The overarching question is not whether PepsiCo (PEP) or Coca-Cola (KO) will push the envelope by selling cannabis-infused beverages in the United States. The real question is what is meant by “pushing the envelope.” They will enter the CBD beverage market, given the early projections on the CBD market opportunity. However, in business as in baseball, timing matters. They will not enter until they are comfortable with the direction the laws are going.
As the American consumer is intrigued by the value of CBD beverages, I expect the governmental relations folks within a number of companies would be working with government legislators to leverage that interest to the benefit of their company. As both Pepsi and Coke have expressed publicly what we might call benign interest in CBD beverages, I expect they have their governmental relations people engaged in helping shape a common-sense approach to future legislation on CBD products.
This is not a bad thing, given the potential market size of CBD beverages.
Context
With the decline in soda that began around 2004, we saw that both PepsiCo and Coca-Cola entered the water category, and they continue to add some variations. But that is not all. Sports drinks? Both are on it! Energy drinks? Roger that! Coffee? Of course, with some version or another.
On coffee, Coke decided to get into the retail coffee business, a business it does not know but was wise enough to retain Whitbread operations management when it bought Costa Coffee. PepsiCo swore off restaurants as too expensive and spun them off into what is now YUM! Brands (YUM). As for coffee? To a smaller degree and with less risk, PepsiCo focused on singular products to add to its extensive distribution network, like Frappuccino. However, since it is limited in its ability to partner with Starbucks (SBUX) in Europe, PepsiCo is working with Lavazza to come up with a European coffee revenue stream.
Pepsi and Coke have also been iteratively buying back and selling the bottling groups, as they question whether they should be engaged in related diversification. Neither company seems absolutely certain, as the actions taken appear more a matter of who is in charge and the logic of the moment.
What remains with the Pepsi/Coke dynamic is that when one company entered a product category so does the other; with copy-cat competitive behavior as a form of legitimacy, as competitors often seek to imitate one another. This is an effort believed to be a safe way to proceed in times of uncertainty. And, at this early stage, we would have to say the CBD beverage market is highly uncertain.
This imitative behavior can often lead to the “bandwagon effect,” which is a phenomenon whereby the rate of imitation in beliefs, ideas, fads and trends increases with their adoption by others. We can see aspects of imitation as a means to legitimacy when looking at a few notable issues both Pepsi and Coke have faced.
For example, we can see how both managed the potable water threat in India. We also saw how an investment in Pakistan seemed to make sense for both financial ledgers.
Rather than being extensive, these are meant to be illustrative points on the competitive landscape for both beverage giants. However, the focus of this article is on PepsiCo and the CBD beverage market opportunity. So, it is worth pointing out that unlike Coca-Cola which claims product diversification within beverages, PepsiCo is actually diversified outside of beverages, with about 52% of its revenues coming from snacks. It also means that at some point, its interest in CBD will expand beyond beverages and into snacks…adding “munchies” to its drinks. This is not a small distinction and a perfect segue for the discussion of PepsiCo’s initial foray into CBD consumer products.
Understanding the Product Market
Yes, there is notable potential in the CBD product markets and there is nothing about PepsiCo’s past that suggests it does not know the markets it enters. When we consider the projected growth of the total CBD product market as being $24 Billion by 2023, with beverages an expected $2.5 Billion market, it is understandable why PepsiCo, with its extensive value chain and experienced distribution network, will want to figure out an entry point.
But, as the broader range of consumers are concerned about the origin of CBD for consumer products, as well as their safety and quality, including whether or not it gets the consumer high, that entry point remains undefined.
A little clarity about CBD might help.
CBD is derived from the hemp plant, whether oils or seeds, and has <0.3% THC (tetrahydrocannabinol), the principal compound in cannabis responsible for the euphoric high. As such, CBD is thought of as the non-psychoactive cousin of THC. But this is misleading, as research has shown CBD has antipsychotic, anxiolytic (anxiety-reducing), and antidepressant effects that clearly demonstrate it is a mood-altering substance (psychoactive or affecting the mind or behavior). However, the important distinction is that CBD lacks the intoxicating effects of THC. (From a consumption perspective, this means there would be no concerns about impaired driving). This matters because making deceptive claims in advertising is illegal and can result in serious consequences.
Although the 2018 Farm Bill removed hemp and the cannabinoids derived from hemp from the purview of the Federal Controlled Substances Act, the farm bill expressly preserves the U.S. Food and Drug Administration’s (FDA) authority to regulate food, dietary supplements, cosmetics, and drugs, including those that contain hemp ingredients.
