Big Tobacco, Big Pharma and Big Oil – they all refer to powerful industry incumbents. But ‘Big Cola’ does not (as you might expect) refer to Coca-Cola, the brand of black, sugary soft drink that presumably needs no introduction.
Rather, Big Cola is an upstart, challenger brand owned by South American beverage group AJE Group. It’s also a source of big problems for the global market leader, The Coca-Cola Company, and its Australian-based bottler, Coca-Cola Amatil (‘Amatil’). So why is Big Cola – a brand you’ve probably never heard of – such a threat?
Premium beverages suffering globally
Price cuts in Australia look desperate
Stock not cheap given risks
Well it’s not, in Australia at least. You won’t see Big Cola in Australia, the country that accounts for 70% of Amatil’s non-alcoholic beverage earnings, any time soon. But Big Cola is a threat in Indonesia, a country that Amatil has glowingly described as an ‘exciting growth market’. The upstart brand is now the biggest selling soft drink in that country with a 14% market share; not bad given that AJE Group only entered Indonesia in 2010.
With increased competition, a wages explosion and the depreciation of the Indonesia rupiah, Amatil’s Indonesian and Papua New Guinean earnings have plummeted (see Chart 1). So much for a ‘growth market’. How is Amatil responding to the threat?
The way incumbents usually do: by throwing money at the problem. The Coca-Cola Company, Amatil’s 29% shareholder, agreed to take a 29% share in the Indonesian business for US$500m last year. According to the 2014 announcement, the funds will be invested in ‘production, warehousing and cold drink infrastructure’ but the venture also intends to develop ‘affordable packages’ and ‘transform its route-to-market model’.
Translating the corporate gobbledygook, this implies Amatil’s products in Indonesia are too expensive, as is its distribution model. Indeed, this only throws AJE Group’s competitive advantage into sharp relief. AJE targets less affluent consumers in developing markets, keeping its distribution costs low by outsourcing delivery to independent drivers.
Premium strategy undercut
In simple terms, Amatil’s premium strategy is being undercut by a low-cost competitor. And, in our view, a defensive US$500m investment in Indonesia is a sign of weakness rather than strength. But with Indonesia and Papua New Guinea representing only 8% of Amatil’s earnings (see Chart 2), perhaps it doesn’t matter?
Well it does. Because the success of Big Cola in Indonesia runs parallel to a problem Amatil has in Australia. The beverage market is fragmenting here too, reflecting a preference for value, changing consumer tastes and a relentless push by supermarkets to steal margin from consumer brands. Nowhere is this more evident than in the market for bottled water.
Whilst surely a contender for ‘most useless product ever’, more than a quarter of Australians drink bottled water in any given week. Almost 40% choose Mount Franklin, Amatil’s market-leading premium bottled water brand. In its 2014 annual report, though, management noted that ‘value water has been the stand out growth category in the grocery channel, a category [Amatil] only has a small share in.’
This is Amatil’s problem in a nutshell. It is strong in categories that consumers have been losing interest in, like premium water and soft drinks. In supermarkets, soft drinks have lost about 7 percentage points of total market share over the past eight years to around 50%, with bottled water gaining about 10 percentage points to 20%. The market share of private label cold beverages has gained a massive 14 percentage points to 23% over the same period. For Amatil, these are extremely unfavourable trends.
So, if Amatil’s beverages have been losing market share in Australia, how has it managed to keep revenue from falling sharply? Simple – by increasing prices.
You can see the effect in Chart 3. Australian beverages revenue rose until 2012 as the company increased the price per case. Ironically, though, this helped drive consumers away from Coca-Cola Amatil’s brands over time. Alison Watkins, the chief executive who joined in 2014, is now cutting prices to stimulate demand. It’s why revenue per case fell sharply in 2015.
Discounting did have an effect in 2015, although not much – volumes rose by only 0.5%. Of course, Amatil’s management is not standing idly by while its business erodes. It is cutting costs, broadening its portfolio, changing packaging sizes and improving its marketing. But revenues are flat or declining at other Coca-Cola bottlers around the world and it’s hard to see how Amatil will escape the same trends.
Companies can still make money in flat to declining markets. Indeed, one of the paradoxes of investing is that they can be more profitable than ‘growth markets’ (exhibit A: Indonesia). But as a potential shareholder you need to pay the right price.
Since we downgraded Coca-Cola Amatil to Sell in Coca-Cola Amatil: Interim result 2013, the share price has fallen 25%. Back then, the stock was trading on a PER of 17 and we stated ‘profits could get badly crunched’.
And so they have. Between 2013 and 2015, earnings per share fell from 65.9 cents to 51.5 cents. That means Amatil currently trades on a PER of 18 and an enterprise value to EBITDA multiple of 9.5. While management is ‘targeting’ a return to mid-single digit earnings per share growth, those multiples don’t seem particularly cheap next to the risks. Remember too that bottling and distributing beverages is a capital-intensive business – over the past three years, capital expenditure has consumed 45% of Amatil’s operating cash flow.
Coca-Cola Amatil isn’t a terrible business; it’s just a worse one than its brand might suggest (and let’s not get into the disaster that is its food business, SPC Ardmona). No doubt the company will use its financial muscle and marketing power to diversify its product range, which it will then push through its unrivalled distribution system.
But the shift away from premium soft drinks towards cheaper and healthier drinks isn’t going away. With strong headwinds buffeting the company, management’s forecast of ‘no further decline’ in earnings per share after 2014 might be optimistic.
There's a reasonable case for reiterating the Sell recommendation made in 2013, but we’ll settle for lowering our Buy price from $8 to $7 and reducing our recommended maximum portfolio weighting from 7% to 5%. Both reflect that Coca-Cola Amatil faces a surprising number of threats for a market leader. Shareholders should be mindful that the risk of profit downgrades in the short term is rising, but our recommendation is HOLD.