Why Coke Desperately Needs -- And Will Likely Buy -- Honest Tea

(MoneyWatch) 
(***UPDATE: On February 16, 2011, Honest announced that Coke elected to exercise its option to buy the rest of Honest Tea, making it a fully owned part of the beverage giant.)

Two and a half years ago when Coca-Cola (KO) bought a 40% stake in Honest Tea, a quirky seller of lightly-sweetened certified organic teas, the arrangement was something of an experiment. Now it's looking more and more like a must-have acquisition for the beverage giant.

Next year Coke has the option to buy the remaining 60% of Honest Tea, and while the company hasn't said whether it intends to do this, they'd be crazy not to. Coke's recent champagne-popping earnings report illustrates why.

For the second quarter 2010, the company reported that its North American revenues increased for the first time since 2006 and that sales of Coke-branded sodas -- on the decline for the past four years -- grew in the US.

This is good news for the company, of course, but it also offers a glimpse of the challenges Coke is going to face to keep this momentum going, since most of the growth came not from flagship sodas but drinks the company considers "healthier" like Powerade sports drinks and vitaminwater. The soda gains came not from regular Coke, but lower calorie options like Coke Zero.

And while these brands are growing now, it's not hard to see a scenario in which consumers lose interest because the reality is that it's a stretch to call these drinks healthy. Vitaminwater, as a lawsuit by food activist group CSPI points out, is essentially sugar water dolled up with a bunch of added vitamins and shrouded in clever marketing. Yes, it's got less sugar than regular soda, but that only makes it less bad, which is not the same thing as good for you. Most varieties of vitaminwater still contain 33 grams of sugar per 20oz bottle. In denying Coke's motion to dismiss the lawsuit, a New York judge recently lent considerable legal weight to CSPI's argument that vitaminwater violates the FDA's "jellybean rule," which prohibits health claims for products that aren't actually healthy, i.e. jelly beans.

Similar amounts of sugar are found in Powerade -- 35 grams per 20oz. Coke and Pepsi (PEP) have always marketed sports drinks as something that helps people recover from the rigors of athletic activity, but even for athletes these products may not be so great. There is some recent science to suggest that consuming sugar after exercise has a negative effect on both insulin sensitivity and the body's natural human growth hormone production.

If Coke wants to see more quarters of growth in the US, not to mention ward off the passage of soda taxes or other government initiatives designed to curb soda consumption, it needs beverages that aren't simply new versions of sugar water. (Coke owns the Odwalla and Simply lines of 100% juices, but they seem to suffer from minimal marketing.)

This is where Honest Tea comes in. It has much less sugar -- 10 to 18 grams per 16oz bottle -- and no artificial colorings, flavorings or preservatives. And unlike tea drinks from Snapple, Arizona, Pepsi's Sobe and Coke's Nestea, they taste like they were made with real tea leaves.

It's unlikely that Honest Tea will be a billion dollar megabrand for Coke the way vitaminwater is (the company's sales in 2009 were $47 million). But having another bona fide healthy brand in its stable will go a long ways towards positioning Coke for the future growth in the US.

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