Coca Cola: When less is more

When true believers like Dan Christensen cross Pemberton Place, a 20-acre plaza in the heart of Atlanta, they are beckoned by the sound of bottles popping and bubbles fizzing from the speaker-system at the World of Coke museum.

Mr Christensen, a farmer from Idaho, grew up drinking 24 bottles of Coke every single day. "Coke is wonderful - it's fizzy, it's bubbly . . . it's America," he says, near the bronze statue of John Pemberton, the Atlanta pharmacist who invented Coca-Cola in 1886 as a "brain tonic" that would soothe nerves and deliver a reinvigorating kick.

But now, like many Americans, Mr Christensen has a doctor who has told him that his sugar consumption is too high, so he is limiting himself to two bottles a day "I cut out candy bars," he says. "But I still have to have my Coke."

Benjamin Guzman a 23-year-old engineer, crossing the plaza on his way to work says he drinks a Coke "probably just once in a while - nothing excessive like one a day."

That difference in definition of what constitutes "a lot" of Coke, between a baby boomer's dozen and a millennial's single bottle, is at the heart of the transformation that the Coca-Cola Company, headquartered just a mile away, is undergoing.

Fizzy drink sales volumes fell in the US for the 10th consecutive year in 2014, according to Euromonitor, and even sales of diet drinks are in decline because of consumer health fears over artificial sweeteners. The trend is similar in many advanced economies even as demand grows in emerging markets

Although still drinks, including bottled water, are growing much faster than their carbonated counterparts, fizzy still makes up 70 per cent of Coke's sales. Out of every two carbonated drinks sold through a shop in the world, one is manufactured by the Coca-Cola Company.

Yet its revenues have fallen - by 4 per cent to $46bn between 2012 and 2014 - and net profits have slipped, by 21 per cent to $7.1bn, in the same period. Leading some shareholders to become restless about the company's direction.

The challenge for Muhtar Kent, Coke's chairman and chief executive, is clear, if not straightforward: to forge a future for the world's largest carbonated drinks company when growing numbers of people are falling out of love with its fizzy drinks.

The 62-year old's solution has been to shift from a volume-centric model that brought the world the 32oz Big Gulp, and its morbidly obese bigger brother, the 1 gallon Team Gulp, to one that emphasises "more people drinking Coke products more often."

Some shareholders remain to be convinced.

"Mr Kent has given the impression that reviving carbonated soft drinks is the be all and end all, but now I hope he finally gets it," says one senior shareholder arguing that Coke has been too focused on volume and not enough on profitability. "Investors will give management a pass this year, but not if 2016 turns out to be another transition year."

The Coke chief declared 2014 the "year of execution" and pledged a $1bn marketing drive to boost volumes. Last autumn he promised a $3bn cost-cutting programme to improve profits branding 2015, a year of "transition."

The critical voices are a minority and Mr Kent enjoys the backing of Warren Buffett, whose Berkshire Hathaway investment company is Coke's biggest shareholder with a 9 per cent stake. But the criticism could grow louder should the Kent plan fail to bring results.

The first indication of how this year is shaping up, will come tomorrow when the group announces its first quarter earnings. Analysts expect the improvement seen towards the end of last year to continue, with organic revenues forecast to rise by 9 per cent against just 2 per cent in the same period last year.

The shares are back at highs last seen in 1998, boosted in part by the cost-cutting plans . But they have underperformed both arch-rival PepsiCo and the S&P 500 over the past three years.

Change comes slowly at Coke, partly because of its size - it is the 13th largest US company with a market value of $177bn. But also because it still bears the expensive and humiliating scars of New Coke - the episode when it risked changing Coke's fabled secret formula only to be forced to reverse the decision after a public outcry.

For more than half of its roughly 130-year existence, the company sold just one product in one of two packages: classic Coke at a soda fountain or in a 6.5oz glass bottle. In 1955, the company introduced 10, 12 and 26oz bottles. But by the 1990s those sizes expanded to what executives now admit are absurd proportions, along with American waistlines and the obesity rate.

"We're now in the business of selling Coca-Cola again in the size that the consumer wants it, which is smaller," says Sandy Douglas, president of Coca-Cola North America. "More people could be drinking Coke more often and paying more money for the experience.

"The notion that the Coca-Cola brand needs to be overconsumed for the company to grow is just mathematically false," he argues.

He points to smaller packages - including 6.5 and 8oz cans and bottles - as the future of the company. These sizes currently account for just 5-6 per cent of total sales, although their percentage of revenue, he says, "is significantly higher than that". But sales are growing at 10-15 per cent annually.

The shift in consumer tastes has a lot to do with warnings from health campaigners and government departments to reduce sugar levels in diets.

