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Morningstar | Coke Amatil’s Australian Business Facing a Challenging 2019, but Long-Term Opportunity Remains

Narrow-moat Coca-Cola Amatil’s full-year results highlighted areas of both challenges and successes. Its core Australian beverages business remained pressured by headwinds from container deposit schemes, competitive pricing responses in water, and ongoing investments to drive growth. We’re encouraged these investments and price cuts appear to be generating positive volume response and market share gains but expect the Australian business to again face falling EBIT in 2019 as further sales, marketing, and pricing actions are taken. As a result, despite continued growth in New Zealand and Amatil’s alcohol and coffee division, we see operating margins slipping to 12.8% in 2019 from 13.2% in 2018, to an EBIT of AUD 621 million versus AUD 635 million. Nonetheless, we believe this year will be the final year of transition for Australian beverages. While we don’t see this segment reaching the same levels of high-teens EBIT margins enjoyed in the past, we agree with management that Amatil will grow its earnings per share at a mid-single-digit rate annually starting in 2020. We maintain our AUD 8.90 per share fair value estimate.

We expect Coke can stem the top-line challenges in Australian beverages over the long run but results in 2019 will remain choppy due to the further advent of container deposit schemes, or CDS, across most Australian states. As Amatil passes through these deposits to consumers through higher prices, volume declines have proven inevitable, at a faster clip than we previously anticipated. This effect was pronounced in 2018 following the installation of a CDS in New South Wales, where volumes declined 3.4%, compared with a smaller 0.4% slide in the rest of Australia. In all, beverage volume in the country fell 1.3% in 2018, with a 0.6% increase in average price per case unable to drive positive revenue gains for the year. We anticipate revenue declines will continue in 2019, with passed-through CDS costs given back to customers through price cuts.

We’re encouraged that outside of these one-time issues, Amatil saw volume share improve across both sparkling and still beverages, with recent launches such as No Sugar helping to drive gains in brand Coca-Cola in the second half of the year, and improved performance in dairy and energy drinks. While we still project falling volumes in sparkling drinks over the long run, we expect performance in other key categories can lead to a slimmer 0.3% total volume annual decline. Along with positive pricing from smaller package sizes, positive channel mix toward more immediate consumption, and growth in higher-priced products such as kombucha and energy drinks will lead to revenue in this segment growing at about a 1% annual clip over the medium term.

We’re less optimistic about improvement in Australian profitability. The company has pulled forward a sizable amount of sales, marketing, and cost-efficiency investments, including another AUD 40 million planned for 2019. Following the company’s investor day in November 2018, we reduced our long-term profitability forecast for this segment’s EBIT margins to 14.5% and remain comfortable with this outlook.

New Zealand’s success remains a stark opposite when compared with Australian beverages for Amatil. Together with Fiji, this geography grew revenue 6.9% in 2018 on volume gains of 6.1%, building market share across all categories in the country. This performance outpaced our expectations, and while we expect some moderation in volume improvement going forward given similar secular health-related challenges as other developed economies globally, we’re confident in Amatil’s ability to drive low-single-digit revenue growth in New Zealand. Profitability also remained solid in 2018, with EBIT margins widening by about 10 basis points to 18.9%. We expect similar annual improvement going forward.

Amatil’s primary emerging market exposure and longer-term growth opportunity remains Indonesia, but results in this segment continued to struggle to achieve revenue growth in 2018. Although volumes ticked up by 1%, challenging product mix and currency translation headwinds drove down top-line results by 2.1% year over year, EBIT margins slipped to 8.7% from 9.1% in 2017 due to cost pressures and additional marketing investments. 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 caution that the turnaround relies heavily on a shift in macro fundamentals. Nonetheless, we project mid-single-digit revenue growth over the medium term for the geography, and margins rebounding as Amatil enjoys improved product mix. We remain comfortable with our 10% segment EBIT margin forecast, which includes the higher-margin Papua New Guinea business.

Amatil’s statutory NPAT of AUD 292 million in 2018 fell 37% versus 2017, but declined a much slimmer 9% when adding back a AUD 122 million noncash write-off for the remaining asset value of Amatil’s food manufacturer SPC. We attribute minimal value for this business, assuming only AUD 0.15 per share in net proceeds, or less than 2% of our total valuation. Nonetheless, selling the business will remove a loss-making endeavour from Amatil’s income statement, while also freeing a substantial portion of working capital.