Still Beverages and a Sparkling Future

We believe

Coke’s noncarbonated beverage portfolio also provides a key growth avenue. Volume from these products has climbed to about 26% of the company’s total from 20% in 2007, and we expect continued positive gains as consumers shift their preferences toward juices and other still beverages. Although

In the near term, Coke plans to shed its North American distribution assets. The firm had purchased these businesses in 2010 as part of an acquisition of its U.S. bottlers, in an effort to streamline operations and develop nimbler product differentiation strategies. While we believe the company has enjoyed synergies from this purchase, we anticipate improved profitability and returns on invested capital after the divestitures given the low-margin, asset-intensive nature of bottling operations. That said, we believe Coke’s ability to market new products, increase prices, and support its overall brands will ultimately drive returns on invested capital in the high teens over the next several years.

Fourth-Quarter Results Highlight Growth in Emerging Markets and Still Beverages Coke reported a solid fourth quarter, and we increased our fair value estimate to $43 per share from $42. Carbonated volume gains from a year ago in emerging and developing markets (including 3% in Eurasia and Africa, 1% in Latin America, and 3% in Asia Pacific) highlight the growth potential of these regions. We continue to believe the firm can drive sales growth here back to mid- to high-single-digit levels over the long run as consumers increase their beverage consumption levels (which largely remain well below those of developed countries) and Coke realizes increased revenue per liter; success in Brazil and other southern Latin America countries with price increases this quarter (total segment price/mix was up 10% year over year) is especially indicative of this potential. The foreign exchange environment looks to harm Coke's financials more than we previously forecast, but slightly altered cost-of-capital assumptions more than offset this impact. Our fair value estimate implies a 21.5 times price/earnings ratio (based on our updated estimated 2015 earnings per share) and a 17 times enterprise value/EBITDA.

We continue to expect the firm to face developed-market carbonated beverage volume challenges in the near term, and although we expect positive pricing and still-beverage growth in 2015, the strong U.S. dollar will probably drive flat total performance. Longer-term, we still expect top-line gains of about 5%, ahead of competitor PepsiCo, driven by Coke’s dominant presence in developing markets, its ability to drive positive pricing, and further gains in noncarbonated drinks; we view volume and price contribution as relatively equal contributors to this growth. The company's North American sales were also a positive, with volume increasing 1% and price/mix climbing 4%--the best performance for both metrics in several quarters. Here, still beverages drove gains, and the firm noted that it gained value share in these products. That said, we remain encouraged by Coke's and competitors' pricing rationality on carbonated drinks as well and expect low-single-digit price/mix gains can continue for the segment.

Overall, revenue grew 4% in the quarter (excluding negative currency impacts), and currency-neutral adjusted profitability expanded from a year ago, despite weaker performance in Europe and Latin America (due partly to marketing investments, as well as structural challenges in Venezuela). The company held its 2015 outlook for earnings to grow at a midsingle-digit rate, excluding currency headwinds, which is in line with our current projection. Including negative currency swings, sales fell nearly 2%, and operating margins were roughly flat year over year during the quarter. Similarly, the company's 2015 currency outlook slightly worsened, to a 5-percentage-point headwind to sales growth (versus 3 previously) and a 7- to 8-point hit to profit before taxes (5-6 previously). We also note that productivity expenses will probably continue to increase, following a 102% jump in the fourth quarter and a 29% increase for the full year; management's earnings growth projection excludes this line item.

Nonetheless, while we will adjust our near-term expectations to account for the weaker foreign exchange situation, we believe the productivity enhancements put in place over the next several quarters should position Coca-Cola for higher margins and top-line growth. We're also encouraged by the firm's increased focus on marketing spending (the expense rose by high single digits in the quarter, accelerating from prior periods), and we remain comfortable with our long-term 7%-8% annual earnings growth forecast.

Free cash flow increased 2.5% to $8.2 billion for the full year, to about 115% of net income compared with 93% in 2013. Although net share repurchases dropped to $2.6 billion from $3.5 billion in the year prior, dividends climbed about 7%; importantly, Coke's cash flow covered these payouts by about $300 million. Offsetting the near-term pressures on Coke's revenue, we now believe operating margins can climb north of 24% over the next five years from about 21% in 2014 given positive mix shift from shedding lower-margin distribution assets assets. We also note that management recently targets $3 billion in productivity-related savings on an annual run rate by 2019. While some of these savings will be reinvested into the business, we nonetheless expect higher margins to result.

Brand Image and Emerging-Market Dominance Drive Wide Moat In our view, Coca-Cola has carved a wide economic moat, stemming from the company's iconic brand image, its strong distribution network, and economies of scale as the world's leading beverage manufacturer. Carbonated soft drink makers will probably continue to face secular volume headwinds in developed markets given rising health concerns and a growing preference for still beverages such as juice, coffee, and tea, but we expect Coke and its primary competitor, PepsiCo, to remain relatively disciplined on price actions. We believe barriers to entry stemming from the company's sizable bottling and distribution network, its premier relationships with major retailers, and strong brand awareness will continue to support low-single-digit price increases and bar major share gains from private-label competitors. In addition, Coca-Cola's noncarbonated portfolio should enable the company to drive volume gains in a growing end market; over the past three years, we calculate that these still beverages have seen volume grow at an average 6% clip, versus just 2% for sparkling drinks.

Coke also enjoys a dominant position in many emerging markets, and its direct-to-store distribution model places it at a competitive advantage to other vendors who rely on third-party distributors. Given its market position, the company is typically able to price higher, on average, than Pepsi in these regions, and we believe this is likely sustainable. The firm’s at-home partnership with Keurig Green Mountain could also build upon Coke’s brand image and drive similarly premium pricing (though probably won’t be a material cash flow driver in the near term). In all, returns on invested capital have averaged an impressive 19% over the past five years, and we expect continued economic profit generation going forward.

Management Focuses on Long-Term Goals We believe Coca-Cola's management is strong, and we assign the firm an Exemplary stewardship rating. CEO Muhtar Kent has led the company since 2009, and we appreciate his focus on the long-term goals set up in Coke's 2020 Vision. We're also encouraged that the firm has remained a shrewd repurchaser of its own shares, and that Coke surpassed its original planned synergies outlined as part of the CCE North American bottler acquisition in 2010.

In early 2014, Coca-Cola faced investor criticism surrounding the potential dilutive effects of its management incentive plan, but we believe these claims largely ignored offsetting factors such as proceeds garnered from options transactions, performance standards that still need to be met, and the company's sizable repurchase program. Nonetheless, the company has since updated its plan, reducing the number of executives who are eligible to receive performance shares, subsequently extending the number of years under which the allocated shares will be granted, and therefore lowering the annual dilution amount.

Although the original program was approved by the majority of voting stockholders, several notable owners (including Warren Buffett's Berkshire Hathaway) abstained from voting, suggesting doubt about the true approval rate. Now, with Coke's plans to increase its transparency on these matters going forward, to continue offsetting share repurchases at attractive market prices, and to offer more detailed performance goals for eligible employees, we remain comfortable with our stewardship rating.