Coca-Cola: Sugar Correction Ahead?

| About: The Coca-Cola (KO)

Summary

Research indicates that sugar and Coke have an intermarket relationship.

Commercial sugar producers (smart money) are net long for the first time in three years.

Non commercial producers (dumb money) have aggressively gone net short.

Ever since October 2016, the iPath Bloomberg Sugar Subindex (SGG) fell approximately 50% from its highs. During the same time, Coke's stock (KO) increased 12% to $45.32. A mean reversion move may be on its way for Coke as sugar prices appear to be bottoming out.

There is research indicating an intermarket relationship between sugar and Coke. The lower the sugar prices are, the better off it is for Coke. It takes about 70 days for these lower prices to flow into the margins of Coke. On the other end, if sugar prices are higher, the worse off it is for Coke's stock as it hits operating costs.

We can analyze the future price action of sugar by looking at the Commitment of Traders Report. Commercial hedgers (smart money) finally turned net long on 06.20 for the first time since the fall of 2014. Compared against the last nine years, the commercials positioned themselves in the most net long position with a total of 36,692 contracts. These producers correctly shorted 387,963 contracts in early October at the top.

The non-commercial money (dumb money) is short 28,943 contracts. Compared against the last nine years, these managed money investors are the most net short. The irony is that this group positioned themselves the most net long ever in October of last year at the peak. Sugar decreased nearly 50% and now they decided to aggressively sell towards the bottom end of the trading range. Non-commercials, at position extremes, are usually wrong and will most likely be wrong here.

Currently, the International Sugar Association forecasted a surplus of 3m tonnes of sugar, and this surplus can extend into next year. Due to the excess inventory, prices may plummet hard. If the prices fall sharply, supply and demand may come into equilibrium. When that occurs, prices should stabilize.

It appears that sugar prices will rise, which will negatively impact Coke's margins. Coke will also have to deal with structural changes in their business. Coke's financials for Q1 stated, "Net revenues declined 11% to 9.1 billion, impacted by a headwind from acquisitions, divestitures, and structural items of 10% related to the ongoing refranchising of bottling territories and a foreign currency exchange headwind of 1%." Their EPS (using GAAP) was at .27, which was a 19% decrease year over year.

Despite weak Q1 numbers, Q2 results may satisfy investors as the dollar weakened during this time. The dollar index peaked around 102 and is currently trading at 95.59­. Coke derives more than 50% of its revenues overseas, and a lower dollar helps multinational firms like Coke to export products. In addition to a weak dollar, lower sugar prices should benefit margins.

Q3 earnings and stock prices may take a hit due to higher sugar prices and a mean reversion move in the dollar index. Commercial hedgers track record at position extremes is stellar, and their bullish bet on sugar should be noted. The interrelationship between sugar and Coke should indicate that a correction is on the way for the stock.

Disclosure: I am/we are long SGG.

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.

Additional disclosure: I have sold a put option in sugar in the futures market.

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Tagged: , Beverages - Soft Drinks
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