Coca-Cola Amatil: Interim Result 2013

The message from Coca-Cola Amatil's interim results is that its overseas businesses are performing well, but its larger Australian soft drinks business is struggling in the face of a supermarket price war.

The net effect was that earnings before interest and tax fell only 7% in the half, compared to the guidance at its AGM in May for an 8-9% fall. But, with no end in sight to the supermarket price discounting, the company now expects a fall in full-year EBIT of up to 4%, compared to the prediction of flat profits at the AGM.

The supermarket discounting led to a 14% fall in volumes through the grocery channel, compared to a 2% rise in non-grocery volumes (volumes in the Australian soft drinks business are split fairly evenly between the two). Overall, EBIT for the Australian soft drinks business fell 10%.

Management said it was lining up a 'strong summer promotional and marketing programme' and had 'a number of new product launches in the pipeline'. It also pointed to (previously announced) targeted cost savings of $10-15m. But it wasn't able to provide a real solution to the underlying cause of the problems – that Coke is becoming very expensive compared to its main competitors.

Poorly placed

In the first half, the premium over Pepsi rose to 48%, from 38% in the first half of 2012 and 24% in 2005. The premium over supermarket brands is greater still. At some point there will no doubt be some respite, but the longer-term trend appears well established – the supermarkets are taking more control at the expense of premium brands like Coke. CCA is particularly poorly placed because it makes its margin on top of what it must pay to its 29% owner, the Atlanta-based Coca-Cola Company, for concentrate.

Management has responded by spending heavily on high-tech 'blow-fill' production facilities in Australia, but the concern is that this won't be enough and that ultimately it will need to take more drastic action, perhaps moving some production offshore.

For the time being management appears dead set against this. In May, managing director Terry Davis was quoted by The Australian Financial Review as saying he preferred to keep manufacturing in Australia 'because I'm a believer that we have to have a manufacturing industry in this country, because if we don't, we do so at our peril'. But Coca-Cola Amatil's job is to make money for its shareholders, not to support Australia's manufacturing industry. Davis is due to retire in August 2014 and his successor will face some tough questions.

Growth offshore

In the meantime, Davis was much keener to talk about the good things happening in Indonesia, where EBIT grew over 15%, and New Zealand and Fiji, where EBIT grew 10%. There was also good news in the Alcohol, Food and Services segment, where the company signed a new 10-year partnership deal with Jim Beam and an exclusive distribution agreement with Molson Coors – although EBIT fell 10% due to the ongoing problems at SPC Ardmona.

But all told, these other businesses provide less than a third of group profit. At least for the time being, results will be dominated by the Australian soft drinks business.

The cash performance was also poor, with operating cash flow falling from $222m to $180m, before significant items, due largely to a $73m increase in inventories. Much of that, in turn, was due to 'temporary stock build to de-risk the business' while production is shifted between sites and two blow-fill facilities are commissioned in WA and Victoria.

These new blow-fill facilities, as well as two more in Queensland, contributed to capital expenditure of $113m in Australia, while $65m was spent in Indonesia and PNG. In all, capital expenditure came to $187m and that's expected to increase to $430m for the full year. Free cash flow for the half was a negative $16m.

Underinvesting

When we reassessed Coca-Cola Amatil on 12 Jun 09 (Hold – $8.40), using 2008 numbers, we removed the company's 'investment in bottling agreements' (ie its long-standing agreement with The Coca-Cola Company) from its asset base and came up with an adjusted figure of $2.9bn for the capital it needs to operate. We were pleased to see that this had only risen from $2.8bn two year's previously, while EBIT had risen 23% to give a return on our adjusted capital of 25% (see Table 2).

In that review we suggested that the stock might be worth between 13 and 18 times earnings. At the time it was trading at 14 times; now it's up at 17 times based on the new guidance.

Making matters worse, though, is that looking again at the capital position, it looks like the company may have been underinvesting in the years up to 2009, thus flattering its returns. In the five years since, capital investment has amounted to about $1.8bn and, by the end of this year, our adjusted capital base will have increased by about a third to $3.8bn. Meanwhile, EBIT will have risen only 23% assuming the company hits the middle of this year's guidance range.

This would drag the adjusted capital figure down to 23%. On its own that would still denote an excellent business, but of course it's the future that matters and the incremental return on capital invested over the past five years is only 17%. This reignites our concerns about CCA's underlying core business, which is essentially caught between the rock in Atlanta and the hard place that is Woolworths and Coles.

Fiddling while Rome burns

These concerns are accentuated by the company's weird approach to capital management. After the payment of $249m of dividends in the first half, net debt rose from $1.6bn to $1.9bn and interest cover fell from 7.2 to 6.1. That's getting to be on the thin side and it's heading in the wrong direction. Yet the company still saw fit to add a special unfranked 2.5 cent dividend to its regular interim dividend, which was maintained at 24.0 cents but which will only be franked to 75% this year (ex date for both 23 Aug).

This is just smoke and mirrors. If the company wants to increase its dividend it should do so, without fiddling around with tiny special dividends. What it should be doing, though, is holding the dividend, or perhaps reducing it, until cash flow improves.

It smacks of fiddling while Rome burns and it makes us very uncomfortable. Don't be fooled by this company's supposed defensive characteristics. It's caught between some powerful players and its profits could get badly crunched.

It's possible that we're jumping at shadows, that Pepsi and the supermarkets will settle things down and that steady profit growth will return. But the price-earnings ratio of 17 doesn't allow much leeway. We're raising our share price risk rating a notch, cutting our price guides and downgrading to SELL.

Note: The original version of this article used a 2012 EBIT number stated after significant items, which therefore gave an incorrect EBIT number for 2013 of $746m. The EBIT numbers for 2012 and 2013(f) have therefore been changed to $896m and $878m. This increases the ROCE for 2013(f) from 19% to 23% and the incremental return on capital since 2008 from close to zero to 17%. However, the price-earnings figure of 17 was always based on an earnings per share figure before significant items and has not been changed, and we think the argument still stands, which is that return on capital has deteriorated (albeit by much less than originally stated) and that we're close to the top of our previously stated valuation range. 22 Aug 2013.