Weak Volume Growth Weighs On Coca-Cola

Jul.23.13 | About: The Coca-Cola (KO)

Leading soft drink maker Coca-Cola (NYSE:KO) posted lackluster second-quarter results Tuesday morning. Revenue declined 3% (+2% excluding currency) year-over-year to $12.8 billion, falling short of consensus estimates. Comparable earnings per share (a non-GAAP figure) increased 4% year-over-year to $0.63, in line with consensus expectations. With lower capital expenditures than in the year prior, free cash flow is roughly flat year-to-date at $2.8 billion, approximately 12% of revenue.

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Image Source: Coca-Cola

Eurasia and Africa outperformed the rest of the company as volumes surged 9% year-over-year, annualizing 10% expansion in the same period a year ago. Currency headwinds weighed on net revenue growth, which totaled 5% (11% excluding currency). The markets in Eurasia and Africa have consumption rates well below those of other areas of the globe, so the growth runway remains strong in these regions. Management cited its "Coke with a Meal" marketing campaign as a key driver of sparkling beverages, where volumes rose 7% year-over-year (led by brand Coca-Cola).

European volumes remain under pressure as the continent deals with sluggish economic conditions. Second-quarter volumes declined 4% year-over-year, cycling a 4% decline in the second quarter of 2012. Still, net revenues declined just 1% during the quarter thanks to price increases, but operating income fell 7% year-over-year. CEO Muhtar Kent refused to simply blame the economic situation, noting on the conference call:

historically wet and cold conditions across Europe including the coldest spring for Germany in 40 years further dampens already weak consumer sentiment and industry trends and contributed to volume declining 3% in Germany in the quarter.

Regardless, Kent sounded optimistic that marketing campaigns and better weather will help the business during the second half of the year. Of course, a return to economic growth in the broader region will be the shot in the arm that Coca-Cola really needs.

The firm's Latin American segment's results were solid, but far from spectacular, with volumes up 2%. Even better, currency-neutral revenue advanced 11% year-over-year, while currency-neutral operating income jumped 13%. Unfortunately for Coca-Cola, we see a large headwind on the horizon in Mexico. The nation recently topped the U.S. with an obesity rate of 32.8%, and many critics blame this on soft drinks. With Coca-Cola per capita consumption in Mexico dwarfing the rest of the world, Coca-Cola may become a target of scrutiny from interest groups (and perhaps even the government). Still, the firm has plenty of room to grow in other Latin American countries, which should allow the company to maintain growth in the region even if Mexican volumes come under pressure.

As for North America, the firm blamed wet/cold weather and holiday timing for the 1% decline in volumes during the second quarter. Net revenues declined 1% during the quarter while operating income fell 3% year-over-year. Revenues in the region dwarf those of the rest of the company, but operating margins in the geography are actually much worse. Fayard noted that revenue declines in the region can actually have a positive impact on margins if prices are increased, saying:

…when an operation like North America is minus one in the quarter that actually -- this is counter intuitive but it actually improves margins, okay, because North America having the finished product business has lower margins. So our expectation is, number one, to continue to get positive pricing and we're going to be rational in pricing and we intend to say premium, as I said earlier.

As with Mexico, North America is dealing with an obesity headwind, which dragged down sparkling beverage volumes 4% during the quarter.

Pacific revenue was relatively weak, declining 5% year-over-year in spite of 2% volume expansion. The Pacific region encompasses many countries with highly divergent performance, as volumes surged 28% year-over-year in Vietnam, 22% in Indonesia, 17% in Thailand, and 1% in both Japan and India. Performance in China was mediocre, with volumes flat year-over-year. Even as Chinese economic growth slows, we do not anticipate Coca-Cola pursuing value-destructive behavior to gain market share, as CFO Gary Fayard stated on the conference call:

…to your question on China. The answer is, there are absolutely no plans for increased price promotion. In fact, the reason for having an evolving OBPPC is to have more sustained volumes at the right price point and the right tax for all the consumers.

More McDonald's (NYSE:MCD) restaurants as well as the backlash against KFC (NYSE:YUM) could help propel Coke products in the region at the expense of Pepsi (NYSE:PEP). It may not seem like a big deal, but we think the fast-food wars in China could certainly help propel Coke going forward-particularly if Chinese consumers continue to shun KFC.

Valuentum's Take

Coca-Cola's performance during its second quarter was lackluster, and we expect headwinds in countries where obesity is becoming a problem. Still, the firm has been (historically) one of the steadiest growth companies of all time, and we think it brings new products to market in order to take back any lost share due to lower sparkling beverage sales. We think shares look fairly valued at this juncture, and we will not be looking to add the firm to the portfolio of our Dividend Growth Newsletter at these levels (despite the firm's very attractive dividend).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.