CORPORATES

SECTOR IN-DEPTH14 September 2016

TABLE OF CONTENTSSummary 1Rise in bottled water consumptionwill help compensate for slowinggrowth in mature segments,supporting revenue growth 2Volume growth will remain driven byemerging markets 4Water segment to stay profit dilutivein the next 12-18 months 5Credit metrics to benefit onceprofitability improves, but this mighttake longer than 18 months 6Moody's Related Research 7

Contacts

Sara Santagostino 39-02-9148-1108Associate Analystsara.santagostino@moodys.com

Marina Albo 44-20-7772-5365Managing Directormarina.albo@moodys.com

Paolo Leschiutta 39-02-9148-1140VP-Sr Credit Officerpaolo.leschiutta@moodys.com

Soft Beverages - Europe

Bottled Water Growth To Offset SlowdownIn Other Segments, But Impact on CreditQuality Limited For NowSummaryRise in bottled water consumption will help compensate for slowing growth inmature segments, supporting revenues. We expect bottled water, which represents23% of the overall soft drinks market in terms of value, to remain one of the fastest growingbeverage categories in terms of volumes in the next five years as consumers move awayfrom high sugar drinks. Volume growth in the water segment will help organic revenuegrowth for Nestlé S.A. (Aa2 stable) and Danone (Baa1 stable) because both companies areexposed to mature segments which are suffering from declining demand. We also expect thewater segment to support revenue growth for soft beverage companies like Coca-Cola HBCAG (CCHBC, parent company of Coca-Cola HBC Finance BV Baa1 stable) and Coca-ColaEuropean Partners plc (CCEP, A3 stable), which faces volume pressure in the carbonated softdrink segment in certain mature markets.

Volume growth will remain driven by emerging markets. Danone is best placedgiven its established presence in China and Mexico with its Aquadrinks flavoured waterbusiness. While just 20% of Nestlé's water sales are in emerging markets, the company has adominant presence in the carbonated water segment. We expect Nestle to benefit from thepremiumisation trend in China and the expected higher growth in this segment in the US.

Water segment will remain profit dilutive in the near term. This is a very fragmentedmarket with high price competition and a large number of small players including privatelabels. Also, in countries where there is a reliable potable water supply consumers arereluctant to pay a premium for bottled water. As a result we do not expect marginimprovements during the next 12 to 18 months. Nestle's bottled water margin continues tolag the overall group, despite improvements in recent years. Slowing growth in China willrestrict margin improvement in Danone's water business. CCHBC has the opportunity toimprove the profitability of its water business considering its currently much less exposure tothe higher-margin carbonated, flavoured and premium segments.

Credit metrics to benefit once profitability improves, but this might take longer than18 months. Profitability should improve in the longer term as companies' investments innew and premium products begin to pay off. We expect a move into products other thanstill water will help companies to increase their price power in the category and their returns,resulting in improved credit quality over time.

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This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

Rise in bottled water consumption will help compensate for slowing growth in mature segments,supporting revenue growthWe expect bottled water (including still, carbonated and flavoured water) to remain one of the fastest growing beverage categories interms of volumes in the next five years. This will help beverage manufacturers offset growth in slowing segments such as carbonatedsoft drinks. Consumption of carbonated soft drinks and fruit juices is falling because consumers are moving away from high sugar drinksto other beverages which are perceived as being healthier, including water.

Increasing regulation on sugar content by governments, such as the sugar tax on soft drinks announced by the UK government inMarch 2016 should also support increased bottled water consumption to the detriment of soft drinks.1

Bottled water segment was worth around $183 billion globally in 2015 and represented 46% of the total soft drink sector in terms ofvolumes, but a much smaller portion in terms of value (23%). 2 This is a fragmented business where the two largest players in volumeterms are Nestlé S.A. (Aa2 stable) and Danone (Baa1 stable), followed by The Coca-Cola Company (Aa3 stable) and PepsiCo Inc. (A1stable) accounted as the aggregation of their different bottlers. The four largest players represented around 26% of the total off tradevolumes of bottled water in 2015. We estimate the two European Coca-Cola bottlers to represent a small portion of the total Coca-Cola's volumes in the water segment. In particular we estimate Coca-Cola HBC AG (CCHBC, parent company of Coca-Cola HBCFinance BV Baa1 stable) to represent around 19%, while Coca-Cola European Partners plc (CCEP, A3 stable)3 to represent slightly lessthan 10%.

