The Coca-Cola Company (NYSE: KO ) reported first-quarter 2014 earnings last week, and shares rose more than 5% for the week, a demonstration of the whimsical magic of beating lowered expectations, as the company's revenue, net income, and earnings per share declined 4%, 8%, and 6%, respectively, versus the prior year. Let's review highlights of Coke's earnings report to seek out any change in the tea leaves as the company works to alter its recent fortunes.
A quarter of attractive cash flow
Despite lower sales than in the comparable prior-year quarter, Coke enjoyed strong cash flow in the first three months of 2014. The company generated $1.1 billion in cash from operations from $1.6 billion in net income. This compares favorably to the $480 million of operating cash flow generated from $1.8 billion in net income during the same period in 2013. CFO Gary Fayard cited efficient management of working capital as a primary driver of the increased cash flow. This makes sense, for if you look at last year's statement of cash flows for the period, you'll see, conversely, changes in working capital items created the greatest drag on operational cash flow. Fayard also noted that Coca-Cola's largest pension plan is now fully funded, which should also have a positive impact on cash for the rest of the year: Coke's contributions to its pension plans in 2012 and 2013 totaled $1.1 billion and $640 million, respectively.
This was Fayard's last earnings call, as he's set to retire this year and will be succeeded by Vice President, Finance and Controller Kathy Waller. Fayard has been a circumspect steward of Coke's resources over the past 14 years, exhibiting a healthy distrust of the overly aggressive share repurchases that many of his Fortune 500 peer CFOs have embraced as a means to increase earnings per share. Waller is also a Coke veteran, with more than 25 years at the company, and shareholders will hopefully see a similarly circumspect attitude toward capital allocation at the company under her watch.
China momentum from an unlikely source
Coke seems to be thriving in every category in China, from sparkling beverages to juices to bottled waters. For example, the company grew total volume 12% during the quarter. Part of this success is attributable to "lapping" a poor Q1 of 2013, in which volume grew only 1%. But as an analyst on Coke's earnings call pointed out, the last few sequential quarters in China have been good to Coke. This is a different experience from other consumer goods companies, from Procter & Gamble to Mondelez to Yum! Brands, which have found tough going in the world's most promising emerging market over the last year.
So, what's driving Coke's revenue in China? On its earnings call the company pointed to smaller packaging and lower price points, which enable greater "immediate consumption" sales. But we may be seeing a demand driver in China similar to one that has sustained the company's growth in Mexico for decades. In Mexico, fresh, clean water, especially in rural areas, is often in scarce supply. Coke's far-reaching distribution system has made its drinks more available in Mexico than potable water.
As odd as it may seem for a developing nation as prosperous as China, the same sort of fresh water proxy may be occurring, as widespread pollution, the price of rapid industrialization, is pushing forward sales of bottled waters and other drinks. According to Euromonitor, the market for bottled water in China will grow nearly 80% from 2012 levels, to reach $16 billion by 2017. As we've seen in Mexico, both soft drinks and water serve as replacements for safe drinking water. Just four days before Coke's earnings release, the Chinese city of Lanzhou, with a population of 3.6 million, experienced a run on bottled water when it came to light that the city's drinking water is contaminated with the carcinogen benzene.
Any light on revenue growth prospects in the near future?
President of Coca-Cola International Ahmet Bozer confirmed on the earnings call that high-single-digit volume growth in China would be the norm going forward. This encouraging projection throws into relief Coke's challenges for long-term company-wide revenue expansion. CEO Muhtar Kent is confident that the company is still structured to produce long-term revenue growth in the 3%-4% range. Yet the perceived difficulty of getting to this number is a weight on the stock at present. That the company is having to convert $1 billion of productivity savings to marketing expense to reach a modest revenue goal can't be comforting to shareholders. In the company's earnings release, it noted that roughly $400 million of this spend will occur through the rest of this year.
Departing CFO Fayard probably isolated one of Coke's best chances for increasing long-term revenue in the following comment: "We evaluate opportunities to grow through bolt-on acquisitions, strategic partnerships, and value-added joint ventures when appropriate." Acquisitions such as the purchase of Honest Tea and the recent equity investment in Keurig Green Mountain should provide opportunities to offset sluggish growth in current categories, but these results will manifest themselves over the course of years, not overnight.
The other major opportunity, of course, lies in the ascendance of still, or nonsparkling, beverages. While sparkling sales declined worldwide by 1% during the quarter, still beverages (waters, juices, energy drinks, cold coffee, and the like) continued their recent trend of outperformance, gaining 8% in global volume. Ideally, applying the type of opportunism Fayard mentioned to the vibrant category of still beverages will provide the momentum boost Coke needs to ensure that its long-term fortunes remain intact. Yet so far in 2014, the tea leaves remain cloudy for Coca-Cola.
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