The Coca-Cola Company (NYSE:KO) Q2 Earnings Preview: Poor Weather Curbing Consumer Thirst

The Coca-Cola Company (NYSE:KO) is expected to report slightly higher second-quarter profit on flat revenue as poor weather and soft economic conditions have negatively impacted beverage consumption around the world. The world's largest soft-drink maker is also trying to adapt to criticism that its sugary drinks fuel obesity.

The company, which reports earnings on July 16 before the markets open, is likely to report its earnings per share, or EPS, inched up to 63 cents from 61 cents on flat revenue of $13 billion, compared with the year-ago quarter, according to analysts polled by Thomson Reuters.

“If you take the first quarter and you throw in lousy weather, payroll tax, actually the price of gasoline, what that then does to your immediate consumption versus future consumption business, it's going to have an impact on your profitability,” Gary Fayard, chief financial officer of Coca-Cola said, during the company's first quarter earnings conference call in April.

The Atlanta-based company is fully hedged on the euro, the Japanese yen, and the British pound for 2013 and into 2014. "After considering these hedge positions and current spot rates, we expect currencies to be a 3 percent headwind for the second quarter, and a 2 percent headwind for the full year," Fayard said.

And, in a note to clients, Goldman Sachs analyst Judy E. Hong said: “The further bifurcation between the high end and low end consumer in the U.S. despite generally improving underlying U.S. fundamentals suggests to us that the payroll tax impact is having a role in the 2013 consumption weakness, albeit a hard to quantify one.”

With commodity cost increases slowing, the company projects an increase of about $100 million in sweetener, juice, metals and PET costs compared to $225 million in 2012.

Coca-Cola continues to see a rational pricing environment and they expect this trend to continue, which is encouraging for the overall profit pool. The beverage giant emphasizes that if commodities go down, that they are unlikely to reinvest that in price as they have worked hard to earn the price they take in the marketplace.

Due to a shift in geographic mix, gross margin improvement will likely moderate over the remainder of the year.

“We expect operating profit to grow slightly faster than sales as higher prices and cost-cutting initiatives offset an unfavorable mix, with lower-margin emerging markets growing faster than developed ones,” S&P Capital IQ Equity Analyst Esther Kwon wrote in a note to clients.

Coca-Cola now expects structural changes to have a negative 1 percent impact for the year.

Poor Weather Damps Soda Sales

A chilly spring and a wet June are not making cold drinks appealing to U.S. consumers.

Heavy snowfall kept many U.S. consumers indoors in April. The first two months of the second quarter were the coldest in the U.S. since 2008 and the 11th wettest in the past 119 years, according to Earth Networks, a weather service.

Memorial Day, typically a big revenue generator, was “no picnic,” J.P. Morgan beverage analyst John Faucher said, in a research note last month, citing Nielsen scanner data at large retailers showing a 3.6 percent drop in U.S. soda sales in the four weeks ended June 8.

Planalytics, a weather-analysis firm, said U.S. precipitation last month was the most in more than 50 years, with 44 percent more rainfall than in June of last year.

Cold and wet conditions in Europe also have damped demand for beverages, prompting regional bottler Coca-Cola Enterprises Inc. (NYSE: CCE) to trim its full-year guidance last month.

Obesity Concerns

As consumers shift away from the carbonated soft drink category primarily driven by health concerns due to high calorie count and minimal nutritional value in these beverages, low-calorie (diet) variants and still beverages are becoming increasingly important to Coca-Cola’s revenue growth in developed markets.

“We see improved trends for non-carbonated beverages as consumers return to healthier products after briefly trading down to cheaper alternatives during the recession,” S&P Capital IQ Equity Analyst Esther Kwon wrote, in a research note.

According to Associated Press, consumption of sugary drinks and obesity rates in America have risen in tandem, doubling since the 1970s.

While Coca-Cola in recent years has grown its business with sports drinks, bottled water, and low- or zero- calorie sodas, overall soda consumption has declined per capita by 16 percent since 1998. Between 1998 and 2010, soda consumption per capita fell by 16 percent. The amount of soda consumed declined 1.2 percent in 2012 -- down to 1996 levels, with per capita consumption in the U.S. falling to 1987 levels.

In a bid to revive consumption in the carbonated soft drink category, Coca-Cola is increasingly focusing on promoting its low-calorie offerings.

Recently, Coca-Cola launched a worldwide campaign against obesity in which the company pledged to expand its low- or no-calorie offerings and labeling calorie count on its products, among a couple of other initiatives.

