Coca-Cola Buys Costa: After 132 Years, the Sugar-Water Company Finally Commits to a New Business

An acquisition worth looking forward to.

Buying healthy beverage brands, running an incubator, going asset-light, repackaging soda with novelties like "Fiber+" and "Zero Sugar" — after working through every transformation playbook the food industry has, Coca-Cola has taken a step with real imagination.

On August 31, the world's largest beverage company announced it would buy Costa, the world's third-largest coffee chain, with nearly 4,000 stores, for £3.9 billion (about $5.1 billion). The deal is expected to close in 2019.

Costa's parent company, Whitbread, bought the brand 23 years ago, when Costa had only 39 stores. This April, under pressure from investors, Whitbread announced it would spin Costa off. According to information obtained by The New York Times, Coca-Cola and Whitbread talked for just five weeks before settling the deal.

Coca-Cola is not a company used to huge acquisitions. For nearly all of its 132 years it has sold one product and its variants — everything else reads like a footnote. The $5.1 billion price is already the largest acquisition in Coca-Cola's history, and it eats up about a quarter of the company's cash reserves.

In the words of Coca-Cola CEO James Quincey: "This is the first time Coca-Cola has had a business that touches the consumer directly."

In a food industry led by capital and used to entering new markets through big acquisitions, this is an unusual deal.

Running stores is very different from running a food-manufacturing business. Beyond the coffee itself, the barista's skill, the location, the service and the atmosphere in the shop all shape what the customer experiences. Those extra parts also cost more to operate, and the gross margin is lower than Coca-Cola's business of selling syrup formulas and building beverage brands — after shedding its bottling operations and its stakes in the big bottlers, Coca-Cola is already an asset-light company.

That is why, even though the food industry never stops buying — Kraft and Nestlé each own hundreds of brands — you can count on your fingers the big companies that have moved from food into store retail. PepsiCo, which built a real restaurant business, spun that part off long ago. Three months ago Nestlé paid $7.15 billion for Starbucks' retail business, but that deal covered only coffee beans, ground coffee and capsules; the stores stayed with Starbucks.

The restaurant business that runs stores and the food business that controls the traditional channels still divide the work clearly between them.

That may also be why CEO James Quincey said it three times at the investor call after the deal: "This is a coffee strategy, not a retail strategy."

Coca-Cola's earlier bets on coffee all failed — or was its core business simply too easy?

Costa was not cheap. Analysts reckon the $5.1 billion price is above the valuation Costa could have reached by listing on its own.

But in a market that has already pulled in a flood of capital, for Coca-Cola to launch and raise a global coffee brand by itself now looks too late — Quincey said at the meeting that investors do not have that kind of patience.

Of course, had Coca-Cola stayed with any of its earlier moves into coffee, it might not be paying this price today.

Coca-Cola was not late to coffee. It bought the instant coffee brand Duncan Foods back in 1964. That deal worked out well: it brought Coca-Cola an important executive, Charles Duncan, who drove the company's expansion in Europe and Asia. But coffee was not on Coca-Cola's schedule then.

Its later attempts at coffee were cautious too — either adding a coffee line or a coffee flavor to an existing brand (the tea brand Gold Peak once put out a cold brew), or finding a coffee brand to make its ready-to-drink products. Its work with Nestlé goes back to the 1990s. The two each held 50% of a joint venture that made ready-to-drink Nescafé and the tea brand Nestea, splitting production and distribution across markets. Nestlé later decided to take these promising brands back, cutting the partnership down in 2006, and the two sides formally ended it in 2017.

The one success was Georgia Coffee, which Coca-Cola developed for the Japanese market. It sells more than $1 billion a year, but its market stops at Asia.

Its rival has been steadier in coffee all along. Since Starbucks launched bottled coffee in 1994, PepsiCo has made and distributed its bottled coffee drinks. In the US, Starbucks and PepsiCo together hold as much as 75% of the ready-to-drink coffee market.

