Even When Coca-Cola Stumbles, It Does Okay

By Stephen D. Simpson, CFA | July 16, 2013 AAA

If this is what a bad quarter from Coca-Cola (NYSE:KO) looks like, it's not hard to see why the stock carries a rich multiple. Even in one of the weakest quarters in a long time (from a volume perspective), Coca-Cola did well with its margins. Add in the possibility of improving the company's global operations, particularly in fast-growing markets like China and Indonesia, and the long-term prospects still look pretty good. Alas, the stock still isn't anything close to “cheap” and is unlikely to become so anytime soon.

A Surprisingly Weak Quarter For Volume
Coca-Cola announced that revenue fell almost 3% this quarter, with core beverage revenue down 1%. Netting out currency, overall revenue would have improved about 2% and Coca-Cola has increased the estimated headwind from currency for the full year.

The real surprise this quarter was the weak volume growth. Overall volume growth was just 1%, whereas the Street was expecting around 3% (even after many analysts revised expectations modestly lower around the mid-quarter point). North American revenue dropped 1% and Europe was down 4%, while LatAm grew 2% and the Pacific region saw 2% volume growth.

In an example of how “even when they lose, they win”, Coca-Cola still delivered solid margin leverage. Gross margin improved almost one point, and adjusted operating income declined only 1% (and rose 4% on an even more adjusted basis). That was good for a roughly 70bp improvement in operating margin.

SEE: A Look At Corporate Profit Margins

Economics Versus Competition
There isn't much evidence yet that Coca-Cola is seeing any real issues from global competitors like PepsiCo (NYSE:PEP) or Nestle (Nasdaq:NSRGY) or regional rivals. Instead, it looks like economics are the principle issue. Although some analysts are already out in print trying to pin some of the weak volume on bad weather, I think the performance in regions/countries like Europe, Brazil, Mexico, and China points to consumer spending issues more than meteorology.

In the long run, I'm not too worried about this. In the short run, though, it could make things sticky for bottlers/distributors like Coca-Cola FEMSA (NYSE:KOF) and Coca-Cola Amatil (Nasdaq:CCLAY).

Time To Learn From The Beer Biz?
Although Coca-Cola already does quite well from an operational perspective, I wonder if there's more to be done. In particular, I wonder if Coca-Cola should study up on what Anheuser Busch-InBev (NYSE:BUD) and SABMiller (Nasdaq:SBMRY) have done in the U.S. and emerging markets, respectively, in terms of manufacturing and distribution efficiency.

Coca-Cola bought up a lot of bottling assets in the U.S., but has yet to really put them through a fundamental restructuring and doing so could result in real savings. Consider this detail from a recent report from Credit Suisse analyst Michael Steib – BUD produces 116 million hectoliters in the U.S. at 13 facilities, while Coca-Cola uses roughly 10 times as many facilities to produce 310M hectoliters. Likewise, SABMiller is one of the most effective companies in the world at producing and distributing beverages in areas not known for having the best infrastructure. By the way, SABMiller is one of the largest Coca-Cola bottlers in the world, so it's not as though the companies are strangers.

The Bottom Line
I do believe Coca-Cola will eventually streamline and improve its U.S. operations, and I likewise believe there may be more transactions overseas to consolidate or otherwise improve bottling operations in critical markets like China and Indonesia. All of that holds the potential for both improving growth and margins over time.

The problem is that the stock's valuation seems to already anticipate such improvements. Even with 7% long-term free cash flow growth (on par with the growth of the past decade), it's hard to generate a price target in the $40s unless your discount rate/rate of required return goes quite low. As a result, I'll continue to admire Coca-Cola from afar as I think the stock is still too expensive for new investors.

As of this writing, the author owns shares in SABMiller and FEMSA (FMX), co-owner of Coca-Cola FEMSA.

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