Coke said that nearly a quarter of its 3,500 beverages, including juices and water, have few or zero calories, but that those options were not widely available in all markets. Coke said roughly one-third of its sales volume in North America is derived from low- and zero-calorie drinks. But in Latin America, for instance, such drinks only make up 18 percent of company volumes. In China, zero-calorie cola sales make up less than 10 percent of Coke's cola sales.

Coca-Cola announced last month it will start to sell a 250ml can alongside its traditional 330ml can in the U.K. as it seeks to meet the needs of health-conscious consumers. The fizzy drink company also launched a stevia-sweetened variant of its flagship brand in Argentina, Coca-Cola Life, which contains 50 percent less calories than the regular Coke.

“We expect the company to reap benefits from this initiative in terms of market share gains, primarily driven by higher sales of its lower-calorie products and increased brand equity. It should also be noted that the higher proportion of smaller servings in sales mix is a net positive for beverage companies since higher revenue per ounce more than offsets lower volume sold per transaction,” according to Trefis research.

Furthermore, a better volume-mix driven by higher priced, no-calorie products such as Coke Zero, will boost operating margins of the company as well. Coke Zero volumes grew by 6.5 percent in 2012 compared to the company-wide volume growth of 4 percent.

Geographic Mix

Coca-Cola sells its products in nearly every corner of the globe -- Cuba and North Korea are the exceptions.

Coca-Cola relies on more than 30 percent of its global sales volume on four international markets, namely Mexico, China, Brazil and Japan. Coca-Cola has noted that Americans on average drink 403 servings of its various beverages a year. That compares with just 12 servings a year in India and 38 in China.

More recently, the company announced a $200 million investment in Myanmar -- a country with a population of more than 60 million people -- over the next five years, and became the first American brand to start manufacturing its products locally since most American sanctions against Myanmar were lifted a year ago.

However, emerging market growth dependence is coming into question.

Goldman Sachs' Hong notes that civil unrest in Brazil, Turkey and Egypt; concerns over a credit crunch and slowing economic growth in China; retreating commodity prices; and broader worries over the ability of emerging markets to transition to tighter monetary policy have all served to increase concerns over what has been largely dependable emerging market growth over the past few years.

The expectation coming into 2013 was that European fundamentals were not going to get better but it was unlikely they would get worse, particularly off easy weather comparisons in 2012.

However, Hong believes that Europe may have seen further softness in the second quarter of this year, partly again due to weather, but additionally to incremental consumption softness as the impact of austerity perhaps is starting to bite more than anticipated, even as economic measures are holding up for the most part.

Refranchising

Less than three years after spending billions of dollars to acquire most of its U.S. distribution operations, Coca-Cola announced in April that it was starting to sell off its U.S. bottling system again.

The plan for the new deal allows Coca-Cola to keep direct control over 75 percent of its U.S. distribution, versus 80 percent currently. The company also indicated that more franchise deals are in the works.

The reason for the move is simple. Getting out of the capital-intensive, low-return business of delivering bottles and cans of soda to stores, restaurants and vending machines will improve margins.

“Longer term, we expect these moves to improve operating margins as the bottling business has significantly lower operating margins than the concentrate business,” S&P Capital IQ Equity Analyst Esther Kwon said.

First Quarter Recap

In April, Coca-Cola announced its first-quarter net income fell 15 percent to $1.75 billion, or 39 cents a share, from $2.05 billion, or 45 cents a share, in the same period a year ago. But excluding items such as restructuring charges, economic hedges and certain tax matters, EPS was 46 cents, slightly ahead of the 44 cents expected by analysts. Revenue decreased 0.9 percent to $11.04 billion. Worldwide unit case volume climbed 4 percent. Gross margin edged down to 60.8 percent from 61 percent.

Stock Performance

Coca-Cola is easily one of Warren Buffett's favorite stocks. In a recent interview, he said, “We've never sold a share, and I wouldn't think of selling a share.”

Coca-Cola pays a dividend of 2.8 percent, and shares have gained 13.2 percent this year. The company's payout ratio is 55 percent. The company said in April that it is still targeting share repurchases in the range of $3 billion to $3.5 billion for the full year.

Coca-Cola's major competitor, PepsiCo, Inc. (NYSE: PEP), is set to report its second-quarter earnings results on July 24 before the market opens on that day.

Other competitors include: Dr. Pepper Snapple Group Inc. (NYSE: DPS), Monster Beverage Corp. (NASDAQ: MNST), Coca-Cola Enterprises Inc. (NYSE: CCE), Unilever N.V. (NYSE: UN), and Kraft Foods Inc. (NYSE: KFT).