Coca-Cola's "Core Business Model" Shows Promise

By Markets Fool.com

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Image source: Coca-Cola Instagram page.

The Coca-Cola Company's(NYSE: KO)third-quarter 2016 earnings report drove home the sense that the global beverage giant is a company in transition. Coca-Cola is deep in the process of refranchising, or selling, substantially all of its North American bottling operations to partners by the end of 2017. We'll discuss the impact of this wide initiative on the third quarter below, but first, let's grasp the big picture through a few headline numbers:

The Coca-Cola Company: The raw numbers

Metric Q3 2016 Actual Q3 2015 Actual Year-Over-Year Growth (Decline)
Revenue $10.6 billion $11.4 billion (7%)
Net income $1.05 billion $1.50 billion

(30.0)%

Diluted earnings per share $0.24 $0.33 (27.2)%








Data source: Coca-Cola Company 8-K filing, October 26, 2016.

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What happened with Coca-Cola this quarter?

  • Coca-Cola's 7% reported revenue decline was due primarily to 8 percentage points of divestiture and structural items, as the sale of bottling operations continued.

  • Organic revenue, which excludes acquisitions, divestitures, and currency effects, improved 3% over the comparable quarter. In Q2 2016, the company lowered its full-year organic revenue growth expectation from a range of 4%-5% to a target of 3%. So it was important for Coca-Cola to hit the 3% mark in the third quarter in support of the revised goal.

  • The company's decline in net income and diluted earnings per share versus the prior year was keyed by writedowns of intangible assets related to its bottling refranchising efforts, as well as a higher tax rate during the period versus 2015.

  • Sparkling (carbonated) beverage unit case volume was flat during the quarter, as a 2% decline in Latin America neutralized modest growth in all other geographic segments.

  • Still (non-carbonated) beverage unit case volume expanded by 3%, led by bottled water and sports beverages.

  • In North America, the company announced four closings of previously announced refranchise deals with bottling partners alongside the earning release. In addition, Coca-Cola announced six new refranchising definitive agreements, or DAs, with regional bottlers.

  • The company affirmed the coming launch of Ready To Drink, or RTD, Gold Peak cold brewed coffees, andDunkin' BrandsDunkin' Donuts branded RTD coffees, both slated for early 2017.

  • Management stated that Coca-Cola is on track to realize $600 million in productivity savings in 2016 as part of its ongoing plan to realize $3 billion in annual cost savings.

  • Except to reduce its capital expenditure target to slightly less than $2.5 billion, the company left all full-year revenue and earnings guidance estimates unchanged.

What management had to say

In management's conference call with analysts, CEO Muhtar Kent addressed a concern that's plagued Coca-Cola for quite a while -- the prevalence of added sugar in its beverages, primarily within the company's sparkling portfolio. As consumers lose interest in sweetened carbonated beverages, and municipalities increasingly explore the taxation of sodas, Coca-Cola appears to be treating the sugar question with more urgency than in recent years. As Kent explained in the earnings call:

...we have been taking multiple actions to shape choice, to address changing consumer preferences around added sugar, while working proactively with governments to provide positive solutions. We have been driving a systematic reformulation effort across our portfolio to reduce added sugar while delivering superior consumer taste and improving margins. For example, we currently have over 200 reformulation initiatives under way to reduce added sugar, and so an example of where that might take us, as a step forward, in [Great Britain], for example, we reduced the sugar and the calories in brands such as Sprite and Fanta by 30%.

Looking forward

When we peel away the bottling operations still owned by Coca-Cola, we're left with what the company refers to as its "core business model." This includes all results from Europe, Middle East, and Africa (EMEA), North America, Latin America, Asia Pacific, and the company's corporate operations, after all intersegment transactions are eliminated.

This so-called core business gives us a sense of how the lighter footprint Coca-Cola -- which will exist as more of a brand developer and marketer, as well as manufacturer of concentrates -- is performing.During the quarter, core business's organic revenue expanded at slightly faster pace than the overall business, at 4%.

Stripping the company into its core businesses and removing the burden of distribution from operations are likely to reveal a more agile and profitable company going forward. It will also allow Coca-Cola's management to focus on solving its most pressing problems, such as the persistent issue of muted sparkling beverage sales. In fact, some of this focus is already apparent, as seen in the following slide, which details current strategy on this topic:

Image source: Coca-Cola Q3 2016 investor presentation dated October 26, 2016.

The slide's four-point plan attacks the problem from several angles: more vibrant marketing, sugar reduction as discussed above, reformulation of beverages with new offerings, and smaller, reduced-guilt packaging at higher price points. By refranchising, the company is freeing up resources to invest in reinvigorating its sparkling labels, the most important of which is trademark Coca-Cola. And as you can tell from the graphic, management believes that the "Coke" brand, though tweaked in a number of ways, will remain the center of a faster growing, more profitable core business model.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.