The business world is rife with rivalries, but there may be no bigger battle for consumer dollars than in the beverage sector. For decades, Coke and Pepsi have been wrestling for soft-drink supremacy. Most of the action has taken place on North American and European soil, but with growth in the developed markets slowing, they’re now taking the fight to emerging markets. In July, Coca-Cola announced it was investing $5 billion in India between now and 2020. Last year, it pledged to put $4 billion in China over the next three years. PepsiCo is investing $2.5 billion over three years in China, and it has sunk billions into India as well.
These two brands may be going head to head, but investors would be well served taking a taste of both. In fact, most of the businesses in the beverage sector—alcoholic and non-alcoholic—are expanding eastward. “There’s going to be a fair bit of growth in this sector,” says Morningstar analyst Ken Perkins. Not only are drink makers experiencing growth, but theirs is a defensive, non-cyclical sector that generates massive amounts of money. People buy beer, soft drinks, teas and other liquids regardless of economic conditions. These businesses also pay dividends, and when they’re not expanding in Asia, they’re continuing to churn profits from loyal customers in North America.
What makes this sector different than some other defensive industries is the enormous emerging-market potential. On average, Americans drink more than 400 eight-ounce servings of cola per year; the Chinese consume less than 40 servings, while Indians drink about 10. According to market research company Euromonitor International, beer consumption in China is expected to grow 28% over five years, from 47.5 billion litres in 2011 to 61 billion in 2016. Still, China’s consumption of beer per capita is half of what it is in the United States. It’s a simple growth story, says Rory Ronan, a vice-president and fund manager with Invesco Canada. Asia’s population is growing, incomes are improving and more people are clamouring for brand-name products. “These brands are very powerful,” he says. “It’s a status symbol. People drink Heineken in China because it’s what they drink in the U.S.”
Beverage consumption patterns are also more homogeneous than other food categories, says David Sealy, a portfolio manager with the Boston Co. Asset Management. Food habits are often dictated by culture and religion, but most people drink the same way regardless of background, he explains. “Everyone likes a cold, refreshing beverage.”
Nonetheless, investors need to be patient for the returns. Coke has been in China since the early 1980s. Other drink operations have been there nearly as long. There’s also a lot of competition in Asia—local alcohol brands dominate certain areas, while domestic soft-drink makers vie for consumer dollars. But the big drink companies have deep pockets and marketing savvy going for them. They can easily buy shelf space at a grocery store, says Sealy, and they can afford to blanket areas with advertising. They can also buy up the competition— which many are doing.
It’s only a matter of time until the masses are downing cold American sodas or European beer, says Jack Russo, an analyst with Edward Jones. “It’s a matter of consumers increasing their income and the companies getting more consumers to buy their products on a regular basis,” he says. Ronan expects total emerging-market growth—including Brazil and other Latin American markets—to add 15% to 20% to the bottom line per year.
And while it may still be some time before investors see share-price gains to match the revenue growth, most of these companies generate ample free cash flow from developed nations in the meantime. It’s these dollars that are being used to fund growth in the developing world, but companies are also paying investors decent yields—between 2.5% and 3%.
They are also still innovating, acquiring and expanding their offerings into other beverages. PepsiCo and Coke have invested in energy drinks, which is the fastest-growing segment of the market, and sell other items like water and teas. PepsiCo also has food products, such as chips, pancake mix and sunflower seeds. Alcohol companies like to acquire as a way to add more products to their lineup, but they’re not afraid to innovate either. It seems like everyone’s got a low-calorie beer or a lime brew these days.
One drawback to this sector is the lack of choice. Investors are mostly stuck with Coca-Cola and Pepsi—though there’s also the Dr Pepper Snapple Group—in the non-alcoholic market. There is more choice among alcohol companies, but most managers recommend sticking to the big-name brands such as Diageo, Heineken, Anheuser-Busch and Molson Coors. It’s still important to do some due diligence before buying, though. Looking at a company’s price-to-earnings ratio is a good place to start. Most of the stocks in this sector are trading at fair value or slightly above—the sector is trading between 14 and 18 times earnings—but Ronan says not to worry about the pricier P/E. This is considered a growth sector, so multiples should be a bit higher.
Perkins likes looking at free cash fl ow. A company that can consistently generate free cash and produce returns on invested capital above their cost of capital is a good buy. “For every dollar they invest, they need to earn more than it cost them to finance a project,” he says. Continued revenue growth is key—Perkins says investors should expect growth of between 3% and 5% a year—as are regular dividend increases. Coca-Cola has increased its dividend for 49 consecutive years, PepsiCo for the past 40.
These companies do carry debt, but within reason, says Ronan. Two to three times debt to EBITDA is normal. That’s high for other industries, but not one that generates such consistent free cash flow. Most of these companies also have a debt cycle. They borrow, buy something, generate cash, pay down debt and then, when something else comes up, they borrow and buy again. “These companies have great credit ratings, so they can raise money at very low rates,” Ronan adds. “They can lock in a 3% interest rate and then buy something that’s fast growing.”
It pays to stick to brand names. There are some smaller companies, mostly alcoholic, that have a more aggressive growth profile, but their international growth is far from guaranteed.
When it comes to the beverage sector, choosing which company to buy isn’t much different than choosing a brand to drink: it comes down to preference. With such a huge potential market overseas, every company should see sales and, ultimately, share prices increase. “All of these businesses are high quality, they pay a good dividend and they’ll continue to grow,” says Ronan. “They have all the characteristics of a very good long-term business.”