Coca-Cola Enters Uncharted Territory With Major Coffee Deal

Coca-Cola (NYSE:KO) is thinking long term as it prepares to write a $5.1 billion check for English coffee house, Costa.

This article originally appeared in The Motley Fool. Watch a video of the podcast here.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, September 4th. Hope everyone at least stateside enjoyed their holidays and long weekend. We're excited to kick off this week for Industry Focus.

On the last Consumer and Retail show, new Fool Nick Sciple and I talked about the upcoming Eventbrite IPO. We planned to follow up on that discussion today with coverage of one of its major competitors, Live Nation. We're going to put that episode on ice just until next week so that I can welcome Fool.com contributor Dan Kline into the studio. Always a pleasure when you're in town and you stop by Fool HQ, Dan!

Dan Kline: Hey, Vince! Thanks for having me!

Shen: Really great to see you! I know that you have Coca-Cola on your mind. They announced a big deal last week.

Kline: This was stunning. It's very rare we're surprised. Usually, we have a bunch of ideas mapped out -- if something by so-and-so. This one... while we knew this coffee company, Costa, was for sale, we did not have Coca-Cola on our radar as a purchaser.

Shen: It's been about, I was looking through my notes, two years at least since we really looked at Coca-Cola. Today, we're going to hone in on this $5 billion deal they did for Costa Coffee. Then we're also going to look at how the company has transformed in the past few years to close out. I'm going to start things off. To provide the context to our listeners, Coca-Cola's spending, with the conversion, $5.1 billion. This is going to be a push for them into coffee, hot beverages, also brick and mortar, which is something we're definitely going to talk about, because that's a first for Coke. What does the deal look like?

Kline: This is basically Coca-Cola saying, "What areas of the non-alcoholic beverage market do we not serve?" Coffee was a glaring hole. They would go into a business, let's call it a restaurant. And they would say to the restaurant, "We can serve you Coca-Cola products. We can serve you energy drinks and we can serve you iced teas. Whatever your mix is, we can meet it." And they'd go, "Oh, great. What's your coffee platform?" And they'd say, "We don't have a coffee platform." This lets them take a well-known brand in parts of the world, and they can bring that brand to the U.S., especially in situations where the brand isn't the selling point. It's really being able to meet the need. A restaurant generally might tell you they brew Starbucks coffee, but that's not usually a selling point in a nice steakhouse. It just says they have cappuccinos. This allows Coca-Cola to add that business. That's a huge opportunity for the company because it already has relationships across retail and restaurants and all these other spaces.

It also puts Coca-Cola into the retail business, as you mentioned. It's about 3,800 stores, with about 60% of them in England and the United Kingdom.

Shen: I'll stop you there, because we have a lot to talk about with that brick and mortar operation. I just want to add some context. It's a really good point -- they have this big opening with hot beverages, essentially, that the company doesn't really address quite as much, especially when it comes to coffee. We're looking at a category, when you look at global coffee and tea, that's particularly strong. That category has seen some of the stronger growth rates, I think 6% last year. This is a $500 billion market, at least.

Kline: And it's a hedge against declining soda sales. Coke has done some interesting things to shore up the Diet Coke business -- the skinny cans, the different flavors. But long-term trend says that market will probably continue to get smaller as healthier choices -- coffee is a growth market. It just makes sense.

Shen: Yeah. Addressable market for the company, in the presentation materials provided for this deal, takes it from something like $800 billion to $1.5 trillion. It's massive. And I'll stress that at the moment, Coke only operates in the ready-to-drink segment when it comes to coffee. Within that, it only has about 15% market share. If you look at the broad category, Coca-Cola is looking to jump from a 2% market share to the additional opportunities that we'll talk about with Costa Coffee.

The last thing that I wanted to mention, in terms of the seller, an interesting company. It's Whitbread (LSE:WTB), they're an English company. They're basically parting with this entire division to focus on their hotel and restaurant businesses. Crazy thing, we talk about Coca-Cola being this historic company, at least for the United States. Founded in 1892 or something like that. I saw that Whitbread was founded in 1742. Always puts things in perspective, being such a much older company. That tends to be the case for a lot of these European businesses.