CCHBC operates mainly in Central and Eastern Europe and recorded total volume of 2.1 billion unit cases in 2015 of which wateraccounted for around 19%. CCEP operates in Western European markets with 2015 pro forma volumes of approximately 2.5 billionunit cases, of which we estimate water represented around 7%.

Exhibit 1

Nestlé and Danone Are The Largest Global Players

Source: Euromonitor (ranking) and companies' data

As Exhibit 2 shows, Euromonitor forecasts bottled water consumption volume growth of around 5% in the next five years. Alongwith energy drinks, bottled water will outperform the 1% growth forecast for carbonated soft drinks (CSDs) and 3% growth in non–carbonated soft drinks.

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3 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

Exhibit 2

Bottled Water and Energy Drinks Will lead the Soft Beverage Market In The Next Five YearsVolume growth rate (millions of litres)

RTD = Ready to Drink; 2016-2019 are forecasted years.Source: Euromonitor

As Exhibit 3 shows, volume growth in the water segment will help organic revenue growth for Danone and Nestlé because bothcompanies are exposed to mature segments which are also suffering from declining demand. Danone is exposed to the dairy sector inEurope, where the market is saturated. For Nestlé the prepared dishes food segment has lost its appeal with consumers, especially inthe US. By contrast, water segment organic revenues have been strong.

Exhibit 3

Water Revenues Have Grown, While Growth In Other Segments Has DeclinedOrganic revenues growth

Source: Companies' data

Danone's dairy segment's organic revenue growth has slowed to 0.6% in 2015 from 4.6% in 2011. However the company hasrevamped its dairy category and revenue growth rose 2.6% in the first half of 2016. We expect dairy performance will continue toimprove towards the 2020 annual growth target set by the company of 3%-5%. However growth in water will remain stronger in thenext 12-18 months. Water now represents 21.3% of Danone's sales, up from 16.7% in 2011.

Nestlé is the market leader in the bottled water segment. The company reported 6.7% organic revenue growth in 2015 in the category,versus the overall group average of 4.2%, which has fallen slightly from its historical level of 5%-6%. This is due to some difficulties inselected markets but also to a slowdown in its prepared dishes segment and more recently in the milk and ice cream divisions. Nestlé'swater segment growth rate has been lower than Danone's in the past because Danone has been more successful in reshaping its brandportfolio proactively. However we expect that water will continue to be one of the faster growing categories for Nestlé in the next12-18 months. Water represents 8.6% of Nestlé's revenues, up from 7.8% in 2011.

We also expect the water segment to support revenue growth for soft beverage companies like CCHBC and CCEP which faces volumepressure in CSD in certain mature markets, where demand is depressed by health concerns about sugar content. CSD volumes

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4 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

represented around 69% of CCHBC's total volumes, but grew just 2% in 2015 in contrast with growth of 4.7% in the water category.Water represented around 19% of total volumes and 10% of CCHBC's revenues in 2015 and we expect its contribution will continueto steadily increase in the coming years. Volume growth will mainly be supported by energy drinks, which have become increasinglypopular with consumers in the past five years, and rose 6.6% in 2015. CCHBC expects to double its revenues from energy drinks by2020.

We do not expect concerns about water scarcity or the waste created by disposable water bottles to slow the segment's growth.Instead we would expect increasing demand to support packaging innovation to reduce the product's environmental impact. Also,bottled water production consumes less water than the production of other beverages, such as beer, where, for example, Heinekenreports to consume 3.7 hectolitres of water to produce 1hl of its beverages.4

Volume growth will remain driven by emerging marketsAs Exhibit 4 shows, we expect bottled water volume growth to remain strongest in emerging markets, with growth in the Middle Eastand Africa the highest, albeit from a low base. Among mature markets the US is expected to grow more than Europe.

