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Morningstar | Coca-Cola Amatil's Investor Day-Ja Vu; We Reduce Our FVE, and Shares Fairly Valued. See Updated Analyst Note from 03 Dec 2018

Narrow-moat Coca-Cola Amatil’s 2018 analyst day echoed the themes of last year's event: continued challenging conditions in Australia due to consumer health concerns and competitive pricing, necessitating accelerated investments; tough Indonesian trading conditions; offsetting positive factors in New Zealand, and the alcohol and coffee segment. While we're encouraged that management remains committed to its medium-term target of mid-single-digit EPS growth, the path to this performance will again face a near-term bump in fiscal 2019. We've also become less optimistic that investments and cost savings will drive the same degree of profitability improvement we previously forecast in Australia, with most of these developments reinvested into the business. As a result, we’ve reduced our long-term EBIT margin forecast for the domestic segment by about 150 basis points, and now see EPS growing at just a 2% clip over the next five years, versus nearly 4% previously. Our fair value estimate falls 5% to AUD 8.90, with shares screening as fairly valued.

Amatil’s Australian revenue growth performance is tracking our expectations. Despite positive developments in first-half fiscal 2018 for Amatil’s Australian business, where volume fell a slim 0.3%, management noted that second-half performance remains below prior comparable, or pcp, levels. This is in line with our forecast for full-year volumes to decline at about 0.2%, with solid performance in energy drinks, water, and other noncarbonated products offsetting further declines in carbonated soft drinks. Similarly, we're not surprised by management’s comments that pricing remains challenging, particularly in noncola categories. We forecast subinflation average price improvements in all categories expect energy drinks over the next five years, albeit with smaller package sizes, positive mix shift, and container deposit scheme cost pass-throughs leading to revenue per liter growing at about 2% per year.

But the cost to achieve these results again looks to be higher than previously assumed. Management has outlined AUD 10 million of additional investment pulled forward into fiscal 2019, for further cost-out, price cuts, salesforce investments, and product innovation. This acceleration follows AUD 40 million of investment pulled into fiscal 2018. While we expect the 80% increase in salesforce in the immediate consumption channel, as outlined by new segment head Peter West, to support our outlook for higher price per liter given the channel ‘s higher pricing, we also now expect this and most future improvements from Amatil's cost-savings programs to be fully reinvested into the business rather than falling to the bottom line. As such, we have lowered our long-term EBIT margin forecast for the geography to 14.5% from 16.0%, rising only slightly from the 14.0% we project for 2018.

Outside of Australia, our outlook for Amatil's beverage portfolio remains relatively unchanged. New Zealand remains a strong enterprise for the company. Here, Amatil has enjoyed better market growth, lower competition, and a better product mix, particularly given its ownership of the Schweppes brand in New Zealand which has benefited by selling mixers during a period of rising spirits consumption. We continue to expect low-single-digit revenue gains in this segment, split between volume and price, and EBIT margins remaining comfortably above 19%.

However, rising private label water sales represents a risk. Amatil already competes in "value" bottled water, with offerings such as Kiwi Blue, and the firm should be able to participate in segment growth. While the company noted its lack of concern regarding this trend at the analyst day, New Zealand trails Australia in private label penetration in value bottled water. A continued structural shift in this segment toward lower-priced water could lead to worse performance in New Zealand than we currently anticipate. Nonetheless, in a bear case, we see margins slipping about 100 basis points, still well ahead of our forecast for Australian profitability.

Conversely, Indonesia remains a sore spot for Amatil. We partly attribute this to continued macroeconomic challenges, but Amatil also noted that the country's population drinks a high degree of low-priced commoditized bottled water, where Coke doesn’t participate. As the economy has remained sluggish, with personal consumption expenditures averaging 4.9% annual growth over the past three years versus 5.4% in the three years prior, per IHS Markit, Amatil’s market-leading positions in higher-priced items such as soft drinks and flavored iced tea have declined at an outsize rate.

We remain optimistic on the long-term potential for this market, given Coke’s investment in go-to-market salesforce and infrastructure, and its work to expand its target market through smaller package sizes and lower prices, but the turnaround relies heavily on a shift in macro fundamentals. Moreover, despite the region's profitability performing better than originally anticipated when Amatil and The Coca-Cola Company set up their joint venture in 2014, this positive trajectory looks likely to reverse in 2018. Management expects cost pressure, additional marketing investments, and a weaker Indonesian currency to lead to EBIT margins of about 5% this year, compared with roughly 6% in the first half of 2018 and a long-term target near 10%. Nonetheless, we project this metric rebounding over the long term as Amatil enjoys improved product mix, and we remain comfortable with our 10% segment forecast (which includes the higher-margin Papua New Guinea business) over the long term.

Beyond its core beverage portfolio, Amatil announced its planned divestiture of food manufacturer SPC following a strategic review of this business signaled in the first-half results in August 2018. We’re favorable toward this decision. In August, we had noted that the segment remained challenged, operating at a small loss despite AUD 100 million invested into the business between Amatil and the government of Victoria over the past four years to modernize processes and drive growth. Moreover, even though SPC is a small part of Amatil’s portfolio (the segment contributed less than 3% of consolidated operating income in fiscal 2017), the business makes up 15% to 20% of Amatil’s consolidated working capital. A divestiture should free up a sizable portion of cash--nearly AUD 100 million--that can be used to fund Amatil’s ongoing investments in other areas of the business.