The Secret to Coca-Cola's Success

By Chad Henage - October 29, 2012 | Tickers: KO, DPS, MNST, PEP | 0 Comments

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With a large company like Coca-Cola (NYSE: KO), most people assume the secret behind the company's continued success is the ongoing push of its most famous brands throughout the world. With brands like Coca-Cola, Diet Coke, and Sprite continually placing in the top 5 most consumed soft drinks, this theory makes sense. However, the real secret to Coca-Cola's success has been its ability to perceive changes in consumer tastes, and then adjust its product portfolio to meet those needs. The company has a chance to once again build upon this successful formula, but it needs a partner.

Don't get me wrong, Coca-Cola is a great company. However, if the company wants to find the next leg of its growth, it needs to do something transformative. I've made the argument before that sparkling beverages (sodas) are no longer the growth driver for the company. Their most recent earnings report makes that abundantly clear. Over the last few earnings reports, the real growth is coming from the company's still beverage division. I fully expect that to continue, and this is the reason Coca-Cola needs to make something happen. In my opinion, this very good company could be great again, but not with its current lineup of offerings. Looking at their earnings report, you can see that Coca-Cola is just sort of plodding along.

With the stock selling for nearly 19 times projected earnings, I'm not impressed by a comparable EPS decline of 2%. Without currency impact, the company's revenue would have been up 6%. This shows that there are some cost issues facing Coca-Cola. While the company saw respectable volume growth overall, real EPS growth will need to be fueled by a few categories that are not soda related. Global volume growth overall was up 4%, but the company's iconic sparkling beverages like Coca-Cola, Diet Coke, Sprite, and others, underperformed by growing volume by 3%. The company's sparkling beverages followed a trend of slow growth in established countries, and faster growth elsewhere. If you want proof that this trend isn't Coca-Cola specific, look at how PepsiCo (NYSE: PEP) and Coca-Cola performed in different geographies:

Since each company is seeing small growth in established countries, and good growth in the rest of the world, why are both seeing such small EPS growth? With PepsiCo reported EPS down 3.2% and Coca-Cola EPS down 2% the problem is cost. So what do you do if you're having a problem with costs rising faster than sales? The only realistic answer is, to find a way to increase your sales at a faster pace.

There are three particular categories that are growing faster than the overall beverage industry. If you look at Coca-Cola's results, it's clear that the industry is undergoing a dramatic change. The company reported volume growth in still beverages of 8%, with tea volume up 13%, packaged water volume up 10%, and energy drinks volume increasing 19%. When you look at the competitive landscape in each of these areas, Coca-Cola appears properly positioned in all but one.

In the tea industry, Coca-Cola's primary offering is Honest Tea. This offering competes with such popular names as Lipton, Brisk, Snapple, and Piece Tea. Since each of Coca-Cola's major competitors owns at least one of these brands, you can see that the company's 14% volume growth is fairly impressive. When it comes to prepackaged water, the two biggest players in this arena are Coca-Cola and PepsiCo. with their Dasani and Aquafina brands. This is a competitive challenge for both Dr Pepper Snapple (NYSE: DPS) and Monster Beverage ) as neither company has an established prepackaged water offering of any note. However, the energy drink arena is a far different story with some of the largest players operating as private companies.

Though some people have voiced their concerns about the ingredients in energy drinks, I've tackled this in a prior post. What I found was caffeine levels are less than, or similar to, a cup of coffee or a bar of dark chocolate. Given the huge growth in energy drinks, there's no question that Coca-Cola needs to lead the way in this growth industry. In the last quarter, Monster saw an almost 30% increase in volume versus the just 4% overall increase in volume at Coca-Cola. Clearly the two companies are different sizes, but the point is Coca-Cola could use a larger market share in energy drinks. In fact, if you look at Coca-Cola's competitive position, their Full Throttle drink has actually been losing market share to even PepsiCo's AMP drink over the last few years. Dr. Pepper Snapple offers Venom, but this drink doesn't even register in the top six or eight brands in the last two years.

On the complete opposite end of the spectrum, Monster has consistently held the number two position behind Red Bull. A name that consistently comes up in the top three energy drinks is the privately held Rockstar brand. If Coca-Cola isn't interested in paying up for Monster Beverage, the company should consider a play for either Rockstar or Red Bull. Rockstar though a steady third place finisher, had sales of about $680 million at the same time that Red Bull had already sold over $2.7 billion this year. For a company the size of Coca-Cola with sales of over $12 billion a quarter, either brand would help, but Red Bull of course would make the bigger impact.

With still beverage volume growth outpacing sparkling beverages in four of Coca-Cola's five geographic regions, you can see that a purchase in the energy drink segment would make the biggest impact. Since Monster has a consistently high growth rate, we can assume that Red Bull and Rockstar are seeing similar trends. In the past, I've figured out that a purchase of Monster Beverage could add 3% to Coca-Cola's revenue growth. If the company were able to push this revenue growth down to bottom line earnings, Coca-Cola's earnings growth would jump to over 10%. Look at how this would change the relative value of Coca-Cola versus its competition:

Without this type of acquisition, Coca-Cola's PEG on Total Return would be 1.86 (P/E 18.87 vs 2.7% yield and 7.43% growth). While that's not bad for arguably the world's most respected beverage producer, a faster growth rate would make the stock the class of the industry by a mile. I've said it before, I'll say it again, without an acquisition Coca-Cola is just sort of plodding along. If the company makes a buy in the energy drink space this would either give the company “wings” or make it more of a Rockstar than it already is.

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