Tuesday, February 7, 2012

Coca-Cola Reports Full-Year and 4Q 2011 Earnings

From the Coca-Cola (KO) Full-Year and 4th Quarter 2011 Results released earlier this morning:

The Coca-Cola Company reported worldwide volume growth of 5% for the full year and 3% during the quarter. Excluding new cross-licensed brands in North America, primarily Dr Pepper brands (which the Company began distributing Oct. 2, 2010), worldwide volume grew 4% for the full year, at the high end of our long-term growth target. Volume growth for the full year was well-balanced across the globe, with solid growth in key developed markets like North America, Japan and Germany and double-digit growth in key emerging markets like India and China. In addition, solid growth continued in countries with per capita consumption of Company brands less than 150 eight-ounce servings per year, with volume up 6% for the full year and 4% in the quarter.

The press release also added the following:

We continued to see growth in sparkling beverages, with gains in global volume and value share for the full year and in the quarter. This growth was driven by our continued focus on and investment in our brands, starting with brand Coca-Cola. Brand Coca-Cola volume grew 3% in both the full year and the quarter, with strong growth in the fourth quarter in a number of markets around the world, including 33% in Thailand, 15% in India, 13% in China, 12% in Argentina, 9% in Germany, 8% in Russia, 4% in both Mexico and France, and 3% in Japan.

Perspective can sometimes be lost comparing earnings year over year or quarter over quarter. Occasionally, it is worth stepping back a bit instead of making such short-term comparisons. For an investor, understanding a company's long run capacity to earn is what matters. Sometimes the near-term noise gets in the way of understanding that sort of thing.

Let's see how Coca-Cola's business has progressed since prior to the beginning of the financial crisis. One test of a good business is how it performs during times of stress.

I think it's fair to say that 2006 to 2011 saw more than its share of economic challenges.

Coca-Cola's earnings in 2006, the year before the market peaked and the financial crisis started unfolding, was just over $ 5 billion.

During 2008, when the financial crisis was really gaining some momentum earnings came in at $ 5.8 billion (slightly lower than 2007). So while many other businesses experienced dramatic reductions in profitability, Coca-Cola continued to do just fine. The economic stresses merely ended up delaying some earnings growth.

From the most recent earnings report, we just learned that Coca-Cola earned $ 8.6 billion for the full year of 2011. 

So, with $ 8.6 billion in 2011 earnings, the company appears to have been able to improve earnings nearly 70% compared to the just over $ 5 billion it earned in 2006 (on a per share basis it's slightly better as share count has been reduced slightly via buybacks). I think that counts as a pretty solid performance considering much of that time contained an extended tough economic environment.

It's not just that Coca-Cola's earnings have fully recovered to pre-crisis levels and then some (some lesser businesses have still not even returned to pre-crisis profitability), it's that earnings didn't drop off much during the worst of the crisis.

A sign of resilience.

A good way to understand the earnings power of most businesses is to see what happens over a full business cycle and be sure the earnings doesn't come from events that result in one time gains.*

For some, a full business cycle isn't even long enough.

One easy mistake to make is to value certain cyclical businesses (something Coca-Cola certainly is not) with higher operating leverage (and, in some cases, financial leverage) using peak or near peak earnings. Cyclical businesses typically look cheapest when they are actually quite expensive. So an investor needs to normalize earnings over many years to get a meaningful economic picture and avoid misjudgment.**

Coca-Cola's stock now sells for around $ 68/share. At that price, the stock is no longer a bargain as it sells for ~18 times 2011 earnings.

On a forward basis it looks a bit cheaper, of course, but as is usually the case the opportunity to buy the stock with a large margin of safety was a couple years back when the economic storm clouds were front and center.

Adam

Long position in KO established at much lower than recent market prices

* In 2010, Coca-Cola bought the North American bottling business from Coca-Cola Enterprises (CCE), its largest bottler: MarketWatch - Coca-Cola buying CCE North American bottling business.  Excluding that type of gain is the best way to understand Coca-Cola (or any business) on an operating basis. 
So Coca-Cola's earnings in 2010 including a large one time gain from the purchase of those bottling operations. Reporting the one time gain this way is required by Generally Accepted Accounting Principles (GAAP) as it should be. Yet, it ends up making net income appear larger than it really is on an operating basis. Though correct from an accounting point of view, it may make Coca-Cola seem cheaper than it is if just a simple ratio is used without backing out the one time gain. The non-recurring gain should be backed out to get a more meaningful picture of Coca-Cola's true current operating economics. (As it turns out, this one time gain did actually make Coca-Cola's price to earnings (P/E) ratio appear lower on some of the popular finance sites. The "E" in "P/E" can't be relied upon unless it has been checked for non-recurring gains and losses.) 
** This is especially true for highly cyclical businesses that are capital intensive (think airlines and auto manufacturers). Those with less predictable revenue and high operating leverage (high fixed costs) are usually more vulnerable to financial strain during a serious economic crisis especially if financial leverage is also involved. Adding financial leverage is usually a bad idea in any business with inherently less predictable revenue, a lack of pricing power, and high operating leverage. So sometimes avoiding certain so-called "cheap" cyclical businesses altogether makes sense. In other words, no price is low enough to account for the potential risks during an economic downturn. In other cases, a perfectly good business with durable competitive advantages just happens to have inherently more variable earnings. So highly variable earnings is not, in itself, a problem if the business is built to handle economic busts. Being built to last likely means having a sustainable position as low cost producer (or possibly some other advantage unique among competitors), a fortress balance sheet, and capable management. Businesses with predictable revenue and a little pricing power can usually safely handle a bit more financial leverage. Both operating leverage and financial leverage magnifies gains and losses (reward and risk). The businesses that had profitability drop the most during the recent financial crisis likely had one or both types of leverage working against them (and if they survive...working for them).
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