PepsiCo is also, by comparison, a more diversified company. It bought Pizza Hut and Taco Bell in the 1970s — running fast food on one side and selling its own drinks through them on the other. It bought Quaker Oats in 2000. All of this rested on a foundation laid in the 1960s: PepsiCo itself came from the merger of Pepsi-Cola and the snack company Frito-Lay.

PepsiCo eventually had to spin its restaurant business off and list it (it became Yum! Brands, the parent of KFC), yet half its revenue today still comes from chips, cereal, energy bars and other snacks outside of drinks. Diversification spreads risk: when the beverage business falls, snacks can make up part of the loss. In the first two quarters of fiscal 2018, PepsiCo's North American beverage business fell 2% and 1%, while its snack business in the same region grew 3% and 4%.

Unlike PepsiCo, Coca-Cola has always been a carbonated-drink company.

"Coca-Cola, despite its extraordinary stock performance, is one of the least diversified companies in the world," Mark Pendergrast wrote in For God, Country, and Coca-Cola. Few companies have defined themselves by a single product for as many years as this one.

In the words of Coca-Cola's loudest investor, Warren Buffett, the company has a wide "moat." Decades of advertising have tied the brand, in consumers' minds, to happiness, cool and American culture. Several wars, the Great Depression, the oil crisis, financial crises — none of it did much to slow its growth.

With its business spread across the globe, cola is now a scale economy almost impossible to enter. No new brand can compete with it here. Even PepsiCo, which has come the furthest, is still stuck with the image of the No. 2.

So Coca-Cola has had little reason to go into other businesses. Mark Pendergrast, the author of For God, Country, and Coca-Cola, argues the reason is that soft drinks earn more than other industries do.

Coca-Cola's other tries at diversification all failed. In the 1970s it ran a winery; the capital-heavy business lost so much money that investors pushed it to give up. It also bought Columbia Pictures, reportedly to place its products in films. And it lost Quaker Oats through a bad board decision, handing the company to its sworn enemy, PepsiCo.

In 2007 Coca-Cola set up its Venturing & Emerging Brands unit (VEB) to find and invest in promising startup brands. The unit's job is to discover and raise Coca-Cola's next billion-dollar-a-year drink. VEB has invested in or bought the low-sugar organic tea Honest Tea, the coconut water Zico and the premium milk brand Fairlife, among others — but these brands are still fairly small.

Defending cola itself, by contrast, is something Coca-Cola has always done well. That same Charles Duncan led the company to build 300 bottling plants across Europe and Asia to cut costs, and made it the first American consumer brand to get through the Iron Curtain into Eastern Europe during the Cold War.

Later, Diet Coke convinced a whole generation that drinking soda did their health no harm. Bill Clinton and Donald Trump — two presidents opposite in build and in politics — are both fans of it.

Buying Costa: the most imaginative new market Coca-Cola has entered in the drinks business

Once the image soda carries turned from "happiness" into "obesity," Coca-Cola had no choice.

In 2016, Americans drank more bottled water per person — mineral water, sparkling water, flavored water and other drinks with no or little sugar — than sugary carbonated drinks like cola. Carbonated-drink consumption has now fallen for 12 years straight. Yet more than 70% of Coca-Cola's revenue in the US still comes from carbonated drinks. Cutting its dependence on sugary drinks, carbonated ones above all, has become urgent.

Setting divestitures and acquisitions aside, Coca-Cola's organic revenue growth in North America is slowing, and its carbonated-drink business there has been close to flat for a long time: quarterly reports from 2015 to 2017 show sales volume in the region essentially stalled. North America is without question Coca-Cola's most important regional market, and it contributes 35% of revenue.

In 2017 Coca-Cola changed CEOs and cut 1,200 jobs, planning to put the savings into non-carbonated categories. The biggest of those investments now looks like coffee — and it is the first time Coca-Cola has stepped off its own path.

