Coke Downgrade Flattens Investor Spirits

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-Heavy discounting continues
-Weak consumer demand
-Earnings becoming more cyclical?
-Strong brand and capital
 

By Eva Brocklehurst

Coca-Cola Amatil ((CCL)) has flattened investor spirits, downgrading guidance for 2013 earnings to a decline of 5-7%. The Coca-Cola distributor, producer of other bottled drinks and canned fruit blamed weak Australian conditions. Despite a warm winter it seems customers were not inclined to reach for more drinks, or maybe it's a structural problem that's been a while in the making and will hang around for some time.

JP Morgan had assumed the company would benefit from the cycling of aggressive promotional pricing that occurred last year but that's not the case, apparently. Pricing in Australian beverages has been driven by aggressive competition in the grocery channel from both Pepsi and supermarket private labels. Volume growth in the non-grocery channel disproves the belief there's a structural shift away from carbonated soft drinks (CSD). The broker also scoffs at the idea that the company is suffering from growth in private label drinks. Private label growth has largely been in water and Coke's Mt Franklin brand has grown commensurately. The overall non-CSD products from Coke grew 16% in the grocery channel in the first half, gaining one percentage point in share. While Coke is significantly underweight in juice and flavoured milk these are not driving market growth.

JP Morgan thinks the weak first half grocery volumes were a result of promotional fatigue and an unsustainable share in the first half of 2012 but accepts that it does not squash debate about the company's sustainable rate of pricing growth. Moreover, the reaction in the market was fair, in the broker's opinion. 2013 earnings are highly dependent on November and December trading in Australian beverages. These two months account for around 25% of earnings. JP Morgan suspects the weakness in the Australian beverages is exacerbated by a weak consumer environment. In shifting profit and volume mix toward cold drinks amid the decision to invest in cold drink equipment placement, means earnings and margins have become far more cyclical, and exposed to the discretionary spending of low to middle income consumers, particularly western Sydney, south east Melbourne and south east Queensland. JP Morgan contends these markets are likely to remain weak for the balance of 2013.

The weakness in the Australian market is an ongoing problem, according to UBS, particularly volumes and price in Australian soft drinks. This is thrown into high relief by the commentary on Indonesia, where robust growth rates expose the weakness of the Australian segment. Despite the more robust circumstances in Indonesia it's not enough to compensate. Furthermore, continued weakness in PNG is likely to be a larger than expected drag on Indonesia/PNG division earnings in the second half. CIMB expects more pressure on price and volume in the Australian market. While cycling a lower base, increased pressure in the supermarket channel is likely to continue as the retailers increase their private label penetration. A further unknown is the impact the Indonesian consumer slowdown will have on Ramadan sales. CIMB suspects a currency headwind may limit growth from Indonesia to the low-single digit range.

Citi believes de-stocking by key retailers has taken its toll while problems in 2013 are as much about the dispute with Woolworths ((WOW)) stemming from 2011 as they are about Pepsi's discounting. The broker suspects heavy discounting in the grocery channel entices smaller retailers to switch from direct Coca-Cola deliveries to sourcing more supply from grocers. Prices and margins for Coke are lower in the grocery channel. While guidance for double digit volume growth in Indonesia is impressive, Citi thinks Coke's biggest challenge will be contending with elevated inflationary pressures. Nonetheless, Pepsi's short-term actions do not change the long-term fundamental value of Coca-Cola Amatil. For patient investors, the broker believes the current share price weakness is a good opportunity to buy a high quality business with a strong growth opportunity in Indonesia.

For once, the canned fruit and juice business, SPC Ardmona, appears not to be the cause of the downgrade. The company continues to expect this division to report a decline in earnings for the year but Deutsche Bank notes there was some relief from new contracts with the major supermarkets, as well as the immediate tariff which has been imposed on Italian tomatoes by the Anti Dumping Commission. South African peaches are also being investigated. Coke previously suggested that the decline in SPCA earnings will constitute a 2-3% drag on group earnings. CSD volumes across most of the developed world are weak, according to Deutsche Bank, and this raises the issue of structural factors which are causing weak demand and encouraging industry discounting. Despite this, Coke is still a powerful brand and at some point Australian earnings should find a base and return to growth while the macro background in PNG and Indonesia should improve.

It's still an opportunity to build a position in a stock where JP Morgan thinks investors will benefit from the potential for value creation from a reallocation of surplus capital towards acquisitions, capital returns or an increase in the pay-out ratio. Strong cash flow and moderating capex is expected to generate significant cash flow over the next three years. Assuming a 2.5 times net debt/earnings ratio, the broker estimates the stock will have $1.23 per share of surplus capital by the end of 2014. The low level of gearing also overstates the price/earnings relative to other companies.

JP Morgan is sticking with an Overweight rating. Citi is also more bullish and retains a Buy rating. These two comprise the two Buy ratings on the FNArena database. There are three Hold ratings and three Sell. The consensus target price is $12.39, suggesting 1.8% upside to the last share price and down from $12.57 ahead of the announcement. The dividend yield on 2013 forecasts is 4.9% and for 2014 it's 5.0%.
 

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