Exhibit 4

Water Consumption in Emerging Markets Will Grow Ahead of the World AverageVolumes growth rate

Source: Euromonitor

Asian and Latin American countries will also remain large markets. In China, demand is being fueled by concerns about the quality ofpublic water supplies, but we expect volume growth to slow to mid-single digits from double-digit growth in recent years as economicgrowth slows down. According to Euromonitor, most growth will come from customers trading up to vitamin and mineral enhanced“functional” and carbonated water, segments it expects to grow faster than the still bottled water segment.

Distrust of public water supply also fuels demand in Mexico, which has the highest per capita consumption of bottled water in theworld, at 80%. Despite slowing volume growth in Brazil in 2015 due to the economic slowdown, Euromonitor forecasts continuedbottled water sales growth, but at a slower pace. In terms of value, the market will remain healthy because the unit price rose sharply in2015 due to water shortages in many regions of the country.

Typically in developed countries, tap water meets drinking water quality standards, so bottled water volume growth in Europe willbe driven more by the ongoing success of flavoured water. In the US, the move away from carbonated soft drinks resulted in sales ofbottled water reaching new highs in 2015. This was further supported by ongoing premiumisation with customers searching for higherquality products. We expect both trends to continue.

Danone is the company best placed to benefit from rising consumption in emerging markets, given its established presence in Chinaand Mexico with its Aquadrinks flavoured water business. Aquadrinks revenues grew 25% between 2010 and 2014. This was drivenby its Mizone brand in China, which rose 44% in the same period, allowing the company to improve price and mix. However, volumegrowth rate in China started to slow since mid 2015, hitting Danone's profitability because Aquadrinks in China are sold at higherprices than in other countries. Danone is now reducing inventories at distributor level and adapting its cost base in order to protect thecategory's operating margin.

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5 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

While only 20% of Nestlé's water sales are in emerging markets, it is the market leader in the US and in the carbonated watersegment globally. This is growing more rapidly than still water in both China and the US. Euromonitor forecasts that carbonatedwater sales in the US will grow faster than the global average, at 4% versus 1% in the next five years. The US is included in its NorthAmerica division which represented 54% of Nestle's total CHF7.6 billion water segment sales in 2015. Nestlé will also benefit fromthe expanding presence of its premium international sparkling brands such as Perrier and San Pellegrino. These represent 18% of itstotal water revenues, but these premium brands have stronger price potential, being sold for four times more than Nestlé's still waterbrand. Premium brands also have more potential to increase international sales, because higher selling prices cover the additionaltransportation costs.

Water segment to stay profit dilutive in the next 12-18 monthsWe expect bottled water to be a key driver of increased volumes and revenues for Danone, Nestlé, CCHBC and CCEP.

However, while bottled water volumes will increase, companies will continue to struggle to improve the segment's profitability and wedo not expect it to contribute to margin improvements during the next 12 to 18 months. This is a very fragmented market, with a largenumber of small players including private labels, resulting in very high price competition. Also, in countries where there is a reliablepotable water supply, it is seen more as a commodity with consumers reluctant to paying a premium for bottled water.

As a result, margins for bottled water tend to be lower than other food and beverage products and dilute overall group margins.Nestlé's 2015 reported operating margin in the water segment was 10.8% versus 15.1% at group level. Its focus on efficiency gains andbrand investment has resulted in profit improvement in its water division of above the group average in the past five years, of 280 basispoints, but the gap in margins remains. Growth in its water segment will probably not help Nestlé improve its group operating margin,which remains lower than its peers. However, we acknowledge that the premium sparkling segment, where Nestlé is leader, carriesstronger margin than average.

Danone's group operating margin has been squeezed by the weak performance of its fresh dairy division, but its water segment marginremained overall flat until 2014. It is not far from the group level, at 12.7% versus 13.5% respectively on average in 2011-2015. Danonehas reshuffled its water portfolio in recent years and increased contribution of flavored and speciality waters, which are sold at higherprices. This also allowed the company to record higher margins than Nestlé in this segment (see Exhibit 5).

However slowing growth in China was a drag on Danone's margins in 2015 and the first half of 2016 and we expect that weakerperformance in China will continue to weigh on Danone's water segment margin for the next 12 to 18 months, making difficult torestore it to previous levels.

