By Henry Kawabe
The Coca-Cola Company (NYSE:KO) quarterly earnings were very disappointing to most. Immediately after the company’s second quarter report, the stock traded lower by more than 3%; this somewhat significant for a non-cyclical company. The company tried to downplay its miss, but a closer look at recent federal rulings and consumer shifts suggest a larger macro issue. Although, it does appear the company is taking small steps to ensure its dominance. Apropos question: What should you do?
A Look At Coke’s Earnings & Valuation
For the second quarter, Coca-Cola’s operating income declined year-over-year by 2% and revenues declined 3% to $12.75 billion… still a lot of sodas sold. The company’s top-line was short just $220 million off expectations, not significant when we’re talking about a company that posted so many billions in sales.
The problem lies in volume, which rose just 1%, as this shows that growth is slowing significantly below GDP. Moreover, guidance was below the consensus, further suggesting long-term weakness. According to the soda giant, weather is to blame, as is overall macro conditions. At 21.5 times earnings, and 3.8 times sales, Coca-Cola trades higher than the S&P 500 average, meaning that room for operational error is limited. Furthermore, with the company paying out 57% of its earnings in dividends there is limited capital to reinvest back into the business.
What Are They Doing About It?
Look, Coke can blame its weakness on the weather all day long, but we all know the truth: A health- conscious consumer and a liberal government is taking its toll on the company’s outlook. Bullish investors will say that Eurasia and Africa remain strong with growth of 9%. However, this emerging market is tiny relative to the struggling markets in Europe and North America.
Just last month new federal rules disclosed that fat, salt, and sugar in school lunches will be limited. As part of this new rule, vending machines will be limited to 200 calories per item. Furthermore, 12-ounce drinks cannot exceed 60 calories, meaning that many sodas will be eliminated from vending machines (probably to the chagrin of a multitude of school-age children). It can be inferred that this could be quite the blow to Coca-Cola — just part of the process with the number of new national rules created by a wiser, more health-conscious society.
What separates a good business from a great business is the ability to evolve with the market. Tobacco companies had to change their entire marketing strategy and fight a government that did everything in its power to push consumers from their products. Consequently, tobacco companies had to make modifications to products, many of which to meet regulatory changes. Coca-Cola is now faced with similar hurdles, as it must make its products healthier in order to maintain its position atop the beverage industry.
Could Stevia be the Answer?
For the last year, certain analysts and investors have seen the new healthy government wave coming, thus urging Coca-Cola to reduce calories in its products. The problem is maintaining taste. Earlier this month, Coca-Cola made its first major stride in the right direction, when it launched stevia-sweetened products in Argentina. This is a big leap for the company and, if successful, could entice PepsiCo Inc. (NYSE:PEP) to follow suit with a larger launch in North America.
Stevia is an all-natural zero calorie sweetener that is several hundred times sweeter than sugar. So if utilized correctly it will give beverage makers more bang for their buck. Unfortunately, stevia has not been grown in large enough quantities to satisfy the size of the beverage market. If Coke is successful in Argentina it could create an enormous, but temporary, issue with supply and demand. Below I have included a handful of companies that have the resources to both aid in stevia production and ones that could also benefit from this Coca-Cola breakthrough.
The world’s leading producer and marketer of stevia is the company PureCircle Limited (LON:PURE), with a market cap of $600 million. PureCircle’s strength is that the company grows stevia in several markets such as South America, Africa, and Asia. For this reason it can give buyers more options regarding taste. The problem with PureCircle is that it does not grow its own product, but rather contracts local growers in each region. This approach leaves PureCircle exposed to potential conflicts with growers, and also could hinder the company’s attractiveness as a takeover target. Additionally, the revenue share that PureCircle must pay to its growers could also affect long-term margins. Nonetheless, the company is still the current leader.
Stevia First Corp (OTCMKTS:STVF) is a more speculative name in the space, but a promising one. The company has its own land: 1,000 acres located in the heart of California’s Central Valley. Stevia First’s “carrot” lies with its fermentation process, which was licensed from Vineland Research and Innovation Centre. The company’s goal is to modify stevia to produce the sweetest parts of the plant without the lingering aftertaste that typically inherent to stevia-based products. This process could be very valuable to large beverage and food companies such as a Coke or Kraft (obvious large consumers of sugar) in modifying the taste of a product. While the company is yet to sell its stevia, Stevia First is testing a number of products (such as table top sweeteners) and could begin to produce revenue in 2014. For this company in particular, its acreage, fermentation process, and goal of being a stevia-focused business is what creates shareholder value.
S&W Seed Company (NASDAQ:SANW) is also a stevia producer located in California’s Central Valley. For S&W, stevia is just a part of its operational goals, as S&W focuses on the production and sales of alfalfa seeds. However, in the last year the company has set a small amount of acreage to produce stevia commercially. The problem is the company wiped out its entire initial crop due to using herbicide in its third quarter, and only salvaged 10% to 20% of its Los Banos crop. The company is still going to remain a player in the stevia market due to its impressive growth potential. However, the company’s decision to rush its stevia production backfired, and it is still reeling from the blunder. This further shows how Stevia First’s approach of testing and re-testing is wise when growing a product that has limited commercial integration in the U.S.
The final mention to benefit from increased stevia demand is Ingredion Inc. (NYSE:INGR), which recently launched a stevia product called Enliten. Ingredion is a very diversified sweetener company, producing a lot of consumer products. However, Ingredion’s core business practice is to produce corn and corn-based products. In the last year, Ingredion has posted stock gains of 37% and pays a dividend yield of 2.4%. This is a larger company with a hefty market cap of $5 billion. Ergo, its upside is not directly tied to stevia– though because of its outreach, it could form several partnerships with large companies.
In 2012 Health Canada approved stevia as an additive in food and beverage products, and in 2011 the European Commission authorized its use for food and beverage. The U.S. is wanting healthy changes, and Coke is testing stevia in Argentina. Evidently, all signs point towards this industry seeing rapid growth, and being very important to the future of Coca-Cola.
When you are the leader in any industry, there is nowhere to go but down. For decades Coca-Cola has controlled this space, but a strong emergence of new competition from health-focused companies such as Sodastream International Ltd (NASDAQ:SODA) and Reed’s Inc. (NYSEMKT:REED), with changes on behalf of competitors Starbucks Corporation (NASDAQ:SBUX) and Kraft Foods Group Inc. (NASDAQ:KRFT)–selling its Mio additives–is causing problems for the beverage leader.
Now, I wouldn’t go as far as to say that if Coca-Cola doesn’t actively incorporate stevia then its future is doomed. I think Coca-Cola will always be an industry leader, and I think its revenue will rise long-term. I remember being a child and my grandfather talking about $0.05 sodas. Today, bottled sodas cost at least $1.50, showing the impact of currency over the years. In addition, population continues to rise, which will aid growth. However, unless Coke does something drastic to change the perception surrounding its drinks, I do think we could see new leaders emerge, and a less relevant Coca-Cola.