Coke: Bubbling Up or Short on Fizz?


By Dean Foust Being a shareholder of Coca-Cola (KO) in recent years has required the patience of Job. Coke stock soared a breathtaking 3,500% during the global boom of the 1980s and 1990s, but it has been on a long, hard slide ever since.

A weak economy and bear market were just the start of Coke's worries. For four years, the soft-drink giant has been battered by economic crises in key Asian and Latin markets, a strong dollar that crimped overseas profits, a management change in the top suite -- and its own hubris, as its heavy investments in developing markets like Russia didn't pan out. Result: Coke's stock, which hit a peak of $88.94 in 1998, has fallen by more than 50%. Bumping along at around $45 a share for most of the year, it closed at $43.98 on Aug. 27, despite a weakening dollar and a surprisingly upbeat performance in the second quarter.

Take a harder look at those second-quarter numbers, though. There is a growing school of thought on Wall Street that says Coke CEO Douglas Daft may finally have the soda giant back on track. Despite continued weakness in key Latin markets, the SARS epidemic which crimped springtime sales in Asia, and revelations that a grand jury was looking at allegations that Coke engaged in accounting fraud (the investigation continues), the Atlanta-based bluechip still managed to post an 11% rise in second-quarter net income, to $1.36 billion, on a meager 6% increase in revenues.

NEW TASTES. Those numbers fall short of the heady 15% to 18% income gains that Coke routinely notched up when its globalist strategy was king. But the bulls think Daft's turnaround efforts may finally be paying off. In addition to relentlessly cutting costs, Daft and Coke President Steven Heyer are rolling out a steady stream of promising new drinks such as Vanilla Coke and Sprite Remix.

Plus currencies seem once again to be aligning in Coke's favor, helping to provide a nice tailwind in the second quarter. And Coke boasts that it has boosted its operating leverage, meaning that every extra bottle of Coke sold beyond its goals is now generating a hefty profit.

Once a skeptic, Morgan Stanley analyst William Pecoriello believes the second quarter was "an important inflection point" for Coke. He thinks Coke's stock could rise to $52 over the next 12 months. Investors jumping in now "have not missed the move that is still yet to happen," Pecoriello wrote in a recent report (Morgan Stanley has done investment-banking work for Coke). Standard & Poor's rates Coke 5 STARS (accumulate), thanks in large part to its product introductions and greater operational effectiveness, particularly at the local level. (Like BusinessWeek and BusinessWeek Online, S&P is a unit of the McGraw-Hill Cos.)

SYRUP DRIP. Under Daft, Coke has successfully undergone a cultural transformation, shifting its focus from worldwide distribution under ex-CEO M. Douglas Ivester to an emphasis on innovation. During the first half of 2003, Coke introduced 225 new sodas and soft drinks worldwide, vs. 140 in the first six months of 2002. And increasingly, Coke is customizing major brands to please local tastes around the world. For example, as Coke's U.S. team launched Sprite Remix -- a tropical-flavored version that helped fuel a 12% rise in Sprite sales in the U.S. -- Daft's troops were testing a mint-flavored version for sales overseas.

The Coke bulls have an interesting theory: There's plenty to drink in -- but don't break out the bubbly just yet. Smart investors may want to wait a little longer for Coke's picture to improve.

Take taxes, for example. Thanks in part to Coke's shifting the manufacturing of the syrup concentrate it sells to independent bottlers to a new plant in low-tax Ireland, the outfit's effective tax rate has fallen from 36% in 2000 and 29.8% in 2001 to just 22.8% in the latest quarter. That was below the 26.5% rate analysts had expected. However, Coke officials readily acknowledge that the effective tax rate will increase to 25.5% in 2004 and beyond -- meaning the recent tax windfall won't be a permanent fixture.

BOTTLE BATTLE. Those concerns pale in comparison beside Coke's biggest challenge: Its two largest markets, the U.S. and Japan, already have a belly full of soft drinks. In the U. S., the average man, woman, and child consumes roughly 54 gallons of soda annually, and Japan is showing similar signs of saturation. As a result, the U.S. soda market is growing 1% at best.

That, in turn, has triggered a fierce discounting war between Coke and archrival Pepsi: Coke's U.S. bottlers tell analysts that roughly 70% of all 12-packs and 50% of all two-liter bottles of soda are now sold at deep discounts by retailers -- as little as 79 cents for the two-liter bottles, and $2.25 for a 12-pack of canned Cokes. "There's a sentiment among bottlers that the two-liter and 12-pack are in serious trouble," Faucher says.

So for all of Coke's success at spinning out new brand extensions like Vanilla Coke and broadening its reach into bottled water and juices, it could be pushing on a string if its two biggest markets remain flat. "We believe very few beverage and food companies can grow earnings double-digit if 50% of its earnings stream may have sustainable growth of 1% at best," Prudential Equity Group analyst Jeffrey G. Kanter wrote in a recent report.

LOOKING FOR GROWTH. Coke acknowledges that the U.S. and Japanese markets have become a challenge, but senior executives remain hopeful that they can grab share from rivals with new products -- and, in time, that more innovative packaging will help overcome the two-liter trap. Plus, markets in Latin American and China could bounce back, boosting sales.

Given how Japan and the U.S. fueled Coke's growth in the 1980s and 1990s, however, the unanswered question about Daft's strategy remains: Where will all the new growth come from? For that reason, investors might want to wait another quarter or two to see if Coke's prospects are as bubbly as some observers already believe. Foust is the chief of BusinessWeek's Atlanta bureau


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