There's going to be the standard shareholder and regulatory approvals that are required for a deal like this. Coca-Cola and Whitbread, they expect the deal to close in the first half of 2019. Coke's going to fund the transaction from the $20 billion of cash that they have on hand.

Before we look more at the strategy for how Coke is going to leverage the assets and the brand here, let's talk a little bit more specifically in terms of what the company's getting. Let's get into the brick and mortar apparatus that they have.

Kline: There's really four pillars to the business. There is a huge vending machine business. 8,200 Costa Express terminals. We were joking about this upstairs, that in the United States, coffee vending is like an old-school, gross, hot chocolate and soup come out of the same spout. This is a very high-tech like you would see at a tech company. Like, at Microsoft, there are coffee vending machines where you could dial up exactly what you want.

Shen: A good analogy within Coca-Cola, they have these freestyle vending machines, right? This is like the coffee equivalent.

Kline: It's very much a coffee version of the freestyle machine, where you get the barista-led flavors. And you do see these at some convenience stores. You could get the real barista experience from a machine where you're pushing the buttons. That is a much bigger thing in the rest of the world than it is in the United States. But it is a huge opportunity.

They're also getting the coffee bean business, which is literally the ability to go to a restaurant and sell them not-ready-to-drink beverages. You're buying the beans, you're brewing them. Maybe you're intentionally differentiating yourself from having Starbucks or one of the other brands. They're also getting 3,800 retail stores in 32 countries. About half of those are franchised, and half of those are company-owned.

They are also getting a huge loyalty program, which is actually something Coke also doesn't have any real experience in. You're generally not buying Coca-Cola from Coke. There's no program where, if I drink a 12 pack every day, I get a free stuffed teddy bear or whatever.

Shen: They sometimes have those contests where you'd look under the cap --

Kline: They generally have to do that stuff with their partners. Now, they'll have the ability to not just have a direct relationship with a certain percentage of consumers. They also have 3,800 stores that they can test products in, or that they can run a promotion or see if people want different things. It's a really different business for them.

They're taking on about 16,000 employees. They're just getting entry to something that they didn't do, that they have all the apparatus in place to sell.

Shen: Yeah. These 3,000 or so locations, you mentioned 32 countries, they're focused in Europe, Africa, the Middle East, and Asia.

Kline: It's about 60% in the United Kingdom.

Shen: Definitely the U.K., and then also in China. Keep in mind that Costa, both for you and me, not a brand that we're as familiar with. But in the U.K., it is the No. 1 coffee brand. They have 35% market share when it comes to coffee houses there. This is just a name that hasn't quite made it across the U.S.

Kline: One of the things that was talked about at the press conference on this, or the media call, is that this is a brand that has already proven it can be a winner. This isn't some underdog. Coke isn't buying a brand no one's ever heard of and trying to make it something.

Shen: That's something management said they specifically wanted to do. They wanted to get the leader in this space, within this market, and to branch it out, rather than try and go in and organically build up something from the ground level. We'll speak to how that's been their strategy really broadly for the company, in terms of the brands that they're really focusing on.

You mentioned the Express system. I'll add that these vending machines, 8,200 units out in the market. At least within the U.K., they generate about 20% of revenue for the business. Pretty significant. Overall, I want to get into some financials for Costa Coffee. Revenue for the business came in at $1.7 billion with about $312 million in EBITDA. The top line has grown 12.5% annually over the past four years. Almost $9 out of every $10 of revenue for 2018 came from the U.K., where, again, it has by far the most stores and those Express machines.

Next up, I want to get into more detail talking about what Coke can do with this coffee business, and how investors should think about the company more broadly going forward.

