On September 10 2020, CEO James Quincey and CFO John Murphy spoke on a webcast during a brokers’ conference. The biggest driver of volume is the degree of ‘lockdown’ being implemented to reduce the spread of COVID-19. April’s 25% volume decline was the worst stock performance the company has recorded because of the weakness in the away-from-home business. Volume was down in the teens in May and June. During the 2Q20 earnings call on July 21, the company said that volume was down in the mid-single digits in July. The company said during the recent webcast that August was also down in the mid-single digits. Mr. Quincey cautioned that there is no guarantee that it will be a straight-line recovery, and noted that getting through the winter in the Northern Hemisphere could be a test.
Mr. Quincey discussed the business reorganization that was announced on August 28. One of the company’s goals is to emerge from the pandemic and the current recession as a stronger company. Key questions are if the company has more consumers, more market share, better profitability, better engagement with stakeholders, and a more engaged organization.
The downturn seems to have accelerated some changes that were on the drawing board. With the business performing well before the outbreak, there wasn’t the same urgency that there is now. One of the major changes announced last month is that there will now be 9 operating units instead of 17. A major initiative will be to reduce the number of brands and streamline the marketing. Mr. Quincey said that the old system wasn’t streamlined enough and they were not disciplined enough in pruning product portfolio as well. He expects that the company will still experiment and innovate, but the focus will be on the biggest opportunities that are capable of creating enough scale to drive profitability and products that can change or disrupt existing markets. In the 2Q conference call, the company said that they had more than 200 single-country brands that collectively contributed about 2% of company revenue. Additional considerations are getting new consumers, increasing the frequency of consumption and being able to maintain pricing. He said that the company has a vision for the recently acquired coffee business but it needs to make it come true.
The August 28 announcement listed five categories as having the strongest consumer opportunities: Coca-Cola; Sparkling Flavors; Sports Drinks, Coffee and Tea; Nutrition, Juice and Plant Based; Emerging Categories. They split the sparkling flavors, like Fanta and Sprite away from Coca-Cola so division management can focus on them as important brands rather than having them play second fiddle to Coke.
The nine operating units are North America, Latin America, Europe, Africa, Eurasia, Middle East, India, China, and Asia.
CFO John Murphy said that the pressure on the revenue line stemming from COVID would not cause the company to alter its capital allocation priorities. Those are to reinvest in the business, continue to grow the dividend, make consumer-focused acquisition and repurchase shares. He said in the conference that dividend would continue to be a priority. M&A would be a lesser priority and share repurchases would probably not be on the table. Growing cash flow faster than earnings remains a major priority. He thought 2022 would be the year when the company would be back to normal growth.
EARNINGS & GROWTH ANALYSIS
The big challenge for the second half is that the company is still likely to receive pressure on sales through restaurants, sporting events, amusement parks, and schools. This is likely to weigh on gross margin.
We remain concerned about the long-term demand for sugary, and non-natural beverages in developed markets. The company is offering innovations including Coca-Cola with coffee, Coca-Cola with fiber, zero-sugar formulations, 90-calorie mini cans, and Freestyle machines that allow customers to add flavors, like vanilla or cherry, to flagship sodas like Coke and Sprite. Before the COVID-19 and currency pressure caused the company to say that it did not expect to meet its 2020 guidance, management’s expectations were for 8% growth in comparable currency operating income.
The company’s growth objective had been 7%-9%. Management was targeting 4%-6% organic revenue growth and 6%-8% operating income growth.
The company has also been aiming for high generation of free cash flow, at approximately 90%-95% of net income. Up from 73% in 2018, the company delivered 96% in 2019. The actual measure is free cash flow adjusted for pension contributions divided by adjusted net income.
The company wants to raise return on invested capital by improving organic revenue growth, raising operating margin, reducing the amount of capital required to run the business, and improving the productivity of accounts payable, receivable and inventory. Drivers of margin expansion are likely to be production efficiencies as sales grow in non-carbonated beverages, a more favorable geographic mix and productivity improvements in other product categories, partially accounted for by growth in categories that are less profitable than carbonated soft drinks.
FINANCIAL STRENGTH & DIVIDEND
The company’s long-term financial objectives are to reinvest in the business, continue to grow the dividend, consider strategic mergers and acquisitions, and use excess cash to repurchase shares.
The company’s debt is rated A1, following a November 2018 reduction from Aa3 by Moody’s.
The Standard and Poor’s rating is A+. The outlook is stable.
Debt at the end of 2Q was about $52 billion, up from $42.8 billion in the previous year.
Debt was 73% of capital, 67% at the end of 4Q19.
Interest coverage has been strong, with adjusted EBITDA standing at about 12-times the interest expense in 2019, about 10-times in 2018 and 2017, and 14-times in 2016.
