Value Investor: Pepsi is taking the fizz out of Coke

Extreme price discounting by its main competitor has popped Coca-Cola Amatil's bubble.

The power of the Coca Cola brand is CCL’s core competitive advantage and supports its large price premium. Its unparalleled brand equity allows CCL to take commoditised inputs, including sugar, aluminium and PET resin, and produce branded outputs with healthy margins and pricing power. The question in a new era of price competition is can the ‘real thing’ sustain this price premium?

CCL’s pricing power might be breaking down. Historically, contractions in CCL’s market share in response to significant price premium increases have been short lived. But in the context of increasingly frugal consumers, combined with a rotation away from sugary drinks and sustained discounting by main competitor Pepsi Schweppes, the ability to recoup market-share losses will be a challenge and are likely to affect long-term volume and capacity for price growth. Management noted increased competitor price discounting recently and guided a 3-5 per cent decline in EBIT (earnings before interest and tax) for 2014.

We have cut our forecast for normalised return on equity (NROE) to 32 per cent. This lowers our valuation by 18 per cent to $9.14.

Coca Cola Amatil’s (CCL) large-scale manufacturing and distribution network, unrivaled brand equity and diversified portfolio have contributed to a strong history of earnings growth and share-price premium. More recently though, challenging conditions in the grocery channel -  driven by extreme price discounting - threatens its capacity to sustain historical rates of return.

CCL’s interim result disappointed the market and highlighted the challenges in the core Australian business. Despite efforts to appease the market with a special dividend the stock fell over five per cent on the day. CCL reported a decline in net profit of 12.3 per cent to $215.9 million. Its Australian business, which generates 70 per cent of EBIT, reported a six per cent decline in sales and 10 per cent decline in EBIT. Volumes were down 6.4 per cent, driven by a 14 per cent drop in grocery-channel volumes.

Most of the decline reflected aggressive discounting. The launch of Pepsi Next saw CCL and Schweppes compete aggressively with in-store promotions. The Pepsi price war saw Coca Cola’s price premium over competitors expand 10 points and triggered a one percentage-point loss in market share, to 52 per cent.

Destocking by the major supermarkets is putting further pressure on grocery volumes. Coles and Woolworths, with a collective market share of an estimated 72%, are reducing excess inventory.

As earnings decline domestically, CCL is looking offshore, in particular to Indonesia where it reported EBIT growth of 12.5 per cent for the half. Management committed 51 per cent of FY14 capital expenditure to boost manufacturing and distribution in the region. 

After a brief hiatus following the sale of Pacific Beverages to SAB Miller in 2011, CCL will re-enter the beer market at the end of the year. Focused on premium beverages, CCL is on track with a joint venture with Casella and distribution agreements with Molson Coors and Rekorderlig cider. In our view the re-entry into the beer market will diversify revenue and offset declining growth in the Australian grocery channel.

What makes CCL attractive to value investors is its large premium of NROE to our 12 per cent required return. However, the valuation is extremely sensitive. Any margin pressure and/or volume losses which cut NROE to, say, 30 per cent would see the 2014 valuation fall below $9. 

Our forecast 2014 dividend yield of 5.2 per cent - 75 per cent franked - should support the share price, however trading at a 25 per cent premium to our 2013 valuation means CCL is not a viable consideration at these levels.

There is no question CCL is a mature, highly profitable business with strong momentum in Indonesia and growth potential as it re-enters the Australian beer market. In a bullish scenario where grocery volumes recover and competitive pressures ease, NROE could rise to 35 per cent and the fiscal 2014 valuation would break $12.00.

But this is still below the current share price, highlighting the stock’s overvaluation, as seen in the chart below.

Figure: Coca Cola Amatil Price vs. Value Chart

Graph for Value Investor: Pepsi is taking the fizz out of Coke


StocksInValue indicates which ASX-listed companies are cheap or expensive, poor-quality or investment grade, and also covers the behavioural aspects of value investing and explores the mind of the market for each stock and investment theme reviewed. Many investors find it too uncomfortable to act against the market’s prevailing mood but we will argue why you must do so to protect your capital and achieve satisfactory returns. We buy uncertainty and pessimism and sell buoyant optimism and blue sky, and think you should too.

Amelia Bott is an Equities Analyst at StocksInValue, a joint venture between Clime Investment Management, a boutique value fund manager, and the Eureka Report. StocksInValue provides valuations of 400 ASX-listed companies by Clime and equities research, insights and strategy, that you won’t find elsewhere, by the StocksInValue analyst team. For a free trial please visit or call 1300 136 225.

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