Remember that, we've talked a little bit about this so far, Coca-Cola tapping into the retail footprint, tapping into the Costa Express vending machine system, the distribution of these roasting ground beans into restaurants and cafes where Coca-Cola products are already going, like you mentioned and ready-to-drink beverages, there's more to that.

Kline: You have to almost look at the United States, and the existing coastal markets, and markets that have some cost of knowledge, separately. In the U.S., Coke has said, "We're not going to open a bunch of retail stores." There's a saturation point with Starbucks and other players there. What Coke can do is they can go to every company that they already sell Coca-Cola products to and say, "Would you like our coffee, too? It'll be cheaper for you and easier for you than having whoever you use now." That's an immediate advantage. It can also go to every convenience store where it has Freestyle, or, Freestyle is in a lot of restaurants -- Blaze Pizza, for example, has Freestyle. A coffee machine would be very logical there. They can go to them and say, "Hey, do you want this?" This becomes a very easy add-on sale.

Coke also has the ability to do it in a way that benefits your business. I used to run a giant retail store. We carried Polar soda instead of Coke because Polar gave me the cooler as long as I signed a two-year contract. The big stand up machine? The local Coke guy wanted $1,000 or whatever it is upfront. I paid for it either way, it was just a question of, did I pay for it over X amount of orders at a slightly higher price? Or did I pay for it upfront? Coke has the ability to go to every Wawa, which have Coke Freestyle machines, and say, "Hey, put in our coffee machine." That part of the business in the U.S. can be very quick growth.

In the rest of the world, where they already have some market knowledge, they could do that part two. They could also ramp up the expansion and the adding shops and adding kiosks, especially where the kiosk business is understood in Europe. In the U.S., coffee kiosks are not yet a thing.

Shen: I know that management has wanted people to see Costa not as a single brand, but as this platform, because of the four pillars that you've talked about. Ultimately, when it comes down to it, you're essentially powering Costa with the scale and the distribution expertise that Coca-Cola very much has.

With the retail storefronts, in terms of what we were talking about before the show, newer products, experimentation. You have this direct feedback now from the storefronts from customers.

Kline: It's the Starbucks model. Starbucks buys Teavana or their juice brand, which is escaping my memory, what the name of it is. You go into a Starbucks. They've figured out which Teavana teas they would sell packaged, which ones they sell fresh-made. They tested all of that generally starting in Seattle and moving to Chicago, for the U.S. Then, they roll it all out. There's no mystery to them, when they put a product into stores, as to how well it's going to sell, for the most part. Coke will now be able to do that. They'll also be able to gauge things like, if I give out free samples of this, do people like it? That's really valuable market research, to be able to say, "The U.K. does not like cherry iced tea," or whatever it happens to be, on the level this market does. They can really now have this consumer lab. It's important, they're keeping all of the retail management. This is not Coke going, "We've never done this! Let's do it!" No, they are buying a ready-made company, and they are going to be involved, but they're going to let the existing people be in charge.

Shen: Yeah, they stress that this is a coffee strategy, not a retail strategy. That allows the management on the Costa side to continue forging their own path there. Essentially, Coca-Cola's management doesn't have to answer the tough questions of, "You guys have zero retail experience, what are you going to do?" It makes sense there for them to maintain some of that ownership.

Kline: There's also a brand strategy here in the U.S. Coke is not going to go to Kroger and say, "Let's put Costa on the shelf next to Starbucks, Dunkin' Donuts, McDonald's, all the ready-to-drink coffee." You don't know what it is. What will likely happen first is, you'll see Costa in restaurants and other places where you don't have a choice, where Coke has done the strong-arming. Then, when you start to know the brand, it will make sense to roll it out in ready-to-drink packaging. You've tried it, you're familiar with it. Maybe you like it better than you like the packaged Starbucks. This becomes a multi-year, multi-prong strategy.

