(KO) Coca-Cola Walks the Tightrope

We have maintained our Neutral rating on The Coca-Cola Company (KO) following the appraisal of second quarter 2012 results.

The Coca-Cola Company delivered adjusted operating earnings of $1.22 per share in the second quarter of 2012, beating the Zacks Consensus Estimate by 2.5%. Earnings also improved 4% from the prior-year quarter. The quarter’s earnings were driven by positive revenue and volume growth, which diluted the impacts from higher commodity costs and currency headwinds.

In the quarter, net revenue increased 3% year over year to $13.09 billion, as benefits from an increase in concentrate sales and positive price/mix were largely pulled down by currency headwinds of 4%. The top-line results were marginally above the Zacks Consensus Estimate of $13.01 billion.

The cola giant witnessed volume growth of 4% in the reported quarter driven mainly by solid growth in the emerging markets of India, Russia, China and Brazil. Among the non-alcoholic ready-to-drink (NARTD) beverages, sparkling beverages grew only 2% in terms of volume. Still beverages rose 9% in terms of volume, registering much better volume growth than the popular soft drinks.

Coca-Cola has a formidable portfolio of globally recognized brands. Coca-Cola markets four of the world’s top five nonalcoholic sparkling beverage brands, including Coke, Diet Coke, Sprite and Fanta, thus boasting a high level of consumer acceptance. Similarly, the company also commands a dominating presence in the juices or still beverages category, with its flagship brands such as Minute Maid, Simply and POWERade. Moreover, the company possesses one of the largest distribution networks in the world, which gives it a huge competitive advantage.

As the developed markets are nearing saturation, Coca-Cola is showing keen interest in the emerging markets of India, Russia and China, encouraged by the high-growth nature of these countries. Currently, 43% of the company’s business is being generated in the developed markets (US, Western Europe, Australia, Japan), 37% in developing nations and 20% in the emerging markets. Management believes that due to the higher growth rates in the emerging and developing markets, each of these geographic segments will contribute 33% of the company’s business by the end of 2020.

Coca-Cola is undertaking various productivity initiatives to streamline its cost structure and boost profitability. In 2011, the company successfully completed its four-year productivity program, with annualized savings of over $500 million. Further, in February 2012, Coca-Cola launched a four-year productivity and reinvestment program which is expected to generate incremental annualized savings of $550 million to $600 million that will be phased over a four-year period (starting in 2012 through the end of 2015). The savings will be used toward further brand building and also help mitigate the negative impact from commodity costs, thereby boosting long-term profitability. Further, the acquisition of North American bottling business from Coca?Cola Enterprises Inc. (CCE) is expected to generate synergies of at least $350 million in the next four years.

Despite all the benefits, we prefer to remain on the sidelines due commodity cost and currency volatility. Moreover, Coca-Cola needs to ramp up its advertising spending to match up competitor PepsiCo Inc.’s (PEP) increased focus on North American beverages. Further, a slow economic recovery, strained consumer discretionary spending, changing consumer preferences, and increasing health consciousness also create headwinds.

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