in the U.S. and the U.K. and Coke Light Plus in Belgium.

PepsiCo (NYSE: - ) this year debuted in the U.S. Diet Pepsi Max, a ginseng-infused cola. The product is marketed as an "invigorating cola," positioning it against energy drinks.

Hansen, with a lineup of energy drinks that includes its Monster Energy brand and Lost Energy brands, has watched earnings climb at a 95% average annual rate from 2005 to 2007.

"Hansen's profitability has been fueled by the shift to energy drinks, which have a much higher margin than its other juice, smoothies and carbonated soft drink products," said Stephen Colbert, an analyst with Canaccord Adams.

Energy drinks are about 56% gross margin, while other products are in the low 30% range, he says.

Coke and Pepsi have higher gross margins than Hansen, but retailers get less of a markup.

Name Of The Game: For the drink companies, the key is launching successful products to drive growth.

For the bottlers, it's executing at the store level and driving higher margins. They fetch higher margins selling to formats such as convenience stores and gas stations, which sell single-serve drinks.

Today, a company must be able to manage a broad product portfolio and to manage smaller-volume products, Hemphill says.

2. Market

The U.S. refreshment beverage market volume grew 2.8% in 2006, according to Beverage Marketing.

While carbonated soft drinks accounted for more than half of total volume, the category's volume slipped 1.1% from 2005.

In market share, the Coca-Cola brand ranks No. 1; Pepsi is No. 2.

Beverages offering functional benefits are growing two to three times faster than conventional beverages, Beverage Marketing CEO Michael Bellas said in a statement.

U.S. energy drink volume soared by 49.1% last year.

Sports drink volume jumped 11.7%, and bottled water volume grew 9.5%. Ready-to-drink tea volume surged 26.2%.

Lal, of Mintel, expects carbonated soft drink sales at food, drug and general merchandise stores to grow 2.5% this year and about 2.4% in 2008.

Stump sees the energy drink market growing 35% to 40% this year and possibly 20% next year.

"The category is still operating from a small base," he said, pegging it at less than 5% of all nonalcoholic beverage sales in North America.

About 35% of the Pepsi system's sales in North America come from noncarbonated drinks, Stump says. That compares with 15% for Coke.

Pepsi's offerings of noncarbonated drinks include Gatorade sports drink and Aquafina bottled water.

Coke is out to gain muscle in fast-growing categories.

In June it bought Energy Brands, known as Glaceau, and its enhanced water brands, including Vitaminwater.

"As we look out over the North America beverage landscape, we see an opportunity to accelerate growth around the platform of active-lifestyle beverages," Coke President Muhtar Kent said in a conference call.

For three straight quarters, Coke's earnings have grown by at least 14% and sales by at least 17%.

CEO Neville Isdell credits those increases to the company's brand portfolio, investments in its brands and -- together with its bottling partners -- re-energized marketing.

3. Climate

The industry faces significant commodity cost pressures. Higher aluminum prices have raised the price of cans. And due to higher corn prices, it's costing more for the high fructose corn syrup used in concentrate.

The industry has passed increases on to consumers. Analyst Stump says overall prices across the industry have jumped 4% to 5%. He sees a 2% to 4% increase next year.

Negative publicity about carbonated soft drinks has turned off consumers. Regular soda consumption by adults fell by five percentage points between 2002 and 2006, says Mintel, citing a Simmons NCS survey.

Sugary soft drinks have been linked to childhood obesity. In response, the nation's top soft drink companies said they'd phase out the sale of sugary soft drinks to schools.

4. Technology

The soft drink industry isn't complicated. But some players are embracing new technology.

Pepsi Bottling Group went live with a new supply-chain service model called Customer Connect last year to address customers' biggest issues.

As part of the initiative, the company moved much of its paper-based information to wireless handheld computers used by employees in the field. The devices give salespeople quick updates on what they're going to sell each day, pending customer issues, and orders and prior orders.

5. Outlook

As soft drink companies continue to expand their product portfolios, the industry should continue to grow. Noncarbonated, functional drinks will be the big drivers. And the carbonated segment will get a boost from new formulations geared to changing tastes.

Upside: Companies that can move the fastest and best understand the changing marketplace will be successful at the expense of the slower, "more stagnant" competitors, says analyst Colbert.

Risks: Consumers are moving away from soft drinks, says Mintel's Lal. With soda being phased out of schools, the industry risks losing a whole generation of customers.