Last drinks for Coca-Cola Amatil

A hot summer is undoubtedly good for Coca-Cola Amatil. If you live in New South Wales and Queensland you're currently sweltering through a heatwave, although you might be wondering where summer's gone elsewhere (at 4pm yesterday it was 33 degrees in Sydney, but just 17 in Melbourne).

Whatever happens from year-to-year, though, the long-term trend in soft-drink consumption is down. It's already starting to show up in Coca-Cola Amatil's numbers: while revenues to the end of 2015 grew 6% over five years – a weak performance – operating earnings fell 24%. Most of that was due to a step down in Australian non-alcoholic beverage earnings in 2014.

Management has been busy trying to plug the holes with cost cutting. As we said in Coca-Cola Amatil: Interim result 2016 back in September, it has had some success. Management is continuing down that road, selling manufacturing plants to fund cost-saving capital expenditure programs.

But cost cutting will only produce long-term earnings growth if it's eventually accompanied by revenue growth. Here, the signs are not promising. Soft drink sales were the weakest performing Australian grocery category in the 2016 financial year. In the United States, soft drink sales have now marked their 11^th consecutive year of decline and per capita consumption is at 1985 levels. While long-advanced in the US, the downward trend in Australia has only recently begun.

Ten green bottles

Even if Amatil manages to eke out a little revenue growth over the next few years, it will face other headwinds. We mentioned in Coca-Cola target at risk in October that container deposit schemes will be launching in New South Wales, Queensland and Western Australia over the next 18 months. Victoria seems unlikely to hold out forever.

Then there's the threat of a ‘sugar tax', similar to the one the UK is introducing on soft drinks from 2018. The current federal government's attitude is more likely a ‘no' than a ‘yes', but sugar taxes are becoming more common worldwide, and future Australian governments will likely consider one.

While Amatil is about more than its Australian beverages business, that division still produced 66% of earnings in the first half of 2016 (the company has a calendar year end and will report its 2016 results on 22 February).

Most analysts are assuming Amatil will return to revenue growth over the next three years. In light of the accelerating 4% decline in Australian beverage division revenue in the first half, we think that's very optimistic. We've run a few scenario analyses for the division for the 2018 year and, assuming a 3% reduction in revenue annually, and that full-year costs are flat on first half 2016 levels, the effect on earnings in Table 1 is clear. This is our base case.

Cold comfort

Perhaps Coca-Cola will cut costs harder than expected, or perhaps revenue declines will be held in check by new products or clever marketing, but we doubt it. You can be sure that if Australian beverage earnings are 23% lower in 2018 then, whatever happens elsewhere in the business, the share price will be much lower. So will the dividend.

The result to be released on 22 February might reassure the market. Cost cutting and lower interest charges mean managing director Alison Watkins is likely to deliver earnings growth. Don't be fooled. The medium-term earnings recovery that many analysts are forecasting to 2018 and beyond is misplaced. Amatil is a higher risk business than its excellent brands and reputation suggest.

We've previously suggested you sell above $10.00 and the stock has exceeded those levels recently. But we think the headwinds are strengthening and that Coca-Cola Amatil faces structural issues it will be unable to overcome with cost-cutting alone. We're lowering the prices in our guide and switching to SELL.