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Tickers in this Article: PEP, KO, PBG, PAS, COKE
The cola wars took a somewhat unexpected turn in recent days as offers made by PepsiCo (NYSE:PEP) were rejected by the two bottlers it was trying to acquire. In other words, rather than focusing on archrivals and outward markets, Pepsi will have to devote significant time and resources to wooing the partners that are responsible for getting Pepsi products to market. But who will benefit?

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Recent Developments
A May 7 press release from PepsiAmericas (NYSE:PAS) rejected Pepsi's buyout proposal of $23.27 per share (at the time of announcement) as "not acceptable and ... not in the best interest of ... shareholders" as it "substantially undervalues the synergies that can be obtained in the proposed transaction". Pepsi Bottling Group (NYSE:PBG) was a bit more blunt when it detailed similar reasoning on May 4. PBG's letter claimed that Pepsi's offer was "grossly inadequate" and that it understated the synergies and cost-saving benefits that could come with a merger. Pepsi's bid for Pepsi Bottling valued it at $29.50 per share at the time of the announcement.

Pepsi estimates that it will cost $6 billion to acquire the portions it doesn't already own in the two bottling companies, and that the combined synergies would be at least $200 million, or 15 cents in additional earnings when the cost-savings are fully realized. Unsurprisingly, Pepsi is standing firm with its offer and said it would provide control of more than 80% of its North American volume, adding to earnings and helping bring its product to market more quickly and efficiently.

Cost Savings
At this point it's difficult to discern the amount of possible cost savings, and there is speculation that the two bottlers are just posturing for a higher buyout price before accepting the offers. In addition, Pepsi already owns 33% and 43% of the outstanding shares of Pepsi Bottling and PepsiAmericas. Pepsi Bottling states that PepsiCo controls 40.2% of its voting stock, while PepsiAmericas calculated that Pepsi beneficially owns 43% of its common stock, which allows Pepsi to "significantly affect the outcome of our shareholder votes." (For more, see Which Is Better: Dominance Or Innovation?)

Upside Potential
In other words, the bottlers in question likely have little wiggle room in avoiding Pepsi's bear hug. Funnily enough, it's the shareholders of Pepsi Bottling and PepsiAmericas that have the most to gain from a possible merger, by gaining shares in Pepsi and its stronger capital generation capabilities; this is evidenced by Pepsi's returns on invested capital (ROIC), which consistently exceed 20%. In stark contrast, ROIC at the bottlers is less than half this amount as annual capital expenditure needs eat up more than half of operating cash flow on an annual basis.

Throw in a hefty share premium from Pepsi, with potential for more upside, and it's hard to see the mergers not going through. It may not be all sour milk for existing Pepsi shareholders either, given synergy benefits could turn out better than expected. Though Pepsi does not consolidate the results of Pepsi Bottling and PepsiAmericas, it already reflects its share of net income based on current ownership percentages, which is significant.

Bottom Line
In my mind, Coca Cola's (NYSE:KO) model with bottlers, including the Coca-Cola Bottling Company (Nasdaq:COKE), is superior to Pepsi's and leaves the capital-intensive operations off its books. But in the grand scheme of things, the businesses of the bottlers and parent companies are very intertwined, regardless of how the business structure is arranged. (For more on these two companies, see Economic Moats Keep Competitors At Bay and Advertising, Crocodiles And Moats.)

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