Coca-Cola Tweaks Its Financial Strategy

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During Coca-Cola's (NYSE: KO) investor day conference last week, CFO Kathy Waller used the final speaking spot to tie various strategic threads together, describing changes in Coca-Cola's financial model that will help the company achieve its near-term goals.

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In this final part of a series in which we've reviewed Coca-Cola's new priorities and brand narrative strategy, let's walk through three important adjustments Waller outlined that will be crucial to Coca-Cola's success through 2020.

Product choice will help drive margin

Coca-Cola is targeting 35% operating margin by 2020, a 12-percentage-point increase over the year-to-date operating margin of 22%. The company's refranchising of its bottling operations will provide most, but not all, of this margin improvement. Waller presented a compelling case that paying more attention to portfolio choice will provide added lift to operating profits.

Waller used the example of Simply orange juice as a brand that has a higher margin than the company's Minute Maid orange juice workhorse, as it's more in tune with contemporary preferences and resonates with customers seeking a fresher, more natural product. Another example is the premium fruit-laden spritzer product Coca-Cola recently launched in Germany, called ViO Schorle (pictured above). This upscale mineral water beverage is infused with local, organic fruit, including apple, rhubarb, and black currant.

Ironically, Waller pointed out that carbonated sodas such as Coke achieve the highest gross margin across Coca-Cola's business. So while the company understands that soda consumption will continue to ebb, it's important to maintain the value of its market share through packaging innovation (e.g., smaller bottles with higher price points) and reformulations such as Coca-Cola Zero Sugar. 

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Share repurchases will ebb in favor of bolt-on acquisitions

Waller announced that the company will curtail its share repurchase program to use cash for bolt-on purchases of smaller companies and emerging brands. This should be a very productive use of the company's capital. It also should assuage investor fears over information CEO James Quincey relayed earlier in the day that Coca-Cola is changing its compensation structure to reward cash flow generation and earnings-per-share (EPS) growth, versus the former benchmark of economic profit.

Quincey argued that employees can grasp EPS and cash flow much more easily than the theoretical concept of economic profit, and thus, these measures, which can be found on the company's quarterly financial statements, make for simpler and better incentives. It's hard to fault this logic; however, management teams that base company performance on higher EPS can often influence this metric simply by repurchasing shares.

It's reassuring that Coca-Cola is already disclaiming any significant share repurchases in the next few years, except for what's needed to offset dilution from stock compensation expense. 

A sharper focus on cash productivity

One of the benefits of higher margin from refranchising should be increased cash flow. Coca-Cola intends to amplify this benefit by continuing to improve net working capital -- that is, the surplus of current assets such as cash and inventory over liabilities due within one year. 

Waller explained that the company is taking cost out of working capital by increasing its payables float. In layman's terms, Coca-Cola is stretching out the time it takes to pay vendors. According to Waller, this has resulted in $1.5 billion in additional net working capital from an initial program confined to the U.S. and Japan. 

The company is also seeking a long-term free cash flow conversion target of 95% to 100%. The free cash flow conversion ratio measures free cash flow to EBITDA. A simpler way to think of it is that Coca-Cola aims to produce at least $95 of operating cash, less capital expenditures -- and, in this case, pension contributions -- for every $100 of income earned, after adjusting the income for non-cash expenses such as depreciation, interest, and taxes. 

A high free cash flow conversion rate is a credible goal for a company like Coca-Cola, which enjoys a certain amount of built-in, recurring annual volume as a global brand leader. To hit a benchmark of 95%-100%, the company will have to ensure that different sections of the profit and loss statement, balance sheet, and statement of cash flows are optimized.

For example, gross margin must remain high, general and administrative expenses should be kept in check, working capital should be optimized, and capital expenditures should produce a favorable return on investment. Without these various constraints, it's not possible to convert an extremely high percentage of income to free cash flow. 

Keeping financial operations tight

If there's a unifying theme in Coca-Cola's modest business model tweaks, it's the idea that discipline over resources is necessary to make the company's overarching strategic goals and brand priorities materialize. Nearly every presenter on Coca-Cola's investor day discussed tighter discipline, but it's particularly welcome when applied to the company's financial functions.

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Asit Sharma has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.