Will Margins Take Some Fizz From Coca-Cola?

By Stephen D. Simpson, CFA | July 18, 2012 AAA

Although many packaged food companies have struggled to maintain their volumes while passing through higher input prices, Coca-Cola (NYSE:KO) isn't like most companies. Although ongoing margin compression merits some attention, it's hard to imagine that long-term holders are going to get too worked up about it. Coca-Cola remains what it has long been - a top-quality company with a price to match.

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Good Volume Drives Solid Q2 Revenue
Coca-Cola did well from a top-line perspective this quarter. Revenue rose almost 3% with "organic revenue" (price and volume) up about 6-7%. Case unit volume rose 4%, while established markets like Europe, Latin America and North America were weaker than expected, but Eurasia/Africa and Pacific were both quite strong. By product, still beverage rose 9%, while sparkling beverage and core Coca-Cola volumes were up about 2%.

Margins continue to lag, however. Adjusted gross margin fell more than a half-point, and adjusted operating income rose just 2% as the company recouped some margin through SG&A. While the company's bottom line result looked alright, a somewhat lower tax rate helped boost that number.

SEE: Zooming In On Net Operating Income

The Push-and-Pull of Competition
Based on these numbers and Nielsen data, it looks like Coca-Cola is gaining on PepsiCo (NYSE:PEP), Dr Pepper Snapple (NYSE:DPS) and Nestle (OTC:NSRGY) in the still beverage category (juices, teas and bottled water). The soda/sparkling category may be a more interesting story - in particular, I will be curious to see how Pepsi did in North America and Europe this quarter and whether their promotional efforts are showing any traction. At the same time, I suspect that generic/store-brand soda companies like Cott (NYSE:COT) are continuing to gain share in North America in response to price hikes.

SEE: Parched For Profits? Try Beverage Stocks

What's to Be Said About the Growth Outlook?
As I've lamented on more than one occasion, there's not a lot to say about Coca-Cola's growth plans, as they are very likely to resemble what the company has been doing so well for so long.

Infrastructure and channel investment is going to continue to be a priority in emerging markets like Brazil, China, India and Indonesia. Commonly-cited stats show that Coca-Cola consumption in markets like China and India is still way below that of North America (or Latin America), and that's the easiest (or at least most obvious) growth opportunity - to that end, Coca-Cola recently discussed plans to invest an additional $5 billion in India by 2020.

I still think that there's room for M&A, though. A deal for AriZona Beverages would boost the company's tea/juice offerings, and though Coca-Cola denied it was in talks to acquire Monster (Nasdaq:MNST), it's not a ridiculous idea.

SEE: Biggest Merger And Acquisition Announcement Disasters

Beyond this, I wonder if Coca-Cola could or would consider reversing course; so much of Coca-Cola's success has been built on taking very successful products in the U.S. and taking them overseas. Well, what about reversing the flow? Maybe a product like Otsuka Pharmaceutical's Pocari Sweat or Uludag Icecek's Uludag Gazoz (a popular drink in Turkey) could do well in the U.S., or maybe broader distribution of Inca Kola outside of Latin markets could drive some incremental growth. I'm not holding my breath, but it's a question that's worth asking.

The Bottom Line
It's going to take a major market sell-off (a crash, probably) or a significant company-specific problem to drive these shares into "cheap" territory. As it is, compound free cash flow growth of 9% only drives a $74 fair value based on an 8.5% discount rate (the lowest I'll go with an equity). By no means would I encourage current shareholders to sell these shares today (they're not really any more expensive than those of Nestle), but it's hard to see how these shares will significantly outperform the broader market over the next few years.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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