The recent first quarter results from Coca-Cola (KO, Financial) showed a further decline in net revenue. It fell by 16% to $7.6 billion versus the same quarter from the previous year and was negatively affected by a 26% headwind from the refranchising of bottling territories. Organic revenue was up 5%, with price and mix contributing 1% and concentrate sales growth remaining robust at 4%.
The company’s operating margin expanded by 220 basis points as the impact of refranchising efforts continued to be felt. Total unit case volume grew by 3%, with growth being generated across all category clusters and geographic operating groups.
The company gained value share on a global basis and saw improved trends across the wider beverage industry. Earnings from continuing operations grew by 13% to 31 cents per share, while free cash flow was 5% higher at $339 million due to reduced capex requirements.
Changing outlook
Since the release of its first quarter results, the company’s stock price is little changed. It is a similar story over the last five years, with the stock rising by 5% at the same time the S&P 500 rose by 12 times that amount.
Clearly, investor sentiment has failed to improve during recent years. The company’s stock price could be catalyzed in future by the changes it is making to its business structure, however. Specifically, it is engaged in the process of refranchising its operations in the U.S. and across the globe. Although this has caused revenue to fall in recent quarters, it is having a positive impact on the company’s operating margin. As mentioned, it increased by 220 basis points in the first quarter following a rise of 319 basis points in the fourth quarter of the previous fiscal year.
Refranchising involves the company selling off its bottling businesses. This means capex requirements will fall over the medium term, since Coca-Cola will become an entity that focuses on marketing and innovation, rather than being a manufacturer or producer with significant annual capex requirements. This capital-light business model should lead to improved margins and stronger cash flow. In turn, this could create opportunities for investment in its brands, as well as in acquisitions in future years.
Changing consumer tastes
Consumer tastes continue to change. U.S. soda sales have fallen for 12 years in a row, while in Europe that have fallen to just over 30,000 liters sold in 2018 from around 40,000 liters sold per year in 2006. This forms part of a trend of consumers becoming increasingly health conscious across the globe, with sugary drinks and beverages that include artificial ingredients seeing demand come under pressure. For example, Diet Coke recorded a 5% volume decline in the U.S. in the last fiscal year. And with the company having a 50% or higher market share of the global sparking soft drinks industry, this could lead to volume pressure over the medium term.
In response, the company is seeking to diversify its product range. In the last fiscal year it introduced over 500 new products that were either new brands or improvements to existing franchises. For example, Coke Zero Sugar is expanding into 20 new markets in 2018, while the introduction of Coca-Cola Plus in Japan highlights the increased innovation within the company’s product portfolio. It contains a type of starch that minimizes fat absorption. As a result, it could prove to be popular among increasingly health-conscious consumers.
Acquisition is another means by which the company is seeking to address changing consumer tastes. For example, it acquired the U.S. rights to Topo Chico sparking mineral water in 2017. It grew its U.S. retail value by over 30% in the first quarter of the year, and increased its exposure to a segment which has seen a near doubling of volume in the last eight years.
A "lift and shift" strategy is also becoming central to Coca-Cola’s growth potential. This is where the company seeks to quickly transplant successful brands into new territories. For instance, Honest Tea and SmartWater experienced strong growth in the last fiscal year in the U.S. and are subsequently being rolled out in other territories. This forms part of a less risk-averse investment strategy that has included forays into alcoholic beverages in Spain and in Japan. This could help the brand to further reposition itself towards growth areas over the medium term.
Verdict
Although Coca-Cola faces a significant and immediate threat from changing consumer tastes, it seems to be putting in place a sound strategy to overcome it. Crucially, its refranchising efforts are creating a more nimble and flexible operation which has improving cash flow that can be used to invest in acquisitions and new brands. This could help to increase the speed of its shift towards faster-growing parts of the beverage industry.
Clearly, the company’s stock price has underperformed the index in recent years. But with a refreshed business model and a strategy that focuses on diversification and increased flexibility, it could offer a value investing opportunity.
