A Little Bubbly For Coke's Second Quarter

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 |  About: The Coca-Cola Company (KO), Includes: PEP
by: David Silver

Before the opening bell on July 17, the Coca-Cola company (KO) released operational results for its second quarter of fiscal year 2012. The results came in better than the Street was expecting on both the top and bottoms lines, as volumes were higher. KO reported that revenue increased 2.8% to $13.08 billion, up from $12.73 billion in the second quarter of 2011. Earnings were essentially flat year over, however, as a result of fewer outstanding shares and the items affecting comparability (one-time items), earnings per share improved to $1.22 per share from $1.17 per share year over year. The Street had expected revenue of $12.89 billion and earnings of $1.19 per share, while I modeled for revenue of $13.2 billion and earnings of $1.21 per share.

Total volumes for the quarter were strong, gaining 4% worldwide, led by 12% growth in Eurasia and Africa and 8% growth in the Pacific segment, which was slightly offset by the 4% decline in Europe. North America lodged at least its sixth straight quarter of growing volumes, delivering growth of 1% compared to the second quarter of 2011. It was a difficult comparison as the quarter was cycling 4% growth in the previous year. Growth was well balanced across the world with growth in key developed markets such as Japan (+4%), Germany (+1%), and North America (+1%), while Brazil (+6%), Russia (+9%), India (+20%) and China (+7%) continued their strong momentum. The following table outlines volume growth by segment over the past five quarters.

2Q12

1Q12

4Q11

3Q11

2Q11

Eurasia and Africa

12.0%

9.0%

4.0%

6.0%

7.0%

Europe

(4.0%)

1.0%

1.0%

0.0%

5.0%

Latin America

3.0%

5.0%

4.0%

7.0%

6.0%

North America

1.0%

2.0%

1.0%

5.0%

4.0%

Pacific

8.0%

8.0%

5.0%

5.0%

7.0%

Bottling Investment

12.0%

11.0%

3.0%

0.0%

0.0%

Total Company

4.0%

5.0%

3.0%

5.0%

6.0%

Click to enlarge

In my earnings preview (click here), I said that I expected volume growth to slow from the previous quarter. I expected a further slowdown in volumes, most notably in the Eurasia and Africa segment. Europe, North America, and the Pacific segments were inline with my forecasts, while Latin America was just under what I was expecting for the quarter

Chairman and CEO, Muhtar Kent, said, "We are pleased with our second quarter and year-to-date results. We are delivering consistent quality performance in line with our 2020 Vision growth targets, despite a very challenging and increasingly unpredictable global economy. Notably, we continue to gain global volume and value share by giving our consumers what they are looking for - meaningful brand connections, wide-ranging product and package choices, greater information about our brands, and significant investments in programs that support healthy and active lifestyles, all at the heart of our brand values."

Despite the increase in volumes and revenues, KO saw its gross and operating margins decline year over year, primarily as a result of higher cost of goods sold. Gross margin declined to 60.3% from 61.0% year over year and from 60.7% sequentially, while operating margin declined to 26.1% from 26.4% year over year, but it increased from 23.0% sequentially. KO should see a slight benefit from lower oil costs during the third quarter (lower transportation costs), and commodity prices have been relatively stable over the past few months. If management is able to leverage income growth overseas with relatively flat operating margins in the U.S., earnings should continue to improve. The following table compares the company's operating margin by segment. The North America segment is by far the least profitable (save for Bottling); however, it still accounts for more than 44% of revenues.

Operating Margin

2Q12

2Q11

% Change

Eurasia and Africa

41.3%

42.0%

(7 bps)

Europe

60.2%

59.5%

7 bps

Latin America

59.9%

59.6%

3 bps

North America

14.4%

15.2%

(8 bps)

Pacific

48.0%

45.2%

28 bps

Bottling Investment

5.2%

5.2%

FLAT

Total

26.1%

26.4%

(3 bps)

Click to enlarge

Sparkling volumes (products include Coca-Cola Classic, Coca-Cola Zero, Sprite, and Fanta) improved 2% during the quarter and 3% year to date. Growth was worldwide including India (+35%), Russia (+23%), the Philippines (+7%), Brazil (+4%), Germany (+3%) and Mexico (+1%). Still beverages (products include packaged water, juices and juice drinks, ready-to-drink tea and coffee, sports drinks and energy drinks) volume grew 9% during the quarter and year to date. KO gained volume and market share across both sparkling and still beverages.

Valuations are getting a bit lofty when compared to the expected 2012 earnings, however, KO's attractiveness increases as you approach 2014 and into 2015 as the investments the company has made over the past five years will begin to see a higher return, namely in China and India. The company is trading with a forward PE ratio of 17.3, compared to PepsiCo (PEP), which is trading with a 15.7 forward PE. However, KO is a much more attractive investment than PEP at this level due primarily to the growth overseas as well as the sustained growth in North America. I would like to see profit margins in North America stay above 15%; since the first quarter of 2011, North America operating margins have averaged 13.2%.

The stock is acting well following a good earnings release and conference call. Additionally, the company approved a 2-for-1 stock split which will be finalized later this month and the new shares distributed in the beginning of August. KO is my favorite in the space and would take any pullback as a good entry opportunity.

Disclosure: I am long KO.