Shen: That's a great description of how they're going to approach. It's a gradual process. The company actually lays out an idea, they give you an idea of what their attack plan is. First, they want to build the Costa brand. They're thinking about that through the retail locations, and also taking advantage of the pretty large loyalty program base. They have 5.4 million members. Start working off of that. Then, second, they're going to start integrating Costa into Coca-Cola's very large distribution network. And again, they're going to offer more products, like you've said, to restaurants, cafes, whatever it may be. Third, once they've made some progress with that, they want to start thinking about launching Costa in ready-to-drink form and then in at-home products.

Beyond that, the company can start with cold or hot ready-to-drink coffee. Then they can branch into these other categories for at-home products. There's also related products, too, like hot tea and cocoa. A lot of paths that the company can take. There's a lot of optionality.

Kline: I was actually really surprised how much they talked about hot ready-to-drink. Hot ready-to-drink isn't a category. It's a category in Japan and a couple of places that have innovative beverage technology. But, think about it. We don't have those cans you open and it's hot. That's actually something they talked about having to innovate, having to create new ways. That's a category that, who knows what the potential is? The vending machine potential of getting a self-heating coffee could be enormous.

Shen: Sure. This optionality means that the company ultimately has to and will tailor its approach by market. We've talked about how, in the U.S., they don't need these Costa Coffee stores.

Kline: I think they said a few.

Shen: Maybe, kind of, to get the brand out there, as a flagship thing. But, whereas, in Asia, where the coffee culture is still very much developing, there's definitely the potential for them to open more stores in that market. Then, within that context, more on the operation side, I'll just mention that Costa has a new roasting facility in the U.K. It provides almost all the coffee the company sells except for some of their Indian market. There's capacity to expand that under Coca-Cola's management.

Moving on, last comments that I'll mention for the deal, unless you have something to add, is around the valuation. In terms of the process for how this deal came together, I've seen both management teams mention that it was a pretty quick process. The price tag paid has garnered a little bit of attention during the investor call. 16X EBITDA. I compare that to another deal recently in the beverage space, which is PepsiCo, because they recently took over SodaStream. Some people have complained, some investors have been unhappy, because that was this huge premium. They bought it at some of the highest prices that SodaStream has been trading at, almost 25X EBITDA. What we're seeing here, definitely some expensive deals in the beverage industry, in terms of the opportunities that the giants are going after.

Kline: I think it's because there are some sharks out there right now. We've done whole shows on JAB, however you want to call them, which is a holding company that owns a billion coffee brands, some you've heard of, some you haven't. They own Panera Bread, they own some equity in what used to be Keurig, that's now Keurig and Dr. Pepper. They were probably a player here. We don't know that, but even if they were just sort of sniffing, it's very easy to go to Coke and say, "If you don't pay our premium, we don't want to sell to these guys, but they're buying." It's very likely that that was out there.

Shen: Yeah. Talking about Coca-Cola more broadly now, just providing some context for how this deal fits into their strategy going forward. There's been a lot of changes with the company. Ultimately, you see Coke pursuing this capital-lite model, where they can be the puppet master pulling the string on brand management and marketing. They've tried to move away from having to deal as much, in terms of the operations, with manufacturing and bottling because of the heavy capital expenditures that requires and a lot of the other expenses that come with that business. For example, in 2017, Coke completed the refranchising efforts of its U.S. bottling operations. There were also some big efforts in shoring up the bottling operations of big markets like China and Japan.

In addition to those refranchising efforts, there's also some big changes in terms of the product portfolio, to address health concerns, sugar content. They've killed a lot of what they call zombie brands that are just not performing well, and with that, hundreds of SKUs in certain markets. There's been new leadership, with James Quincy as the CEO. They also have a chief growth officer that they've added. A lot of shifts there, as well.

What that ultimately means if you're looking at Coca-Cola as an investor is, their top line is shrinking, no doubt about it, because of these efforts. But at the same time, with this asset-lite business model, their profitability is getting stronger and stronger. There's a give and take there. The way the company sees its product brand strategy is to become the No. 1 or No. 2 leader market or product because that brings in the most profitability and the best returns for the company. I have a quote from Quincy, the CEO, where he basically says, "It's better to be the leader in half of the world than No. 3 in all of the world from a scale and profitability point of view." This, again, speaks to why they picked up Costa, right?

