Coca-Cola (NYSE:KO) on Tuesday reported flat revenue and lower earnings per share today for the third quarter, and warned of the impact of currency headwinds on full-year results. The company also announced an expansion of its productivity plan to target annual cost savings of $3 billion by 2019. Furthermore, the soda giant communicated other new initiatives to drive growth, as well as some changes to the metrics it uses to gauge its progress. Let's briefly review the quarter and the announced changes, and what they mean for the world's largest nonalcoholic beverage company.
A flat quarter, and currency trouble ahead
Coca-Cola reported worldwide quarterly revenue of $12 billion, a flat performance versus the prior-year quarter. Year to date, the company's reported revenue is down 1.9% from 2013. Global volume increased 1% during the quarter. Operating income improved by 10%, yet remeasurements of balance sheet items due to currency changes, recorded in the "Other Income (loss)" line of the income statement, pressured earnings per share, which decreased 13%.
Yesterday's Fool earnings preview stated, "Don't be surprised if Coca-Cola management blames currency woes for its results." The U.S. dollar surged against international currencies over the summer, and could appreciate further in 2015. Coke said today it will miss its full-year EPS target of "high single digits" due to an anticipated fourth-quarter currency drag that its hedging activities will not fully cover. The currency effect on operating income will equal 7% in the fourth quarter, and 6% for the full year.
An ambitious cost-savings target, and potential impacts
Coke also said it would aim to produce another $3 billion in annual cost savings by 2019 through expansion of the company's current productivity plan. This represents nearly 30% of annual operating income. Achieving this magnitude of cost savings would cushion Coca-Cola against the vagaries of currency fluctuations and raw materials inflation.
More importantly, carving an additional $3 billion annually out of operations would boost cash flow markedly, enabling management to pursue a strategy it has beta-tested this year: increasing marketing dollars to "brand Coke" in order to stabilize the decline of its flagship soda.
This summer, the company activated its "Share a Coke" campaign in the U.S., after seeing positive results in other global markets. The company reported today that the campaign helped Coca-Cola North America gain value share in sparkling beverages for the ninth consecutive quarter.
It is becoming clear that Coca-Cola's management aims to hold sales of brand Coke steady so that the faster-growing "still" portfolio (bottled teas, juices, coffees, waters, and energy drinks) can help the company return to mid-single-digit revenue growth. Earlier this year, management increased the company's marketing spending by $1 billion. In investor presentation slides issued today, Coke indicated that some of the new $3 billion in cost savings would "support investment to deliver sustainable net revenue growth."
Investors should read between the lines here: management will invest in new brands and its still portfolio, but also allocate whatever it takes in marketing dollars to ensure that brand Coke and the company's No. 2 beverage, Diet Coke, remain at least neutral in sales and maintain current market share.
It's time for bottlers to leave the nest
Coca-Cola announced one other substantive change to its business model today: it intends to refranchise its company-owned North American bottlers by 2017, and to refranchise other company-owned regions globally by 2020.
With this initiative, management essentially acknowledged that it is better to have nearly 100% of its bottlers operate as independent entities. With the beverage industry increasingly fragmented among newer forms of refreshment, including energy drinks and craft sodas, and with the challenge of a new generation of consumers who are disinclined to consume sugary carbonated beverages, management needs to focus on its core brand products. Refranchising (selling) company-owned bottling operations to existing bottlers will help Coke keep its attention squarely on products rather than bottling and distribution.
To this end, Coca-Cola said it will start using "profit before tax" rather than "operating income" as a primary metric to track profitability. This is because most of the revenue from company-owned bottlers will now appear below the operating income line on the Coca-Cola income statement, where revenues from business partnerships and equity investments are tracked. I bring up this slightly technical item only because it might appear that Coke is trying to change the game on how it measures its profitability (this is not the case).
There's one small nuance to this change in Coke's preferred profitability metric: it will now include results from equity investments such as Keurig Green Mountain and Monster Beverage, as these corporations' contributions are recorded in "profit before tax," but not "operating income." Eventually, Coke might decide to acquire greater stakes in these companies, in which case their revenues will be consolidate under Coke's own, leading to higher reported revenue growth.
Piecing the news items together
What should shareholders make of the rather significant announcements today? While investor sentiment might initially be negative due to Coca-Cola's flat revenue growth and currency headwinds, the company has been taking steps throughout the year to ensure future growth. Today's introduction of additional cost savings plans and the refranchising of bottlers should be taken in context with the $4.5 billion Coke has already spent this year on buying stakes in Keurig Green Mountain and Monster Beverage. It's an interesting dichotomy: the market has a skeptical eye on Coca-Cola today, yet management is squarely focused on outcomes 12 to 24 months ahead.