"More and more people are connecting soda to tooth decay, obesity, heart disease, diabetes - it's kind of lost its cache as just this fun, frivolous product that you drink because it tastes good," says Michael Jacobson, head of the Center for Science in the Public Interest.

The trend for consumers to choose natural over processed is likely to stick for the long term. Instead of Coke, they choose Smartwater or Simply Orange or Honest Tea or Vitaminwater or Powerade - each, as it happens, a product of the Coca-Cola Company.

The company says it is dedicated to "following the consumer", which is why it has been on a spending spree to diversify. Last year it paid $2.15bn for a 16.7 per cent stake in Monster Beverage , the energy-drink maker; went into coffee by paying $2bn for a 16 per cent share of Keurig Green Mountain and also acquired Zico coconut water. It has even entered the dairy business with the launch last month of Fairlife, a line of lactose-free milk.

The company now sells 3,500 varieties of 500 brands in dozens of package sizes and configurations, up from 2,600 varieties of 400 brands when Mr Kent took the reins in 2008. Last year US sales of the company's juices rose by 7.6 per cent, flavoured waters by 2.5 per cent and teas by 16.3 per cent, according to Beverage Digest data. While its fizzy offerings fell 1.3 per cent by volume.

The question is whether Coca-Cola has been too slow in spotting and responding to these consumer trends.

"We do think that they're really taking steps in the right direction," says Ali Dibadj, analyst at Bernstein. "Perhaps not as quickly, or as deeply, as we would like."

Mr Dibadj argues that Coke's relentless pursuit of market share has led to needlessly weak pricing in the US. Though the US accounts for 45 per cent of Coke's sales, it contributes only 22 per cent of profits.

Profitability has also been dragged down by Coke's ownership of its biggest North American bottler which it took over five years ago to address underperformance. Coke has a complex global bottling system of 250 independent or partly Coke-owned franchisees, to whom it sells its concentrate and which the franchisees manufacture and market locally.

Nomura calculates that the operating profit margin of the Coca-Cola system - the company plus its bottlers - is 16 per cent, which is far lower than the industry average for fast-moving consumer goods of 24 per cent.

Mr Kent has tried to improve efficiency by encouraging more consolidation among bottlers. In Spain and Portugal, for instance, eight bottlers have combined, sparking a furious reaction from workers and a dispute with Spain's Supreme Court.

The chief executive insists he will improve profitability. His $3bn cost-cutting package includes 1,800 job losses among its 130,000 global employees. But some analysts believe he could go further. In 2012 when PepsiCo faced a similar problem it cut 8,700 jobs, 3 per cent of its total workforce.

Wintergreen Advisers, a small Coke investor, says a combination of this underperformance and attempts last year to push through a large pay rise for management have undermined Mr Kent. David Winters, its chief executive, has called for the Coke boss to resign.

"Coca-Cola should be a fabulous business but current management has produced only a pedestrian performance from what is probably the best brand in the world," says Mr Winters. "There is no sense of urgency here that there's a problem or that the cost base has got to be addressed more radically."

While Mr Winters agitates for change, some larger institutional shareholders welcome Coke's cost-cutting plan and recent dividend hike.

"This is a pretty good management team, front-footed and innovative," says one of Coke's largest investors.

But if Mr Kent does not extract more value from the company, some M&A bankers and analysts believe it could one day become a target - albeit a huge one - in particular for Anheuser-Busch InBev, the world's biggest beer company, and the trio of Brazilian cost-cutting investors that are its biggest shareholders.

The ambitious Brazilians, including Jorge Paulo Lemann, also own 3G Capital, the New York private equity fund. Mr Buffett has said he would like to do more deals with them following the joint acquisition in 2013 of Heinz, the US food manufacturer, which last month struck a $100bn deal to take over Kraft Foods .

Ian Shackleton, Nomura analyst says: "The numbers are enormous but feasible. You could create more value out of Coke than almost any other fast-moving consumer goods company." He cautions that the Kraft deal rules out such a scenario in the short-term but believes Coke would benefit from deeper cuts to its operations and could squeeze better returns out of its bottlers.

Mr Buffett's 9 per cent stake in Coke would make a good start point but asked last year whether he might take Coke private, the veteran investor said there was "absolutely no chance of that".

Mr Kent faces an uphill struggle if he is to meet his target of doubling revenues while expanding margins for the Coca-Cola system to $200bn by 2020.

One thing seems certain, however; there will be no return to the supersized containers of the past. In a comment that would have been corporate sacrilege even five years ago, Mr Douglas says: "There'll be some archivist looking back at the big packages of the 1990s, and people will shake their head and say, good Lord, who would drink that much?"

Additional reporting by Stephen Foley

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