Can Coke Squeeze More Out of North America?
Firm's results beat expectations, but we think its North American pricing targets will prove to be too optimistic.
Coca-Cola (KO) narrowly beat our expectations for the second quarter, thanks to another very strong performance in international markets, but the results have no impact on our valuation. However, the slowdown in North America will raise some eyebrows, as consumers appear to be retrenching once again, and we think this will prevent Coke from achieving its ambitious pricing targets for the second half of the year.
Second-quarter revenue, adjusted for the asset swap with Coca-Cola Enterprises (CCE), the benefit of cross-licensed brand volume (primarily Dr Pepper (DPS) brands), and foreign exchange, grew more than 7% year over year, driven by a 6% increase in concentrate sales and a 1% impact from higher prices and product mix. This was a slight acceleration from the first quarter, with growth primarily driven, once again, by emerging markets. Volume grew 7% in the Pacific and the Eurasia and Africa segments and 6% in Latin America. In China, volume grew a staggering 21%, despite cycling double-digit growth in the second quarter last year. Coke's $2 billion investment in China is paying off, as expanded distribution and greater points of sale are driving this growth. However, the Pacific segment's growth rate may slow in the third and fourth quarters, as we think the replenishing of inventories in Japan may have temporarily boosted second-quarter volumes. We expect to see similar trends in Asia from PepsiCo PEP when it reports earnings Thursday. The mid- to high-single-digit growth rates in international markets continue to support our thesis that Coke is a solid emerging-markets play. Its heavy investment in infrastructure in Asia and Africa should allow the company to increase volume for several years to come, while Latin America should also be an important, if inconsistent, driver of volume and value growth.
As we said in our first-quarter earnings note, there are risks to the recovery in North America, and this played out in the second quarter. Internal volume was flat, but Coke did manage to raise prices 1%-2% during the quarter. Management reiterated its commitment to raising prices 3%-4% during the second half of the year, a target that we believe will prove to be too optimistic unless gas prices remain off their highs and the unemployment picture begins to improve. Elevated packaging costs and hedges already in place mean that Coke will probably face above-average input costs for the remainder of the year, but we doubt consumers will be willing to swallow the higher costs, given that the pressures on low-income consumers remain heavy. With Pepsi refocusing on the flagship Pepsi brand, we believe the competitive environment will prevent Coke from achieving its pricing targets and the firm will be forced into heavy promotional discounts that could wipe out the price increases.
The acquisition of the North American bottling operations drove a 700-basis-point decline in the second-quarter operating margin. Although Coke reiterated its target of $110 million-$140 million in operating cost synergies from the bottler acquisitions in 2011 (less than 1% of operating costs), its exposure to commodity costs is likely to be a headwind in the second half of the year. We may slightly increase our 2011 earnings per share estimate, currently $3.86, but in light of increased competition from Pepsi and a deteriorating North American market, we now expect even greater challenges in the second half of the year, and both our near-term assumptions and investment thesis remain intact. Coca-Cola is one of our favorite consumer packaged goods companies--vast and effective global distribution, scale, and pricing power give it a wide economic moat--but with increasing costs posing a risk to margins and rising gas prices and fragile housing markets a threat to consumer confidence in developed markets, we think the stock is fairly valued at around 17 times forward earnings and just under 12 times forward EV/EBITDA. PepsiCo, on the other hand, still appears to offer some upside. If the firm's refocused Pepsi strategy succeeds in taking share from Coke, this could provide a catalyst to Pepsi's stock in the second half of the year.
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Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.