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Can Coca-Cola be the real thing again?
After eight years of poor performance, the pieces may be in place to turn the worlds best-known brand around. All Coke has to do is make it happen.
By Jon D. Markman
On the surface, the future of Coca-Cola (KO, news, msgs) looks as dark as the companys signature drink. Everywhere you turn, from the companys financials to its product strategy to its management team, you see chaos, destruction and strewn bodies. Its Hurricane Ivan in a can.
Yet emerging from the murky depths of this great American success story gone bad is a measure of hope. For it seems that the latest high-profile fiasco -- the botched introduction of the new low-sugar, low-carb, high-priced cola C2 -- might have finally jolted the companys demonstrably inept board awake. Bubbling to the surface now are indications that directors will finally permit the sort of deep institutional change that will finally bring back Cokes fizz.
That would be a welcome relief for current shareholders, who last week saw the value of their stock certificates sink to mid-1996 levels after the company announced that it would fail to meet fiscal 2004 earnings projections by a big margin. So much for the stabilizing value of dividends. If you bought the stock eight years ago and reinvested the cash distributions every year, youd still be down 7% on your investment. In the meantime, rivals PepsiCo (PEP, news, msgs) and Cadbury Schweppes (CSG, news, msgs) are up 150% and 100%, respectively. (Cadbury Schweppes owns such brands as Dr Pepper, Canada Dry, 7 UP and Orangina.)
Why the optimism now? So much has gone wrong so publicly for the company in the last few years that aggravated holders have had every opportunity to sell the stock out. Its not exactly a value stock at this point -- with a price/earnings multiple of 19.9 vs. estimated next-year earnings growth of a meager 9%. But at about $40, it is now trading at just a 10% premium to the S&P 500 price/earnings multiple -- the lowest decile of the stocks trading range over the past decade, according to a Goldman Sachs analysis.
All that has to happen at this point is for new chief executive Neville Isdell to set a couple of problems straight, and investors will push the multiple up as they fall back in love with Coca-Cola's prodigious cash flow, bulletproof balance sheet and fantastic international brand recognition. This is one mega-cap company whose products will never become obsolete, as Polaroid's products have. Shares are not going to zero. When your business consists of making an addictive syrup for pennies and selling it for dollars, you are never going to go broke. If Isdell can simply stanch the bleeding and provide a little confidence, he could earn credit for a nice 25% share boost over the next 12 months.
Setbacks and weak strategy
Cokes latest crises are emblematic of whats gone wrong for years, but they also provide a road map for improvements in the future.
- In the United States, Coca-Cola recently made the strategic decision to increase its share of carbonated soft drink sales by raising prices. The tip of this spear was the much-ballyhooed mid-calorie cola C2, which was introduced with a 15% price premium over Classic Coke. Bad move. The price of C2 was too high to compel consumers to try it, and it has been shunned. The company is already backpedaling on the brand, pushing the price down to parity with Classic Coke. In the meantime, however, this stinker has also taken up shelf space that could have been held by higher-velocity brands like Diet Coke.
- In Europe, the company has faced four setbacks. In the spring, Coke had to abort its introduction of Dasani water and recall 500,000 bottles after they were found to contain levels of the chemical bromate that exceeded legal levels. In Germany, sales volume has plunged all year in the wake of a law requiring consumers pay a deposit of up to half a euro, or 50 cents, per bottle. Northern European markets suffered from unseasonably cool weather that chilled soda sales. And according to a Sanford Bernstein analyst, sales volumes in France sank at a double-digit rate as retailers pulled inventories off shelves ahead of government-mandated retail price decreases that will take place later this month.
- New product innovation has been sorely lacking. Coke has bombed with C2 and failed to get in front of consumers increasing interest in noncarbonated and healthy drinks. While Coca-Cola is the worlds largest noncarbonated beverage company, says Morningstar analyst Matthew Reilly, it badly lags PepsiCo in the United States in that category, with a 28% market share vs. 46%. It also lacks anything like Pepsis highly profitable and inventive Frito-Lay salty snacks division. Part of the problem is a lack of managerial talent to drive successful initiatives -- a situation many analysts blame on former chief executive Douglas Daft, who slashed 5,200 jobs during his reign, substituting expense cuts for sales growth as a means to boost earnings.
New leadership
Now what could go right?
- Isdell, an Irishman who made his reputation at the company as a bottling subsidiary executive in the emerging markets of southern Africa, has already begun to regain Wall Streets confidence with a communications style far less opaque than his predecessors. Pulled out of retirement for this job, he promised to change the companys institutional culture to be more flexible, accountable and fast-moving. (He could have started by refusing the incredibly lucrative compensation offered by the board -- $1.5 million in salary plus $13.5 million more in performance-based add-ons.)
- Isdell said he believes the company will not require major infusions of capital because the business is fundamentally fine. Goldman Sachs analyst Marc Cohen points out that this provides the stock with substantial valuation support as it suggests no major negative cash events are on the horizon. Cohen also points out that this means Isdell is unlikely to push the company to buy back its major bottling operations, whose heavy capital needs would be a drag on valuation.
- Global income trends support increased spending by consumers in developing countries on Coke products, allowing the company to take advantage of its tremendous competitive edge in international distribution processes.
- Isdell has pledged to improve the efficiency of Coca-Cola's marketing message, not just turn up the volume. Cohen forecasts an advertising and promotion increase of $200 million to $300 million over the next two years. That sounds like a lot, but it is considerably less than the $500 million-plus bump in ad spending that more pessimistic analysts are forecasting.
The catalyst for the next move in Coca-Cola stock could be a Nov. 11 meeting with analysts to describe a more far-reaching strategic vision for the company. These meetings are typically love-fests when new management has been installed whom analysts and the media are predisposed to like. So long as Isdell does not announce he will spend an exorbitant amount on advertising, hint that he will attempt to buy back the capital-intensive bottling operations it spun off years ago or institute a new round of price increases, major investors may be persuaded to recommit funds to this long-disappointing stock.
Its not too hard to envision Coca-Cola shares re-approaching the $50 level over the next 12 months -- a 25% hike from current levels -- if managers can demonstrate, or at least persuasively argue, that they are back on track for reliable 10% earnings-per-share growth. Im normally a Pepsi One drinker, but I would toast that kind of news with a Diet Vanilla Coke.
Fine Print
Big paydays are still alive and well in the corporate suites. Isdell will be eligible for $3 million over his base salary as part of the company's annual incentive program and $10.5 million as part of the company's annual long-term equity plan, according to a filing with the U.S. Securities & Exchange Commission. (He will also get company-paid membership and reimbursement of dues and initiation fees associated with country clubs and social clubs he joins for business purposes, and hes eligible to receive reimbursement of $10,000 in financial planning and counseling services.) . . . See this page for a list of Cokes brands. . . . Cooking with Coca-Cola is a Southern tradition. Heres the recipe for Coca-Cola ham and a link to other recipes. The Coca-Cola Worldwide site provides links to Coke operations around the world.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman controlled positions in no stocks mentioned in this article.
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