Exhibit 5

Danone's Water Business is More Profitable than Nestlé'sReported Operating margin 2011-2015

Note: CCHBC's profitability for its water business is not availableSource:Companies' data

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6 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

CCHBC's water business is dilutive both in terms of revenue per case and operating margin. CCHBC has the opportunity to improve theprofitability of its water business considering its currently much less exposure to the higher-margin carbonated, flavoured and premiumsegments.

Credit metrics to benefit once profitability improves, but this might take longer than 18 monthsWhile we do not expect margin improvement in the next 12-18 months, profitability should improve in the longer term as companies'investments in new and premium products begin to pay off. A shift towards more innovative products and away from still water willhelp companies to increase their price power and their returns, and this should help improve credit quality over time.

Nestlé and CCHBC are both investing in expanding their brand portfolios to increase value by moving towards new products withhigher margins. Nestlé is investing in functional water and in its premium brands to strengthen profit growth and further improve analready above-average cash flow generation. This will help the company to improve its Moody's adjusted retained cash flow (RCF) tonet debt ratio which, at 30.8% at the end of 2015, is currently at the lower end of our guidance to maintain the rating, of above 30%.The weak RCF to net debt ratio, however, is in line with our expectation and is the result of its CHF8 billion share buyback programmecompleted last year.

CCHBC will find it more difficult to grow its water business, given its current focus on still water in the mainstream segment. However,innovation in packaging including single servings and the introduction of functional and flavoured water should help the company toimprove its margins over the next two to three years. Its strategy targets an EBIT margin improvement to 11% by 2020 from 7.5%currently. CCHBC's EBIT margin is lower than other Coca-Cola bottlers, at 7.4% on a Moody's adjusted basis versus 10.2% on averagefor rated Coca-Cola bottlers. Among other triggers we indicate that an improvement in the company's EBITA margin towards 8%,currently also at 7.4%, could lead to a rating upgrade. 5

Slowing growth in China will continue to weigh on Danone's profitability at least through the end of 2016. However strong growthin other developing markets will help offset this: Danone's water revenues for outside Europe, excluding China, rose 12% in the firsthalf of 2016. Danone continues to invest in its Aquadrinks business in emerging markets and in innovation in its still water segment(e.g. packaging). This should improve its profitability on the back of expected strong volume growth outside China and should help thecompany achieve its long term revenue annual growth target of 7%-10% in the water segment by 2020.

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7 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

Moody's Related ResearchSector in-depth: Investment-Grade Packaged Goods - Europe - Profit Growth, Stronger Free Cash Flow Generation To Support CreditQuality, 6 July 2016

Sector Comment: Soft Beverage Manufacturers - UK - Impact of Sugar Levy Will Be Limited but May Set Precedent, 18 March 2016

Credit Opinions:

» Nestlé S.A., 6 April 2016

» Danone: Update Following Acquisition of WhiteWave Foods Co, 12 September 2016

» Coca-Cola HBC AG, 20 November 2015

» Coca-Cola European Partners plc, 17 June 2016

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.

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8 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

Endnotes1 See “Soft Beverage Manufactures - UK- Impact of Sugar Levy Will Be Limited but May Set Precedent,” published 18 March 2016

2 Source Euromonitor

3 The new European bottler that was formed through the merger of Coca-Cola Enterprises, Inc. (CCE, A3, stable), Coca-Cola Iberian Partners, S.A. (CCIP, notrated) and Coca-Cola Erfrischungsgetränke GmbH (CCEG, not rated)

4 Source: Heineken's Sustainability report 2015. Data represents hectoliter of water per hectoliter of beer, cider and soft drinks.

5 See “Coca-Cola HBC Finance B.V. – Soft beverages – EMEA Frequently Asked Questions About Coca-Cola HBC's Weaker-Than Expected 2014 Results And2015 Pressures” published 4 March 2015

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9 14 September 2016 Soft Beverages - Europe: Bottled Water Growth To Offset Slowdown In Other Segments, But Impact on Credit Quality Limited For Now

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