Coca-Cola: Stock Valuations Will Contract In The Near Term

| About: The Coca-Cola (KO)

Summary

Company needs to actively diversify and strengthen its product portfolio by focusing on non-carbonated soft drinks category.

Near-term performance will be challenged due to weakness in emerging markets and carbonated soft drinks category.

Stock is trading at a forward P/E of 21.5x, in comparison to its five-year forward P/E average of 23x.

The beverage industry is facing sales volume pressure due to decline in carbonated soft drinks sales. In the U.S., soda volumes were down by 0.9% and 1.2% in 2014 and 2015, respectively. As carbonated soft drinks sales volume remains weak, beverage companies, including Coca-Cola (NYSE:KO), are working to expand their international footprint, diversify product portfolio, cut costs and increase prices to support growth. KO has a strong product portfolio, and the company is working to expand its international presence to support growth; however, in the near-term, it is likely to face challenges in emerging markets, which will weigh on its sales volume growth. The company has the financial muscle and expertise to drive long-term growth, but it needs to increase its efforts on strengthening its product portfolio by focusing more on healthy beverages portfolio and addressing challenges in emerging markets. The short-term challenges faced by KO will weigh on its stock valuation; therefore, I recommend investors to wait for an improvement in absolute earnings performance of the company before initiating a buy position in the stock.

Financial Performance and Growth Catalysts

The company performance in the recent quarters has been negatively affected due to weak sales volume. The company reported EPS of $0.60 for 2Q16, ahead of consensus estimate of $0.58. Although earnings for the quarter came better expected, the quality of the earnings beat was poor, as favorable equity income drove it. Moreover, organic revenues for the company were up 3%, positively affected by 3% price increases in the quarter. As the company sales volumes remain weak, the company has been relying on price increases to support revenue growth; in the last three years, the company has increased prices by almost 3% annually. However, sales volumes for the quarter were flat, versus the consensus estimate of 1%-2% increase in sales volume.

The sales volume for the quarter were mainly affected by weakness in emerging markets, including China, Venezuela, and Argentina, due to which the company decreased its organic revenue growth target to 3% from 4%-5% for 2016. Weakness in the major emerging markets weighed on the top-line growth. However, the challenges in the emerging market are cyclical in nature rather than secular; therefore, I believe the company needs to focus more on addressing the challenges in the emerging markets. To improve its performance in emerging markets the company needs to concentrate more on small packing initiatives, which are consistent with consumer demand and offer better revenue and margin per ounce. Also, the company needs to increase its marketing and advertisement activities to support volumes. Moreover, in China, KO needs to make more efforts to introduce new premium offering across multiple product categories. The company has financial muscle and expertise to address the challenges in the international markets, which will fuel its long-term growth. However, the challenges in emerging markets will weigh on the company's performance in the second half of 2016.

Also, the company needs to work actively to diversify and strengthen its product portfolio consistent with consumer demand. The company's product portfolio is skewed towards carbonated soft drinks category, which accounts for 60% of KO's stock value. As the carbonated soft drink category remains challenged, the company needs to diversify its product offering by targeting healthier beverages, and take advantage of growing non-carbonated soft drinks sales. The following chart shows bottled water sales will surpass soft drinks sales for the first time in 2016. However, a shift towards non-carbonated soft drinks might affect the company's profit margins as carbonated soft drinks have relatively higher margins.

Click to enlarge

Source: Bloomberg.com

Moreover, the company is correctly working to improve its cost structure, which will not only bode well for its profit margins but also allow it to reinvest savings in business to support long-term growth. KO's cost cut initiatives are important to mitigate the challenges in the carbonated soft drinks category. The company expects to generate cost savings of $600 million in2016, by improving its supply chain productivity and simplifying its business operations.

Valuations

The stock has historically traded at a premium valuation to its peers, including PepsiCo (NYSE:PEP) and Dr Pepper Snapple (NYSE:DPS), mainly because of its strong product portfolio and higher profit margins. However, in the recent times, the valuation premium has narrowed as the company's product portfolio is skewed towards carbonated soft drinks category, which is experiencing weakness. I believe the continued weakness in the carbonated soft drinks category and the challenges in emerging market will weigh on the stock valuation in the near-term. The stock is trading at a forward P/E of 21.5x, in comparison to its five-year forward P/E average of 23x.

Click to enlarge

Source: marketrealistic.com

Summation

The company needs to diversify and strengthen its product portfolio by focusing on non-carbonated soft drinks category, to support its long-term growth. However, in the near-term, the company's performance will be challenged due to weakness in the emerging markets and carbonated soft drinks category. Because of the ongoing challenges, the company has lowered its organic sales growth target to 3% from 4%-5% from 2016. Also, the challenging conditions in the near-term will weigh on the stock valuation; therefore, I recommend investors to wait and see for an improvement in the absolute earnings power before initiating a buy position in the stock.

Disclosure: I/we 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.