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Barron's got bullish on Coke (KO) last weekend, saying the stock is presenting a good opportunity in 2014 with an upside of 20%. Yet, many of the reasons noted make little sense. At this point it is very hard to imagine Coke trading higher until the company finds solutions for and corrects its lingering problems.

What's Barron's Saying?

Barron's made a number of key points in the firm's weekend piece, much centering around the analyst-- Jonathon Feeney-- saying that 700 million additional people will join the middle class over the next seven years and that soft-drink sales will benefit.

Barron's notes the potential of a spin-off with the company's bottling operations, which could drive margins higher.

Lastly, for its valuation call Coke trades at a premium of just 4% to Pepsi-- assuming P/E ratios-- but has at times had a 20% premium, implying terrific upside potential.

What's Wrong with Barron's Argument?

After reading the headlines from Barron's piece, we could poke holes in just about everything. Yet, let's begin with the headline itself and the call for 20% upside, basing much of this figure on its premium of "only" 4% on PepsiCo.

Coke trades at 21 times earnings and PepsiCo (PEP) has a P/E ratio of 19.4, which might explain Barron's valuation metric of choice. However, a closer look at other metrics show that Coke trades at a much higher premium than 4%.

PepsiCo

Coke

Coke's Premium

Price/Sales

1.91

3.78

98%

Enterprise Value/EBITDA

12.11

14.95

23.5%

Price/Operating Cash Flow

12.68

17.06

34.5%

Price/Free Cash Flow

18.12

24.12

33%

Need I say more? Clearly, Coke is much more expensive than PepsiCo, unless you're using P/E ratios alone.

All investors know that companies with greater growth often trade with higher premiums. But if we use analyst outlooks, then PepsiCo is expected to grow 1.5% in 2013 and another 4.4% in 2014. Combined, this equates to two-year growth of 6%. On the other hand, Coke is expected to see a decline in sales of 1.6% in 2013 followed by growth of 3.4% next year. Together, this equals total growth of less than 2%! What does this mean? Pepsi is the faster growing and more reasonably priced company.

This brings up the statement regarding Coke trading at a 20% premium to PepsiCo… P/E ratio. Why? It definitely doesn't deserve it, so to imply that Coke could rally 20% because of historical premiums is like suggesting that Oracle still has 100% upside because it surpassed $100 back in the year 2000. Simply put, you can't make valuation related calls based on the history of two companies, as fundamentals change over time. Right now, PepsiCo is the company performing better; it is also the less expensive option.

Lastly, the "700 million new middle class" statement is simply ridiculous. This implies that wealthier consumers drink more sugary and unhealthy beverages; recent data might contradict this opinion.

Grocery store sales data in New York City suggests that sales of soda declined 6.8% in 2013 as more consumers elected to drink water. This is interesting because of census data showing that New York's median household income is $57,683 versus $53,046 for the national average. Furthermore, 32.8% versus 28.5% of citizens over 25 years old have their bachelor's degree in New York versus the entire U.S., respectively. These figures prove that, in a state with higher earnings and more educated consumers, soda sales have fallen.

Granted, Mayor Bloomberg has been on a crusade to ban large sodas and has resultantly increased awareness regarding the health effects of soda. Yet, this data still shows that more income doesn't necessarily mean more soda.

At the very least, Barron's statement is speculative, most likely based on historical trends and not accounting for a more well-informed general public versus in decades past.

What Problems Need to be Addressed?

Given the disconnect in fundamental performance between PepsiCo and Coke (and Coke's already inflated stock price), it makes you wonder how Coke could be a top-pick. Who knows? Maybe the inflated market means that identifying value is more difficult-- but then again, PepsiCo looks like the better investment opportunity for 2014.

Keeping these ideas in mind, once you get past the Barron's headline and look deeper at the areas that we've explored in this article, you're likely wondering what is going on with Coke. Why is the company seeing a lack of fundamental growth? And is there anything the company can do to change the trend? Or is there possibly a catalyst that could drive future gains?

Fortunately, there are three things investors should watch with Coke-- and these things would signal both change and future gains.

First, Coke needs a more diversified business, a growth driver if you will. Coke does have emerging markets and continues to grow in case volume with a larger global population. However, Coke's problem is that competition has also increased in the last decade, so the company can't be as aggressive with pricing. Also, Coke is constantly performing damage control, fighting corporations, politicians, and consumers who have damned the company for its unhealthy line of products.

PepsiCo faces most of these same problems, but has managed to grow because of its snacks business. In PepsiCo's last quarter, its beverage sales grew just 1%, but snacks revenue increased 3% including 7% in the Americas. Accordingly, snacks have become a great growth driver for PepsiCo, a way to diversify its business, and Coke has no competitive edge outside of the beverage market. While the beverage market is huge, food and snacks are just as big. With Coke being a $180 billion company, it has limited itself by not expanding or investing in R&D to create a snack business. Until this occurs, watch for PepsiCo's growth to remain superb, as Coke simply does not have an answer to counter PepsiCo's performance with snacks.

