Does the Market Think Coca-Cola Needs Glasses?

When Coca-Cola (NYSE: KO  ) introduced its plan in 2009 to double systemwide revenue by the year 2020 (dubbed the "2020 Vision") it issued a strategic road map developed in conjunction with its bottlers from which you can trace most of Coke's broad corporate actions to date. The document is divided into six sections: profit, people, portfolio, partners, planet, and productivity.

While Coca-Cola deems each group as vital to its business, the area that is turning out to have the most impact on the company's future is "portfolio." In describing the actions needed to develop its future drink portfolio, two bullet points in particular stand out in 2013, the fifth year of the plan:

  • Accelerate growth of Trademark Coca-Cola, the epicenter of our business.
  • Acquire or develop scalable, innovative premium brands.

The first point seeks to ratify the strategy of Coca-Cola's first 123 years: extend the company's reach through the iconic drink branded with the Coca-Cola logo. (Management refers to this drink as "Brand Coca-Cola," but you and I know it as "Coke.") With each passing year, this fundamental tenet of Coca-Cola's seems shakier. Soft drink sales have been declining in North America since at least 1998, and since the 2020 Vision document was written, conversations around the perceived unhealthiness of sweetened carbonated beverages have intensified.

The second point provides a hedge against the ambitions of the first. "Scalable, innovative premium brands" refers to drinks such as bottled waters, teas, and fruit juices. Improving revenues from non "Brand Coca-Cola" beverages diversifies the company's revenues and insulates it from a rising backlash against Coke.

Developing economies may not provide expected growth
A specific headwind has emerged this year to buffet the first ambition. Coca-Cola may have assumed that it could continue to grow its carbonated beverages in developing nations, where awareness of health issues tends to lag more developed countries, but, surprisingly, this may not be the case.

It turns out that developing nations are just as concerned about the effects of sugary drinks as developed nations. Mexico's Congress is considering a 20% tax on soda, and President Enrique Pena Nieto offered up a bill this month to tax not just soda, but all sugary drinks, including syrups and concentrates, a move that would affect Coca-Cola FEMSA, a major bottler in which Coke has a 28.7% interest through wholly owned subsidiaries.

More problematic for Coca-Cola is the potential long-term effect on an extremely vibrant market. Mexico boasts the highest per-capita consumption of Coca-Cola products in the world: At the equivalent of 745 servings per person per year, Mexico's consumption is more than 50% greater than the next highest country, Chile (the U.S. ranks fourth worldwide, at 401 servings per person per year). By unit case volume, Mexico makes up 44% of the entire Latin American market (Coke includes it in Latin America rather than North America). Coca-Cola does not want to lose a generation of potential Coke customers in its most successful country by per-capita consumption.

A forecast of future market pessimism?
How can we get a handle on what declining Coke volume and rising alternate brand volume means for Coca-Cola? The metric known as operating earnings yield -- that is, operating earnings divided by market capitalization -- may provide some guidance.

Operating earnings yield answers the following question: What does one dollar of investment in a stock yield in terms of operating earnings? This measure is the inverse of the P/E ratio (although the P/E ratio uses net income rather than operating income in its denominator). Coca-Cola's operating earnings yield has actually declined since 2009:

KO Operating Earnings Yield Chart

KO Operating Earnings Yield data by YCharts.

The fact that Coca-Cola's operating earnings yield has declined since the 2020 effort began may signal an erosion of earnings potential as reflected in the market price of the stock. The operating earnings yield ratio, while not a daily metric that you or I might track, is utilized by institutional money managers when making decisions on where to invest their clients' funds. Generally, it makes sense to invest in companies that will return an ever-higher yield on a growing market capitalization. If this number continues to decline, money managers may conclude that the 2020 Vision doesn't necessarily equate to 2020 eyesight.

500 brands and counting
To this point, Coca-Cola has been working on its hedge against brand Coke's decline. The company currently owns more than 500 brands spread around the world. Of those 500 brands, 16 are "billion-dollar brands," i.e., they enjoy revenues of more than $1 billion each year.By my count, the company has produced at least five of the $16 billion brands since the beginning of the 2020 plan. And most of these beverages are non-carbonated. A fun example is I-LOHAS bottled water, one of the newest monster brands, sold in Japan. The drink has an environmentally friendly if gimmicky "twist:" Coca-Cola designed the bottle to twist and crumple with ease to encourage recycling and save space in recycling containers.

The company is also working on non-carbonated innovation through its North American bottler, Coca-Cola Refreshments, which it purchased from one of its major franchise bottlers, Coca-Cola Enterprises, in 2010. Coca-Cola CEO Muhtar Kent sees Coca-Cola Refreshments as a future emblem for best practices in bottling, a center for other bottlers to visit and absorb the most current techniques for profitable bottling and distribution. In a recent earnings call, Kent and Executive Vice President Steve Cahillane described this idea while discussing a number of non-carbonated brands the company has acquired recently, such as Zico coconut water and Honest Tea. Experimentation in North America bottling, close to the company's Atlanta headquarters, will help Coca-Cola determine the most profitable bottling and distribution strategies for an ever-diversifying group of teas, waters, juices, and naturally flavored sodas.

Is this vision cloudy or clear?
Because Coca-Cola's management has invested so much energy and resources into building alternate brands, over the very long term Coca-Cola will likely remain one of the most solid investments around. But the near term may be shaky. If you have a multiyear time frame, there may be buying opportunities ahead as the company tries to keep its 2020 vision clear.

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