The company’s target is for net debt to be 2 to 2.5-times the EBITDA. That is a wider range than the prior guidance of 2.3-times or better. 2.3-times is just below 2.5-times which was the figure in 2019. Before the company pulled its guidance, management was expecting leverage to remain in the target range in 2020. Net debt (total debt minus cash) was about $34, which was almost the same as it was at the end of 4Q because cash balances are higher even though debt is also higher. Our estimate for 2020 EBITDA is about $10.9 billion. That puts the ratio at about 3.2. This looks elevated relative to the company’s guidance range and high single-A ratings. If we use the current level of net debt and our estimate for 2021 EBITDA, the ratio would be about 2.8, which, based on that ratio alone, would probably equate with a low-A or a high BBB. The agencies might give KO some room because it has such strong margins. At this point, we don’t plan to take our financial strength rating lower as long as management maintains its debt target and shows progress towards getting there.
In 2018, KO spent $1.9 billion on stock buybacks. The company does not intend to repurchase any shares in 2020 because of disruptions from COVID-19. We don’t expect the company to repurchase shares until it reduces the debt ratio.
The company expects a dividend payout of 75% of EPS over time. With no obvious prospect for raising the payout rate, the dividend is likely to rise in line with EPS.
MANAGEMENT & RISKS
Based on recent comments from the company’s CEO and CFO, the company is seeing weakness in sales to restaurants, which will weigh on 2020 earnings. The company has also seen currency pressure.
James Quincey was previously the president of the Europe group from 2013 to 2015 after running operations in Northwest Europe and Mexico since 2005. He became chairman on April 24, 2019, replacing Muhtar Kent, who had been chairman since 2009 and had also served as CEO from 2009 until Mr. Quincey’s ascension in 2017. In October of 2018, the company announced that Brian Smith, the head of the Europe, Middle East and Africa group, would become president and COO, effective January 1, 2019. With Mr. Smith in place to oversee operations and relationships with bottlers, Mr. Quincey will focus his attention on the company’s strategic direction and presumably broadening the product line.
John Murphy, who started as an auditor in 1988 and worked his way up to president of the Asia Pacific group, became CFO on March 16, 2019.
Nancy Quan replaced Ed Hays as chief technical officer on January 1, 2019. On September 1, 2020, she bagged the title of chief innovation officer. Also on that date, Henrique Braun became the president of the new Latin American operating unit, Nikos Koumettis became president of the new Europe operating unit, and Alfredo Rivera became the president of the North America unit.
Interestingly, KO has an executive to oversee the alliance with McDonalds and its 35,000 restaurants in more than 100 countries.
As a major multinational corporation, Coca-Cola is exposed to substantial currency and commodity price risk. A bigger concern is that the company’s core products are perceived as being unhealthy. There are growing concerns about obesity and the harm caused by sugar-sweetened beverages that may hurt demand for many of the company’s core products. Harvard professor, Vasanti Malik who recently co-authored a paper on health issues related to sugary drinks told the NY Times that the ‘optimal intake of sugar-sweetened drinks is zero.’ The company is offering no sugar versions of some of its most popular brands and offering smaller serving sizes to reduce total sugar content. Unfortunately, the press on ‘diet’ beverages is not much better. Searching the New York Times archive on ‘Diet Soda’ delivers the headlines: ‘Death by Diet Soda,’ Diet Sodas Tied to Dementia and Stroke,’ and ‘For Weight Loss, Water Beats Diet Soda.’ To be sure, a professor of pediatrics, also writing in the Times, said that a recent study and some of the related news stories on diet soda lacked important context and caused more worry than was warranted. The company has recently launched Coke Energy and Coke Plus Coffee. The company is also currently putting more emphasis on Tea.
Philadelphia, for example, has a tax of 1.5 cents an ounce on sweetened beverages, which adds about $1 to the price of a 2-liter bottle of Coke. Media reports said that sales of sweetened drinks dropped by 55% in Philadelphia; they increased by 38% in areas just outside the city. The Federal court ruled against a San Francisco ordinance to put a warning label on sugary drinks. The company is also increasing its efforts to recycle the millions of plastic bottles and aluminum cans it produces.
Coke could be hurt significantly if its independent bottlers ran into credit or financial problems or if the company’s business interests did not align with the interests of bottling partners. Coke would also be hurt if it was unable to defend its intellectual property rights, particularly as it expands to more emerging markets.
KO’s operating groups are Europe, Middle East & Africa; Latin America; North America; Asia Pacific; Bottling Investments; and Corporate. The company sells beverage concentrates or syrups and finished beverages. 69% of the beverage volume sold and distributed is ‘Sparkling.’ Categorized by brand, 43% is under the Coca-Cola trademark. In 2019 the company created Global Ventures division which includes both the new Costa coffee business and Monster Beverage.
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