Second, Coke really has no answer for many of the health-related concerns surrounding its products. These concerns have been covered in detail by me, but most famously in reports by Credit Suisse, calling sugar the new tobacco. Thus, Coke must find a solution to this problem, such as substituting stevia for sugar.

One thing I found interesting about Barron's call is that it didn't address new legislation or political pressure that could further weigh on soda sales, yet called for gains due to a larger middle class. So I ask Barron's, what about the calorie intake limit on school vending machines, which essentially removes most Coke products from a large adolescent user base? This is a serious problem for Coke.

So back to my suggestion involving the substitution of stevia for sugar, a move that I believe is necessary to quiet critics, boost sales with health conscious consumers, meet any current and future legislation that could ban sodas, and push Coca-Cola's stock higher. Stevia is an all-natural zero calorie sweetener that is several hundred times sweeter than sugar. Coca-Cola has been experimenting with stevia in recent years. The company launched Vitamin Water Zero, which had sales in excess of $100 million in its first year, and launched Coca-Cola Life in Argentina, which uses stevia instead of sugar. In essence, my proposal (using stevia) is definitely on the minds of executives and is a real possibility for the future… although a slow-moving possibility.

Coke already has a partnership with the world's largest stevia supplier-- PureCircle (OTCPK:PCRTF). This is a company whose stock has risen 160% in the last year, showing the bets being placed on stevia to become the next sugar. However, PureCircle does not own its own land or grow its own product, but rather contracts with local growers throughout the world. This fact brings about another potential problem for Coke, and that is the need for stevia in its U.S. ecosystem. PureCircle partnered with S&W Seed (SANW) for this purpose back in 2011. Though after a botched harvest S&W is no longer working towards mass production, but rather research. In fact, it is unclear as to what S&W plans to do with stevia production, which can be read about here in great detail.

This brings up an interesting situation for Coke: The company needs stevia production in the U.S., whether it's for production or research. For this reason, I am briefly going to discuss Stevia First (OTCQB:STVF)-- a company that I've explored in the past and stated as having exactly what Coke/PureCircle need, and is conveniently located in the same region as S&W. Stevia First has 1,000 acres of land in the Central Valley of California. And most importantly, the company has a patent protected fermentation process that eliminates the aftertaste from stevia, which is a major hurdle to cross in replacing sugar with stevia.

Hence, removing the aftertaste from stevia becomes another problem for Coke-- and Stevia First has that technology. Last month, Stevia First hosted a tasting event, where five different products were put on display. According to the video linked above, lingering aftertaste was not an issue with Stevia First's products, and it's this technology that might be attractive to the likes of Coke/PureCircle. Looking ahead, Stevia First wants to become the first large scale grower and seller of stevia products, and has the resources to do so.

Either way, regardless if Coke seeks a partnership with the likes of Stevia First or other small stevia growers, the company needs to build stevia into its ecosystem. As of now, 31% of all U.S. sugar is used to supply major beverage companies, including Coke. Combined with rising sugar prices, you can see Coke's reliance on this commodity and it needs to seek new and healthier sweeteners. This will be interesting to follow in 2014, as PureCircle's stock shows both the growing demand for stevia, its outlook, and Coke now looks primed to make big investments in the commodity. Or at least it should!

Third, in connection with the stevia discussion and the company's need to make larger investments, Coke also needs to invest in cheaper and more efficient manufacturing alternatives. Barron's noted the possibility of a spin-off with the company's bottling operations, which is the one thing I find likely and also needed. However, Coke's problems are not as much operational, but rather perceptional-- almost like the tobacco companies of the 90s targeting children.

Coke needs to make investments in all-natural products-- those that are reusable and that are cost effective. Furthermore, there are reasons to believe that Coke is aware of this need, as the company recently partnered with Gevo to use its PlantBottle technology. This is a technology made-up of 30% plant-based materials, thus making it more eco-friendly and potentially cheaper long-term. It's deals such as this that can drive margins higher long-term, while also boosting sentiment.

Conclusion

Coke needs to address the issues noted above. And at that point, Coke might once more see growth and become a great investment for the future. However, in my opinion, Coke is going nowhere fast until calories are lowered, the business is diversified, and sugar becomes obsolete.

To conclude: after a year of underperformance, 20% upside might seem logical to some who read the Barron's piece. However, when you really look at the fundamentals, valuation, and the problems surrounding this company, its chances might be more likely to fall 20% in 2014.

Source: Is Barron's Right Or Wrong In Predicting 20% Upside In Coke?