Is Brand Loyalty Dead?

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty." – Warren Buffett

In 2012 Ernst and Young released a study that found that consumers in developed markets were significantly less likely to make purchasing decisions based on brand loyalty. Younger generations of consumers were more willing to switch brands than their previous generation counterparts and were more likely to compare different product offerings online to find the best value.

This change in the way consumers behave could pose a potential threat to many existing businesses and pave the way for new competitors to emerge, creating new opportunities in what were once thought to be dead industries.

SodaStream (NASDAQ: SODA) is one example of a company that could potentially disrupt the status quo.

While not a beverage maker in the traditional sense, SodaStream sells home soda-making kits that allow consumers to make soft drinks themselves. The consumer buys a machine that carbonates water as well as bottles of soda concentrate that are used to flavor the water to give it its soda taste.

While SodaStream is still a minor player in the beverage industry it is gaining traction. Revenues were up this quarter by 33.9% year over year, with its primary growth drivers being the Americas and Western Europe.

Some feared that SodaStream was a fad product that would die out over time, but the company has shown itself to be consistently reliable with steady growth rates in the sale of both machines and consumables.

Additionally the company found that 70% of SodaStream owners were still using their product after one year, and of those active users over 80% were using their machine at least once a week.

This shows that SodaStream can maintain their razor/razor-blade model of selling consumers the machine first, and then continually selling them the soda concentrate to make the drinks.

While SodaStream’s growth is impressive the company is not without its risks. For starters there is always the threat that a major competitor may jump into the market. Pepsi (NYSE: PEP) or Coca-Cola (NYSE: KO) could come out with their own machine at any time with very little barrier to entry and disrupt SodaStream’s business entirely. Because Coca-Cola or Pepsi could use their own concentrates SodaStream would have a tough time competing.

SodaStream also has to worry about a decline in soft-drink sales altogether. Since 2005, carbonated beverage sales have been declining continually and this could impact SodaStream negatively. SodaStream may be faced with the challenge of taking a larger share out of an increasingly smaller and smaller market.

Because SodaStream’s growth is tied primarily to the U.S. the company has to worry about a slowdown in U.S. sales growth. As the company matures it will become increasingly more difficult to grow sales and earnings at rate consistent with its past.

While the company still looks cheap at under 30 times trailing twelve-month earnings, and about 20 times foreword earnings, investors should look out for slowing growth rates. The company appears undervalued at today’s prices but given the rise in price that shares saw over recent months it may be prudent for investors to wait for a pullback before accumulating shares.

Also benefiting from this change in consumer trends is COTT Corporation (NYSE: COT).

Cott produces and distributes private label soft drinks throughout North America and Europe, and owns several brands of beverages including the non-North American version of RC Cola.

While COTT does have some interesting opportunities opening up it is unlikely that it will benefit much from these changes.

For starters COTT does not offer a compelling reason to switch beverage brands for most of their products. Consumers are not likely to switch from Coca-Cola or Pepsi to RC Cola merely for cost savings, and the brands behind any successful private label product that they manufacture are likely to be bought out by either Pepsi or Coke.

Unlike SodaStream, which offers several benefits to consumers including lower calorie drinks, environmentally friendly products, and convenience, COTT has no advantages besides offering a marginally lower price than its name brand competitors.

For this reason Cott Corporation’s growth could be limited.

One area in particular, however, where Cott could benefit is oddly enough in SodaStream’s growth. SodaStream announced in March a deal with Cott Corporation that would allow Cott to manufacture SodaStream flavor concentrates in the U.S. This deal will be great for Cott as it gives the company another product that will likely continue growing for years to come.

But even with this deal, the business does not look great.

For starters the company has low profit margins, $600 million in debt (more than half its market cap!), and inconsistent earnings.

While the company’s free cash flow numbers look slightly better than its earnings and the company does offer a solid 2.8% yield, I’m staying away. There are much better companies to invest in with significantly better business models.

Coca-Cola and Pepsi are among the first to come to mind.

Coca-Cola is among the most iconic brands. The name is the second most recognized term around the world after the word “okay.” But can Coke’s brand overcome the change in consumer trends that are currently underway?

According to the 2012 Ernst and Young report, while western consumers are becoming increasingly less loyal to particular names, emerging market consumers are becoming more likely to make their purchasing decisions based on a product’s brand.

This helps explain the growth of products such as Coca-Cola in emerging markets.

While per capita consumption of Coca-Cola products has fallen from 2002 to 2012 in the U.S., worldwide consumption has increased during that same period of time.

Per capita consumption of Coca-Cola Beverage Products - based on U.S. 8 fluid oz of a finished product

<img alt="" src="http://g.fool.com/editorial/images/47101/cocacola-consumption-chart_large.png" />

Pepsi has also seen a similar trend. In 2006 24% of PepsiCo’s revenue came from emerging and developing markets. In 2012 that number jumped to 35%. PepsiCo is currently the largest food and beverage company in Russia, India, and the Middle East.

Both Pepsi and Coca-Cola have a long history of growth, so any decline in brand loyalty in the developed world is unlikely to affect either of these companies significantly, however if sales do decline domestically they should more than be made up for by gains in emerging markets.

So with three companies looking to take advantage of changing consumer trends the only question left is deciding which one is the best value.

SodaStream appears the most expensive trading at 31.68 times earnings, with Coke and Pepsi following behind with a PE of around 21. Given SodaStream’s significantly higher growth rate, however, this high multiple is well deserved.

SodaStream is growing earnings annually by about 30% a year, whereas Coca-Cola and Pepsi have been growing in the single digits. Coca-Cola and Pepsi reward shareholders with both yearly dividends and frequent share buybacks. SodaStream on the other hand is using its cash to fuel growth.

So which is the better buy?

It all comes down to which company can take greater advantage of changing consumer trends. With SodaStream’s incredible growth rate and untapped potential both in the U.S. and abroad it appears to be the winner of today’s Cola-Wars. While recent run-ups in stock price should make investors hesitant to purchase today it is an interesting opportunity that investors should look into, especially on any pullbacks.

Coca-Cola's wide moat has helped provide its shareholders with superior gains in the past, but the company faces some new threats to its continued market dominance. The Motley Fool recently compiled a premium research report containing everything you need to know about Coca-Cola. If you own or are considering owning shares in the company, you’ll want to click here now and get started!


Kyle Farrah owns shares of SodaStream. The Motley Fool recommends Coca-Cola, PepsiCo, and SodaStream. The Motley Fool owns shares of PepsiCo and SodaStream. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus