Switching Sides In The Soda Wars

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

Burger King (NYSE: BKW) recently inked an agreement with PepsiCo (NYSE: PEP) to serve Pepsi beverages in its Chinese stores. Although there are only about 100 Burger King locations in that country today, there is plenty of growth opportunity. That should be good for both companies.

Everyone's growing in China

At the start of 2013, Burger King had 940 restaurants throughout its Asia Pacific operating region, about a third of which were in Australia. Management believes that it can expand from about 1,000 sites to 3,000 in the region. Clearly that's a multi-year goal, but it means that Burger King is focusing heavily on its Asia Pacific operations. Moreover, with only 100 of the current locations in China, it is clear that a large increase in that massive nation is likely.

It should come as no surprise that Burger King thinks China is a market in which its brand is ripe for expansion. It clearly has room to grow since larger competitors Yum! (NYSE: YUM) and McDonald's (NYSE: MCD) each have large and still growing presences in the country.

McDonald's, for its part, hopes to open hundreds more restaurants over just the next year alone. In other words, it wants to open multiples of what Burger King has in the country today in just one year. Yum!, meanwhile, sees massive long-term growth ahead in the country, expecting to go from around 5,000 units today to 20,000.

This is one reason why Yum! has labeled China one of its top growth priorities. The company has even started to embrace the local culture, buying Chinese food concepts. That should give it plenty of leverage to grow its business and in a way that builds on its strengths in operating multiple concepts.

McDonald's doesn't share that strength, as it has historically performed best when it focuses only on the McDonald's brand, though it has owned or partially owned many other food concepts through the years. Still, the McDonald's name is ubiquitous the world over and has provided plenty of opportunity for profitable growth.

The Soda Fountain

When it comes to fast food restaurants, the soda fountain is a major source of revenue. The restaurants basically get to sell flavored water at exorbitant prices. It's big business for the major soda companies, too, which earn a good chunk of their revenue from deals with restaurants. While those deals clearly extend beyond fast food, the size and scope of the fast food market makes contracts with these companies particularly important.

Coca-Cola (NYSE: KO) has had a solid lock on burger joints in China selling to both Burger King and McDonald's up until the new deal between PepsiCo and Burger King. That said, PepsiCo has had a long standing relationship with Yum! Brands, which is massive in China, since that company was spun off from Pepsi in 1997 and has been investing in China for many years. Thus, it already has an a relationship with a big fast food player in China. However, pushing into the burger space, even only in a small way, is a nice feather in PepsiCo's cap.

China expansion

Pepsi and Burger King intend to “ramp up their partnership with a joint promotion during the Chinese New Year leveraging PepsiCo’s immensely popular marketing campaign, 'Bring Happiness Home.” This deal will be an important tool for PepsiCo as it attempts to compete with Coca-Cola in the important Chinese market if no other reason than it gives the company access to a restaurant that has the potential to materially ramp up its business in that country.

Pepsi, in fact, has become increasingly aggressive in its efforts to expand in China. For example, late last year it opened a research center in the country to better tailor its products to local tastes. It also inked a deal with a large Chinese beverage company to distribute Pepsi products. Some estimate that the agreement with Tingyi will make the two companies China’s largest beverage company.

Of course Tingyi won't exclusively sell Pepsi, so the benefit to PepsiCo isn't as large as that grandiose statement suggests. However, Pepsi will start with a 5% stake in Tingyi that it has the option of increasing to 20% over a couple of years. This type of partnership is common in China, but can come with some risks. Particularly for a company with proprietary information, like a soda recipe. While that secret sauce is probably safe, it's something to keep in the back of your mind as an investor.

Burger King, meanwhile, is using the franchise model to underpin its expansion. This, too, is a common practice for entering China and, for a fast food company, a very profitable and relatively low risk way to expand. Burger King simply lets its franchisee use its name and systems and collects revenues and royalties. The franchisee, meanwhile, takes on the material financial risk for the potential of material financial reward from the growth of the business. With the added advertising might of Pepsi behind it, Burger King franchisees are likely to be pleased with the deal.

Good for everyone but Coke

So both Pepsi and Burger King look like solid beneficiaries in this deal, with PepsiCo helping to advertise for Burger King which helps get that company's name out. PepsiCo, meanwhile, gets more outlets selling its sodas. As the cola wars heat up in China, the only one this deal doesn't help is Coca-Cola, but that's to be expected.

Reuben Gregg Brewer 

Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide, Coca-Cola, McDonald's, and PepsiCo. The Motley Fool owns shares of McDonald's and PepsiCo. 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.

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