Kline: It's a big diss to RC Cola.

Shen: [Laughs] Exactly. This latest deal with Costa, it makes sense that they have a dominant name in its home U.K. market and something that's very strong in Europe and is branching out from there and taking that strength and molding it into their system.

Kline: And it's a brand that could plausibly become the No. 2 in the United States in some of these categories. It is not going to be the No. 2 coffee house. It could absolutely be the No. 1 or No. 2 restaurant brand. It could become the No. 1 or No. 2 convenience store brand.

Shen: Ready-to-drink brand, yeah.

Kline: Ready-to-drink, I think, is harder because that is much more, if you're looking at labels, it is about brand name. If you want a nice hot cappuccino and they put this glorious-looking machine in, you're not probably going to think about who made the beans. You're going to think "I want a barista-made coffee, and this is the closest I can get." I worry about their ability, for a long time, to put a Costa bottle next to a Starbucks and McDonald's. You saw the Starbucks-Nestle deal, which is all about ready-to-drink and expanding. This is a space that everybody is targeting. Dunkin' Donuts has rapidly. Those are very big names. Costa has proven it can be a name, but it's going to take a while in the U.S. until it is a name.

Shen: Yeah. The last thing is, the new brand, and with the retail storefronts. A big part of that is the ability to experiment. You mentioned some examples from Starbucks. The chief growth officer position, I think it's really interesting, he talked about experimentation during a June presentation. He said, as of the first quarter of 2018, Coca-Cola has increased its number of experiments 30% with the volume from those products up 32%. Coffee is basically this whole new playground now for them, to see what works, what doesn't.

Again, I think this is a really interesting deal for Coca-Cola. You think about their dominance in these non-alcoholic beverages. It does make sense. You've essentially opened up the entire additional market that coffee and hot beverages provide.

Kline: Coffee has also become a bit like craft beer. I'm not sure how big a coffee guy you are, but I'm a pretty big coffee guy. If a new coffee house opens up in my neighborhood, I am going to check it out, and I'm going to try three or four different things before I make a decision on whether that becomes part of my rotation. There's a certain anti-Starbucks. It's not that you don't like Starbucks, but you've been there 1,000 times. When they're in a market, when they're opening in China, where there's thousands of Starbucks, and a Costa comes in, your coffee aficionado is going to try it in a way that doesn't work necessarily in fast food or other places, just because it's new. And the product is good. It's proven that people like it. That's going to give it an ability to grow in markets where they don't have to supplant someone. They just have to take a piece of the business. Maybe they'll be a strong No. 2 a lot of places that doesn't exist. The U.S. has a whole bunch. There's a lot of fragmentation across the rest of the world.

Shen: Yeah, definitely. That's something they speak to for coffee. I'll leave listeners, the last comment for this deal -- the potential that you always have to remember when you're dealing with a company of this scale and experience, when it comes to beverages, there's a reason why it's the market leader. Coca-Cola has their distribution system, they get about two billion drinks into the hands of customers in 200 countries every single day. Now, you're just adding this new what they consider platform to the mix. I'm really excited to see what not only Coca-Cola is going to do with this, but I'm excited with the other deal, with PepsiCo and SodaStream, to see how that works out. We're definitely going to follow up on this. It's been too long since we've talked about the majors in beverages. Any last thoughts from you, Dan?

Kline: I don't know, are we going for coffee? [Laughs]

Shen: I'm down for coffee right now. Fools, thank you for listening! Dan, thanks for being here!

Kline: Thanks for having me!

Shen: People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Daniel B. Kline owns shares of Microsoft. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool owns shares of SodaStream. The Motley Fool recommends Dunkin' Brands Group, Live Nation Entertainment, and Nestle. The Motley Fool has a disclosure policy.