Coke Struggles to Find the Next Real Thing

By Peter Pham - August 28, 2012 | Tickers: KO, PEP | 0 Comments

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Coca-Cola (NYSE: KO) continued its trend of solid sales growth in the second quarter of 2012. Their global reach and introduction of drinks in different sizes and prices helped the beverage maker to post solid results despite economic uncertainty over Europe and a slowdown in Asia.

For the second quarter, the soft drink maker reported a profit of $2.79 billion, or $1.21 a share, down from $2.8 billion, or $1.20 a share, a year earlier. Revenue increased by 2.7% to $13.09 billion. While the gross margin saw a little decline to 60.1% from 60.8% and input costs increased by 4.7%. 

The fall in commodity prices, especially sugar, aluminum and plastic, will not be enough to offset the changing behavior of the U.S. consumer where discretionary out-of-the-home spending is seen by management as continuing to contract in the 3^rd and 4^th quarters.  This will shift sales to larger containers than single serving sizes.  Margins on 2-liter bottles are far lower than on 12 oz. cans or 20 oz. bottles. 

But U.S. sales from convenience stores for certain brands improved according to Pepsico’s (NYSE: PEP) earnings call.  Coke certainly is seeing the same things.  With gas prices back on the rise thanks to rising Brent crude prices, that effect is likely over and the shift back to home consumption and lower margin drink volumes continuing.

Regional Differences Continues

But, Coke isn’t just the U.S. and Europe.  Sales were up in each of its operating regions except for Europe where sales were down 4%.  As things continue deteriorating in Europe this trend will continue for the foreseeable future.  There is no easy fix to the problems of the Euro-Zone. Global sales were up by 4%. Regional growth was led by Eurasia and Africa, up by 12%, while the Pacific region was up by 8%. In North America, sales were essentially flat, up just 1%  due to increase in volume for drinks like Powerade, which helped to compensate for a 2% decline in soda sales due to higher prices.  

Despite the slowing Chinese economy, sales there were up 7%, helped by the introduction of a 300-milliliter bottle, where margins are the highest.  Coke is still on track to invest another $4 billion into China in the next few years as well as adding another $3 billion in investment into India.   This is where growth will happen and this is where Coke has to go considering the shift in behavior in their developed markets in the U.S. and Europe. 

Of Sagging Economies and Expanding Waists

But the bigger concern for the entire industry is the growing awareness of the danger of a diet rich in fructose and other liver metabolites, like aspartame.   It is their search for artificial sweeteners that are both low calorie and carry a low load on the liver which is the fulcrum to insulin resistance and type II diabetes. From that perspective Diet Coke is actually worse for you than regular Coke.  This will have a big effect on Coke’s product mix.  This search for the sweetener mix that is less-unhealthy than sugar or high-fructose corn syrup is vitally important to Coke’s long term outlook. 

Hence, consumers will be at war with themselves over serving size and their drinking habits.

If all of this presents a muddied picture for Coke and the industry in general it is because it is.  Trapped between macro-economic trends, changing consumer tastes and behavior due to dietary considerations, traditional soda sales are under a lot of pressure.  For Coke their varied product mix and production efficiencies ensure a future that will generate consistent, if unspectacular profit growth in the medium term while providing good cash flow and a solid yield with low risk. 

Coke has have been rewarding shareholders with a mix of stock buybacks and dividends and an announced split.  For while we are not leaving this low growth period any time soon, it is times like these where value stocks have a chance to shine, using their cash to provide investors with some yield in a near zero yield environment.  At a multiple of 21 carrying a 2.7% yield, in this environment Coke is expensive and the split nothing more than a move to increase liquidity to support the share price. 

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