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Coke's (KO) Brand Value And Category Leadership Merit A Premium Value; Has This Stretched Share Price Too Far?

|Includes: The Coca-Cola Company (KO)

Coca-Cola (NYSE:KO)

Executive Summary

Sales growth in 2Q14 was the lowest since the 2008/2009 downturn. Asia-Pacific was the only outperforming market in terms of organic revenue growth. Coke is experiencing problems throughout its value chain and remains a poor investment given that the company's brand image and category leadership have already stretched share price.

Business Profile

The Coca-Cola Company is the world's largest producer of soft drink concentrates

and syrups, as well as the world's biggest producer of juice and juice-related products. Finished soft drink products bearing the company's trademarks have been sold in the U.S. since 1886, and are now sold in more than 200 countries. It owns or licenses more than 500 brands

Weak 2Q results

  • Topline struggles persist - Despite easing comparisons, organic sales performance remains lackluster with KO's ~2.5% two-yr avg. sales growth in 2Q14 its worst result since the 2008/2009 downturn
  • Business segment details -
    • North America (44% of sales, 23% of operating profit) - NA segment had flat unit case volume in 2Q, below the +1.3% consensus
    • Asia Pacific (13% of sales, 23% of operating profit) - APAC segment grew volume by +8% in 2Q (consensus +7.4%), on 9% growth in China
    • Europe (12% of sales, 25% of operating profit) - Europe volume was flat in 2Q vs. +2.3% consensus as growth in Northern and Western Europe was offset by a 4% decline in Central and Southern Europe
    • Latin America (9% of sales, 17% of operating profit) - LatAM volume was flat, below consensus of +1.8%, as a 3% decline in Mexico and flat growth in Brazil were offset by growth in the rest of the region
    • Eurasia & Africa (6% of sales, 8% of operating profit) - Eurasia & Africa volume growth of +5% was below consensus at +5.9%, as decline in Russia was more than offset by growth in the Middle East, South Africa, East Africa and Pakistan
    • Bottling (16% of sales, 3% of operating profit) - Big volume growth of +8% was led by China and India, and was well above consensus of +5.0%
  • Asia-Pacific the sole outperformer on organic revenue growth -
    • China - Coke's 2nd largest international market by volume behind Mexico, saw strong 9% volume growth with overall APAC organic revenue growth of 5%
    • LatAm organic sales growth was lower than expected (+7% vs +12%) due mainly to flat volumes in Brazil, where macroeconomic weakness and competitive activity more than offset the increased marketing around the World Cup
    • Europe (+1% vs +6%) and Eurasia/Africa (+5% vs +7%) were also below consensus estimates
  • Muted margin expansion:
    • KO has one of the least earnings contribution from cost savings among mega-cap peers, at ~1-2% of FY14 EBIT (not including the marketing reallocation) vs. a ~12% average at peers
    • Majority of the $1bn announced program is slated to be reinvested behind the business, which is concerning given the expectations for only a muted topline payback from higher marketing spend

Business challenges

  • Euromonitor data shows CSDs (carbonated soft drinks) are slowing more than other CPG categories, and hence the slowdown is due more to secular health/wellness concerns and a fragmentation of consumer demand, than temporary concerns such as macros
  • Analysts believe KO topline struggles will persist due to a CSD category slowdown, given CSDs are ~70% of revenue mix over the long-term
  • Increased government regulation of sugar-sweetened beverages is a significant risk for Coke's business, whether they take the form of taxes on a per-volume basis (as in Mexico), maximum limits or restrictions on marketing
  • Consumer preferences is shifting away from Coke's primary CSD category, and that trend may continue or accelerate going forward
  • Local competition, especially in China, could restrict Coke's ability to increase margins over time
  • Soda Taxes - Public health officials, legislators, and consumers are becoming increasingly concerned with rising obesity and health issues, and their relationship to the consumption of sugar-sweetened beverages. Coupled with government budget deficits, there is a potential for new taxes on sodas, as well as more onerous regulations regarding the marketing, labeling, and potential availability of such beverages

Investment Rationale

KO current valuation does not look compelling in light of a secular slowdown in CSD demand globally with increasing health/wellness concerns and consumer demand fragmentation. Coke's brand value and global category leadership merit a premium valuation, this is already stretched given its growth outlook.

Coke's stock (KO) ($41.2, 21- Aug with P/E ttm of 22.1) currently trades at 19x CY15 P/E, a 1% premium to mega-cap peers and hence its valuation does not looks attractive in the near term. It is currently trading near the higher end of its 52 week range ($36.8 to $42.6) and hence investors should wait for substantial correction (10-15%+ from current levels) to enter this stock.