While the FDA is accepting public comment and is holding a hearing to evaluate alternative approaches for regulating CBD products, the FDA’s current position is that THC and/or CBD cannot lawfully be added to food or marketed as dietary supplements and the FDA has sent warning letters to several CBD companies expressing this position and requesting corrective action.
So, while it is incorrect to claim that the 2018 Farm Bill has fully legalized hemp as well as any and all derivatives of hemp, the bill did exempt hemp and its derivatives from the definition of marijuana under the Federal Controlled Substances Act. However, it does not require states to do the same. Furthermore, under the bill, states are permitted to prohibit hemp production and several states continue to do so.
While some states explicitly authorize and regulate the production and sale of CBD, or otherwise provide legal protection for authorized individuals to engage in commercial hemp activities, other states maintain drug laws that do not distinguish between marijuana, hemp and/or hemp-derived CBD. This results in hemp being classified as a controlled substance under some state laws. In these states, sale of CBD, notwithstanding the origin, is either restricted to state medical or adult-use marijuana program licensees or remains unlawful under state criminal laws. Additionally, a number of states prohibit the sale of certain consumable CBD products, such as CBD-infused foods, beverages or dietary supplements. (Still, I expect we might look for more clarity and consistency among the state laws when they realize the taxes they might garner over time).
As such, it is easy to see why PepsiCo and Coca-Cola are moving cautiously. But they are moving forward nonetheless, because CBD provides some intriguingly valuable claims that make for a product market poised for exponential growth.
Why do I say that?
Because CBD has a marketing message that claims to treat low grade pain and sleep disturbance; both categories that Americans are broadly struggling with. While pain is personally subjective and can be broken into chronic (long term) and acute (immediate, shorter term), the number of Americans affected are significant. According to the Centers for Disease Control, 50 million Americans have long-term pain that interferes with their daily existence. Also, some 30 million will have back pain during their lives that can be both acute and chronic.
Further, with the advancement of medical procedures and the increased aging of the US population (the number of Americans over 65 years of age is expected to double over the next three decades), this is driving a 6X increase in hip and knee replacement surgeries that, along with increased dental surgeries, is increasing the acute pain Americans are experiencing. Given the concerns about opioids, any product that can be said to address, ameliorate or minimize pain is going to find a very interested consumer.
Then we have the sleep disturbed or deprived. And, while a better bed or pillow might make a difference, the idea that one might consume a tasty drink or snack that could help improve sleep is compelling. Just so we are clear about this opportunity…according to the American Sleep Association:
-
37% of 20-39-year-olds report short sleep duration.
-
40% of 40-59-year-olds report short sleep duration.
-
35.3% adults report <7 hours of sleep during a typical 24-hour period (a number less than the suggested 7-9 hours per 24 hour period).
-
Then there is the staggering 100,000 deaths that occur each year in US hospitals due to medical errors; with sleep deprivation having been shown a significant contributing factor to the mistakes.
So, it is clear that there are significant and compelling market opportunities for CBD, both in drinks and snacks, and we know that soda sales have dropped as consumers search for healthier options.
This is not lost on PepsiCo, as it has strategically identified its product portfolio as divided into three categories: “fun for you,” which covers the Pepsi and Doritos tier of products; “better for you,” which encompasses products like Diet Pepsi and Baked Lay’s; and “good for you,” which includes the likes of Quaker Oats, Sabra hummus and Naked juices. It is not hard to see where CBD drinks and snacks might fit into one or more of its portfolios.
Moreover, PepsiCo has a reputation as a consumer brand with high marks for brand value, reputation and, to no lesser degree, talented people. As is clear from any research on organizational management, it is the people that lead and make the decisions that enable the organizations to take advantage of the perceived opportunities.
The Development of CBD Products
While I would not expect a full CBD product line to be developed at this early stage, it is a fact that any CBD products that would allow for initial market entry must be developed to some extent before the federal and state governments open the starting gates; otherwise the company would risk falling behind. In fact, if PepsiCo wants to be an early entrant, it has to be developing products now. Despite the statement from Hugh Johnston, PepsiCo’s CFO/vice chairman, who indicated a solid equivocation, it should not come as a surprise to learn that Johnston also told CNBC that “we’ll look at [the cannabis industry] critically.”
That put the investment community into an initial frenzy when combined with a story that the Coca-Cola Company was in “serious talks” with Aurora Cannabis (OTC:ACB) to develop a CBD infused beverage.