Since 2015, the name Coca-Cola has kept appearing in headlines next to the word "transformation." But its transformation over these years has not left the beverage business.

A good deal of its energy has gone into developing new versions of cola, into making people love carbonated drinks again: the stevia-sweetened green cola Coca-Cola Life; "Fiber+" Coke and Sprite, made with resistant dextrin and launched in Japan and China; four fruit-flavored Diet Cokes in North America; the rebranding of Coke Zero.

There have been plenty of acquisitions in non-carbonated drinks too — Vitaminwater, the coconut water Zico, the grain-drink brand Zhonglü Culiangwang. But none of them went beyond the routine Coca-Cola knows: mass production, advertising, then selling through restaurants, supermarkets and vending machines.

Coffee is different. It is the new trend. "Twenty years ago, people would wake up in the morning and want a sip of Coke," says Nik Modi, an analyst at the Royal Bank of Canada. Not now. "Go look at how long the line is at Starbucks at eight in the morning or two in the afternoon."

Coffee has taken cola's place, and Coca-Cola itself calls the drink "on-trend." It is the fastest-growing beverage in the global market. Euromonitor puts the compound growth rate of the global coffee market over the past five years at 5.5%; Coca-Cola's own number is 6%.

Coffee is also a business with far more shapes and occasions of consumption than bottled drinks and soda: freshly ground coffee in coffee shops, machines in convenience stores and other food-service outlets, bottled coffee drinks, capsule machines at home and in the office, whole beans. A relatively fragmented market means there are many points at which to break in, and that is the opportunity. So in coffee, alongside the big companies charging ahead, new brands appear every year.

Traditional food and coffee companies like Nestlé and Lavazza, and the investment firm JAB as well, are all eager to consolidate and buy up coffee businesses.

Germany's JAB Holding (Joh. A. Benckiser Group) has put more than $40 billion since 2012 into at least nine coffee-related acquisitions. Keurig, which makes coffee capsule systems, and JDE, the No. 2 by market share, both belong to JAB.

Nestlé, the largest player by market share, is not content with instant coffee and capsules either: in 2017 it spent $500 million on a 68% stake in the specialty coffee chain Blue Bottle. Three months ago it also picked up Starbucks' retail business outside the stores — packaged beans, ground coffee and capsules.

To become "the total beverage company," selling not just cola and juice but healthier teas and bottled water, Coca-Cola could hardly miss coffee.

For Coca-Cola, Costa is not just an attractive brand but a coffee platform: behind it sits a complete coffee supply chain, with the systems and the expertise for sourcing, trading and distribution. None of that existed at Coca-Cola before.

"The Coca-Cola Company gains a global coffee platform, and one that complements our existing system," Quincey said in a press release.

Costa holds the largest share of the UK market, but its growth has run out of steam. To find new growth it needs capital to enter new markets, or to add stores quickly in places like China. Against Starbucks' 28,000 stores worldwide, its fewer than 4,000 are small. That Whitbread meant to spin it off, list it on its own and keep expanding it in markets led by China says a great deal.

Under Coca-Cola's management, a mid-sized Costa can keep scaling. Putting out Costa-branded packaged ready-to-drink coffee is certainly one important step; rough product mockups have already turned up in the investor presentation.

Costa Express, the coffee vending machine Costa has been trying out in recent years, also fits Coca-Cola's food-industry routine neatly. More than 8,200 Costa Express machines now bring in $275 million a year. Quincey has said he will take Costa Express to North America and put it in convenience stores, gas stations and schools to sell hot drinks.

Coffee vending machines and coffee shops open the door for Coca-Cola to the $485 billion hot beverage market. Coca-Cola says that market is growing at 6% as well.

Then there is China's coffee market, full of potential. Costa has more than 450 stores in China. In 2017 it bought the remaining 50% of its southern China joint venture back from Yueda Group, and it has said it will reach 1,200 stores in China by 2022 — more than 700 new stores in five years.

