Coca-Cola - Operational Headwinds Continue, Investors Are Pushing Up Shares In Search For Yield

Jul.22.14 | About: The Coca-Cola (KO)

Summary

Coca Cola reported an unexpected decline in topline sales.

Currency headwinds and divestitures hurt revenues more than projected.

I remain cautious amidst a premium valuation, lack of growth, worries about the soft drink markets and the dilutive effect of the sizable share-based compensation program.

Investors in Coca-Cola (NYSE:KO) are disappointed by an unexpected decline in second quarter revenues. Continued softness in the developed markets' soft drink markets, currency headwinds and sales of bottling operations could not be offset by volume and pricing growth.

I remain cautious on valuation concerns despite the appealing dividend yield in this low interest rate environment.

Highlights For The Quarter

Coca-Cola posted second quarter sales of $12.57 billion which is down a percent compared to last year. Analysts were anticipating Coca-Cola to post a modest gain in sales to $12.85 billion.

Reported GAAP earnings were down by 3% to $2.60 billion. As a result of modest share repurchases, the fall in earnings was limited to a penny to $0.58 per share.

Non-GAAP earnings of $0.64 per share beat consensus estimates by a penny.

Looking Into The Latest Trends

The company stresses that worldwide volumes were up by 3% on the year, while North American volume in total was flat. Despite the reported volume growth net sales were down, driven again by adverse currency headwinds which have hampered the company for years now, while the sale of bottling operations hurt as well. Adjusting for all of these headwinds, revenue growth would have come in at 3%.

Coca-Cola continues to rely on its North American business in its overall results with North American revenues coming in unchanged at $5.72 billion. Despite flattish sales, operating earnings did see a 13% improvement to $827 million.

The real growth driver this quarter were the European operations which posted a 7% jump in sales towards $1.57 billion. Operating earnings rose by a similar percentage to $892 million, for incredible operating margins of 56.8%. As a matter of fact, despite Europe posting just 27% of sales versus the North American operations, actual earnings in dollar terms are higher in Europe! Note that results were aided by currency movements as volumes were down by 2%.

Asia-Pacific sales were largely unchanged at $1.72 billion while operating earnings were flat as well at $846 million. Strong 8% unit case volume growth was offset by currency movements.

Sales declines were reported in Eurasia and Africa despite a healthy 4% unit case growth with sales being down 4% to $732 million. Latin American sales fell by 8% to $1.12 billion, also being hampered by adverse currency movements. Bottling investments sales were down by 8% to $2.06 billion, yet operating earnings were just $38 million for the quarter.

Despite the fall in sales, Coca-Cola managed to boost gross margins by 80 basis points to 61.7% of sales. This was of course driven by the sale of bottling operations. Selling, general and administrative expenses rose by 50 basis points to 34.9% of sales, offsetting most of the gross margin expansion. Higher ¨other¨ charges resulted eventually in the fall in earnings.

Valuation

Coca-Cola ended the quarter with $21.6 billion in cash, equivalents and marketable securities. This is as total debt has risen to $40.2 billion, resulting in a net debt position of little over $18 billion.

On a trailing basis, Coca-Cola has now posted sales of $46.2 billion on which it earned about $8.4 billion.

Trading at $42 per share, equity in Coca-Cola is being valued at roughly $185 billion. This values equity in the company at roughly 4 times annual sales and roughly 22 times annual earnings.

Looking At The Past, To Catch A Glimpse Of The Future

Over the past decade, Coca-Cola has roughly doubled its revenues from nearly $22 billion in 2004 to $46 billion at the moment. Earnings growth trailed topline sales growth but rose by nearly 80% to $8.6 billion. Note that earnings have been stagnant in absolute terms in recent years.

To boost earnings per share a little more, Coca-Cola has retired nearly 10% of its shares outstanding over the past decade. Important to realize, Coca-Cola held a roughly flat net cash position almost ten years ago. This has steadily risen to current levels of $18 billion.

Final Takeaway

I had to dig up Coca-Cola's Vision 2020 presentation, which is still CEO Muhtar Kent's priority. Key parts of this vision calls for annual case volume growth of 3-4% while operating income is targeted to increase by 6-8% per annum going forwards.

Of course this vision was laid out before continued softness in the soft drink markets as well as severe currency headwinds have pressured topline growth and earnings. Despite the softness and stagnating sales, shares continue to trade near all time highs. Part of this reason is of course the general rise in equity markets, as well as low interest rates, which makes Coca-Cola interesting. The interesting 2.9% dividend yield and global diversified and well-recognized brand are appealing to many investors.

All the company can do for now is to continue to relentlessly focus on goals and case growth. While the company generated the majority of revenues in North America, its foreign operations are much more profitable, making up roughly 75% in operating earnings.

Important to realize is that the company sees future currency headwinds becoming less of an issue. This is as the company will continue to focus on the return of sustainable growth levels which could be expected by investors under the Vision of 2020.

A key discussion so far this year among Coca-Cola's shareholders has been the controversy surrounding the equity plan for management. The plan which Coca-Cola's largest shareholder Warren Buffett called ¨excessive¨ could be diluting to investors going forwards, reserving a total of 500 million shares for future compensation.

I am not impressed with the reported growth. While overseas markets can continue to drive growth, global obesity remains on the rise and developing markets could rather quickly opt for healthier choices in my eyes in the coming decades.

While the dividend is very compelling in this lower interest rate environment, the steep valuation at 22 times earnings, deteriorating balance sheet and worries about dilution for management compensation is a bit worrying in my eyes. I remain cautious and stay on the sidelines.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.