Coca-Cola's (NYSE:KO) second quarter didn't have any real surprises. Sales declined 5% (missing by $100 million) on weak demand in emerging markets, and EPS came in at $0.60, beating estimates by $0.02. Currency and divestitures weighed on reported sales and masked decent organic growth in KO's core markets. Management lowered its revenue growth outlook for the year but maintained profit guidance, which helped prevent a larger slide in the stock's valuation. Shares fell 4.6% after earnings and now trade closer to fair value, in our opinion. Challenging economic conditions in developing markets should persist, and the improved profitability in Q2 was not very impressive, for reasons we will discuss.
With soft drink consumption in secular decline in developed markets, KO relies on emerging markets for volume growth. The slowdown in countries such as China, Argentina, Venezuela, and Brazil is therefore troubling, but not surprising. Each of these economies has either slowed down or contracted during the past several quarters, and the writing has been on the wall for a while. Consumer spending in China continues to slow as a result of the country rebalancing its growth model away from investment and manufacturing. Wholesalers slashed inventories in Q2, which drove down volumes in KO's bottling segment. KO is banking on China for long-term growth, and while we do expect rising consumption to boost demand over time, volumes will remain sluggish over the next few quarters. Argentina is still mired in stagflation - the dreaded combination of economic contraction and high inflation that wrecks havoc on the spending power of consumers. In Venezuela, KO had to suspend production at its bottling plants due to raw material shortages. The Venezuelan economy is a mess and investors shouldn't expect things to change here anytime soon. The economy is going through a protracted period of hyperinflation, which has made it difficult for Venezuela to import the materials needed for production (because the currency is worthless to exporters). Thanks to price increases, KO generated organic growth of 4% in its core markets, with solid performance in the US, Japan and Mexico. But weakness in emerging markets will continue to drag down results. Management lowered its full-year organic growth forecast from 4-5% to 3%, which is more in line with our expectations.
Operating margin improved 180 basis points in Q2 and KO maintained its full-year profit outlook, but investors shouldn't get too excited. The improvement in profitability had more to do with factors beyond KO's control than anything related to productivity initiatives. First, currency has less of a negative impact than last year. In Q2'15, FX reduced sales by 7%, compared to just 3% in the latest quarter. Second, KO benefited from favorable geographic mix. The slowdown in emerging markets meant that a larger portion of sales occurred in developed markets, where KO charges higher prices and earns higher margins. Third, commodity prices were lower than last year. These factors drove a 100 basis point improvement in gross margin, and accounted for most of the improvement in operating profitability. SG&A, as a percentage of sales, did fall from 34.6% last year to 33.9% this year, but this reflected the impact of acquisitions and divestitures. Finally, other expenses, which typically comprise non-recurring items, decreased on a percentage of sales basis from 5.5% last year to 2.6%. After adjusting for these items, operating income actually declined (1.5%) year over year. We are optimistic that KO can unlock value over time through higher margin refranchising, but after the latest quarter we aren't convinced that KO's productivity initiatives are making a real difference.
KO once again reported respectable results in developed markets, but the broad-based weakness in emerging economies is a problem. Profit margins expanded year over year, but it had little to do with anything KO is doing. We remain optimistic on the long-term outlook for KO in emerging markets, particularly in the Asia-Pacific region, and think that refranchising will create value for shareholders. But the company will struggle for growth in the short term and investors should be cautious.
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.