Quincey admits food-service retail is not Coca-Cola's strength, so Coca-Cola will let Costa run relatively independently. It plans to handle different regional markets and channels flexibly. In Asia, Costa will roll out across the board: vending machines, packaged ready-to-drink coffee, beans and ground coffee, and stores as well. Coca-Cola means to use the stores to build the brand's image, because Asia has not been drinking coffee for long and coffee-shop culture is not yet flourishing there.

Building a brand through stores is how Häagen-Dazs became the leading premium ice cream in China. Its operator, General Mills, is a food company too. In China, Häagen-Dazs opened lavishly fitted stores in busy shopping districts to establish a premium image, which paved the way into other channels: supermarket retail, B2B food service, even corporate bulk orders. Häagen-Dazs now has about 800 stores worldwide, roughly 350 of them in China.

Coca-Cola has been bolder this year. In Japan it launched Lemon-Do, the first alcoholic drink it has ever made. In China it invested in Le Pur, a Greek yogurt brand that sells through internet and "new retail" channels — the first time Coca-Cola has made a strategic investment in an Asian startup and worked with one. Buying Costa is another case.

The competition ahead is uncertain: the coffee groups run by Starbucks and JAB are larger, and McDonald's and convenience stores have started selling freshly ground coffee. But set against persuading consumers to accept carbonated drinks all over again, this is the more imaginative thing to do.

After 132 years, Coca-Cola has finally made up its mind to build a business beyond sugar water.

Coca-Cola's more important acquisitions through history

1960

$725 million for Minute Maid; buying this juice brand was Coca-Cola's first move into a non-carbonated category

2001

$181 million for Odwalla; Coca-Cola enters chilled juice and smoothies

2007

$4.2 billion, at a steep premium, for Energy Brands Inc. (Glacéau), whose products include Vitaminwater; the deal broadened Coca-Cola's non-carbonated lineup

2007

Acquisition of Fuze Beverage, which mainly makes iced tea and juice

2007

Joint acquisition with Coca-Cola FEMSA (a Coca-Cola bottler) of Jugos del Valle for $470 million in total; the company ranked second in juice output in Mexico and first in Brazil

2011

Completed the full acquisition of Honest Tea, a brand built on low-sugar iced tea; three years earlier Coca-Cola's Venturing & Emerging Brands unit (VEB) had taken a 40% stake, spending about $43 million at the time

2013

Completed the acquisition of Zico, the coconut water brand ranked second in market share behind Vita Coco; Coca-Cola's VEB first invested in it in 2009 and raised its stake afterwards

2014

$1.25 billion for a 10% stake in Keurig Green Mountain, plus a strategic partnership; Coca-Cola entered the Keurig system, making single-serve capsules of standard formulas for cold drinks mixed on the spot, and once launched the carbonated capsule Kold, though production stopped in 2016

2015

$2.15 billion for a 16.7% stake in the energy-drink company Monster Beverage, plus a strategic partnership: Coca-Cola handed its own energy-drink brands to Monster, Monster transferred its non-energy products to Coca-Cola, and Monster gained the use of Coca-Cola's global distribution

2015

$400 million for full ownership of Xiamen-based Zhonglü Culiangwang, a move into grain drinks

2016

Bought AdeS from Unilever, the top non-dairy milk alternative brand in Latin America, a move into soy-based drinks; Coca-Cola and its Mexican bottler put up $575 million together

2016

Took a 40% stake in Chi, a Nigerian dairy and juice company, and established a strategic relationship between the two, with a possible acquisition later

2017

$220 million for the sparkling water brand Topo Chico (no sugar, no calories, few additives), added to the VEB portfolio; before this Coca-Cola had no dedicated sparkling water brand

Chart: Feng Xiuxia

Cover image: Photo by Nathan Dumlao on Unsplash

Image credits: Coca-Cola, PepsiCo, Starbucks and Costa