However, that was quickly followed by the CEO of Coca-Cola Co., James Quincey, clarifying that the company was not interested in entering the cannabis-infused beverage market. Quincey’s comments came in response to a question from Cowen & Co. analyst Vivien Azer during an earnings conference call with analysts.
Still, as PepsiCo’s Johnston had said, “I think it’s fair to say we look at everything but I think that the difficulties in investing in that category particularly in the US where federally these things are still not legal is quite a considerable challenge. We look at everything but certainly no plans at this point to do anything.”
For Duane Stanford, the executive editor of industry publication Beverage Digest, the question for both Coke and Pepsi is whether CBD beverages are going to be something akin to energy drinks – a new category that is trendy at first, then actually grows into a meaningful long-term business? Or is it going to merely be a fad?
It has been argued that PepsiCo needs cannabis more than it realizes, suggesting PepsiCo will face immense shareholder pressure to explore the cannabis market and CBD-infused beverages or risk falling further behind.
Others have expressed downright surprise that PepsiCo is not looking into cannabis. In fact, Patrick A. Terrion, a principal of Founders Capital Management, a Hartford-based advisory firm that oversees 10,525 shares of PepsiCo, said the move will come in time. “There’s no question Pepsi will be experimenting with cannabis, just like everyone else,” he said. “It’s going to happen.”
As I previously pointed out when looking at its growth opportunities, perhaps PepsiCo is not as far behind as some might think.
In fact, as noted by this local headline:
CBD Beverage Hits Mainstream via Pepsi Independent Distributors
According to the subsequent article, Xanthic Beverages has been rapidly entering the mainstream marketplace. Its flagship product, Xanthic CBD Water, is produced by a Pepsi independent bottler, and is currently being distributed by a network of Pepsi independent distributors in hundreds of retail locations throughout Washington and Oregon; both states that allow the sale and distribution of CBD products.
This is consistent with the approach to product testing PepsiCo has long conducted, as it works to find the right formula to meet consumer tastes while focusing on a single product, seeking to get it right before expanding into additional product lines. Water makes the most sense to begin with because it appeals to a wider range of consumers. And, this would provide the sales and marketing platform to be followed by other forms of soft drinks, sports drinks and energy drinks.
As it awaits legislative support of CBD products and the consumer response to its CBD water, PepsiCo is all about building on and expanding product success. At some point, that means leveraging CBD into more beverages, as well as an effort to enter some selected snack markets.
Summary
When we consider CBD beverages, being first to market is fraught with challenges. The most obvious problem is ensuring the consumer truly understands the price-value of the products they are purchasing. As noted previously, the genesis of the CBD used in the beverages, along with its THC content, is a concern. So it is that the CBD product acquisition to be used in the beverage manufacturing process is important from a safety and consistency perspective. With its significant buyer power that enables it to access products at a lower cost, PepsiCo can derive a source of pricing advantage that would contribute more to its bottom line than would be true for other beverage or snack companies.
However, as a product category that is capable of imitation, there will be no competitive advantage that is sustainable because CBD beverages would not be costly to imitate or distribute in established networks. This means the barriers to market entry would be lower, as would be the ability to attract customers through a pricing strategy that offered lower priced products (albeit with a smaller profit margin).
Still, the challenge for any new product is to infer differentiation even if the product is commoditized and focuses on a cost basis. While one could argue that a CBD beverage is differentiated from other beverages, that is an unlikely distinction when comparing CBD products. Rather, for CBD beverages as for sodas, taste matters and, along with price, drives the purchase decision by the consumer; as does product availability.
So it is that, with its refined value chain that includes an extensive distribution capability and marketing reach, PepsiCo possesses economies of scale and buyer power that enables it to access production materials at a favorable price, along with learning curve cost advantages that lower production costs; all of which would provide a significant advantage over smaller or even larger but later entrants into the CBD beverage market.
The announcement late last week that privately held Arizona Beverage Company, the maker of Arizona Iced Tea, is entering the hemp drink market, seeking to be the first to market in the United States, only serves to help educate the consumer PepsiCo would seek to reach. It also helps address what will certainly be early market concerns about the path to profitability.
Once PepsiCo has determined that the laws will not impair its ability to manufacture, market and sell CBD beverages on a scale that garners its desired 15% IRR, I expect it will jump into CBD beverages with both feet.
Disclosure: I am/we are long PEP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Recent Comments