How Much Will Refranchising Boost Coca-Cola’s Margins in 2018?

by Trefis Team
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The Coca-Cola Company (NYSE: KO) is set to announce its fourth quarter results on February 14, 2019, followed by a conference call with analysts. The market expects the company to report net revenue of $7.03 billion in Q4 2018, 6.4% lower than in Q4 2017. Adjusted earnings for the quarter are expected to be $0.43 per share compared to $0.39 per share in the year-ago period. For the full year, revenue is expected to decrease by 10% to $31.9 billion and adjusted EPS to increase by 9.4% to $2.09. Increased earnings are likely to be the result of large-scale refranchising of the company’s bottling business, coupled with lower tax expense for the year.

We have summarized our key expectations about the earnings in our interactive dashboard – Lower Revenue and Higher Margins: Coca-Cola’s Mixed Bag in 2018. In addition, all Trefis Consumer Staples data is here.

 

Key Factors Affecting Earnings

Impressive growth of zero sugar: As the world over people are increasingly moving away from soda consumption due to increased health concerns and awareness, Coca-Cola has benefited from this trend with the revamping of its Coke Zero into Coca-Cola Zero Sugar in Q3 2017. The company witnessed impressive growth in sales of Zero Sugar, which increased by 11% in Q3 2018 compared to the year-ago period. We expect consumption to remain robust in the fourth quarter as well, thus driving revenue for the product.

Potential of ready-to-drink tea: Research has shown that the ready-to-drink tea category has shown steady growth in 2018, growing at about 3.4% year-on-year driven by consumers’ preference for healthier and easily available options. This corresponds to a steady rise in Coca-Cola’s tea portfolio, driven by Fuze Tea, Ayataka, and Gold Peak. The US and Asia Pacific are the two main regions where the ready-to-drink tea market is surging. In the Asia-Pacific segment of the company, tea and coffee witnessed 4% growth in volumes during the first nine months of 2018. Ready-to-drink tea and coffee market size is expected to reach $116.13 billion by 2024. Such immense growth potential would drive sales of Coca-Cola’s ready-to-drink tea in 2018 and beyond. FY 2018 growth is expected to be around 3.5% to 4% for the full year as Q4 sales are generally lower due to seasonality.

Refranchising of bottling operations: Coca-Cola is refranchising many of its bottling operations in a bid to move away from the capital intensive and low margin business of bottling, and focus more on the concentrate business as the consumption of carbonated drinks continues to slow down, especially in developed markets. Coca-Cola’s net sales growth has been hurt in the last few quarters due to these structural changes. The bottling business comes with four to five times more revenue per drink sold and the accompanying cost. Thus, any impact on the sales of the bottler is going to have a magnified impact on overall sales for Coca-Cola and much less effect on the company’s profits. In the last two years, the company has completed the refranchising of its bottling operations in China, Japan, Canada, and Latin America. Thus, in spite of higher revenues in almost all the geographical segments of the company, total revenue for 2018 is most likely to see a drop of close to 10% due to the near halving of bottling revenues compared to the previous year.

Productivity and Reinvestment plan: This plan, which was introduced in 2012 and expanded a couple of times since then to extend up to 2019, focuses on restructuring the Company’s global supply chain; implementing zero-based work, an evolution of zero-based budget principles, across the organization; streamlining and simplifying the Company’s operating model; and further driving increased discipline and efficiency in direct marketing investments. The new productivity plan means that Coca-Cola now has extended its previous productivity plan to save $3 billion in annual savings by 2019 to achieve incremental savings of about $800 million, bringing its current program to $3.8 billion in productivity savings. If the $500 million of productivity that will transfer to Coca-Cola’s bottling partners due to the accelerated pace of refranchising is added, the program extends to $4.3 billion in productivity savings by 2019. This program has boosted margins to 22.4% in the first three quarters of 2018 compared to 14.3% in the corresponding period of 2017. We expect margins to remain elevated around the same level in Q4.

Coca-Cola is also expected to report a close to 10% year-on-year reduction in its tax expense in 2018, benefiting from a lower effective tax rate due to the implementation of the Tax Cuts and Jobs Act. Lower tax expense, operating efficiency in the form of lower costs due to the refranchising initiatives, and the productivity program would help the company increase its profitability. Net income margin for 2018 is expected to witness a sharp increase to 22% from 3.5% in 2017, thus translating into a higher adjusted earnings per share of $2.10 compared to $1.91 in the previous year.

We have a price estimate of $53 per share for the company, which is higher than its current market price. We believe that the company’s focus on its high-margin core products and diverse offerings to cater to the health-conscious young generation, along with steps to boost its bottom line, will provide support to its stock price going forward.

 

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