Coca-Cola shares ready to pop

By Michael Brush

Do market corrections go better with Coke?

Recent evidence says yes. Stocks are down about 5% since early May, but Coca-Cola (KO, news, msgs) shares have held steady. Why? For the same reasons Coca-Cola shares could rise more than 20% to $54 over the next year or two.

• A "new Coke" has arrived. The formerly cautious company is now willing to take risks on new brands to capture the strength of hip soft-drink trends such as energy drinks and flavored waters.

• Coca-Cola remains rock-solid financially and will continue to sell its drinks even if the economy cools off.

• An emerging consumer class in developing countries such as China is only now taking its first sips of Coca-Cola. If history is any guide, they'll get hooked and become loyal consumers.

• Finally, Coca-Cola does most of its business outside of North America. So the ever-weakening dollar should serve as an earnings pick-me-up, since income from abroad will be translated into more dollars back home.

Here's a closer look at these trends.

Innovation

During his 1980-1997 reign, legendary Coca-Cola CEO Roberto Goizueta invigorated the company and expanded its global reach -- turning it into a worldwide soft-drink giant. After Goizueta's untimely death in 1997, Coca-Cola went into a kind of lockdown mode under chief executives Douglas Ivester and Douglas Daft. They ran an overly conservative Coca-Cola that seemed reluctant to try new products unless they could be proven to work in advance -- a nearly impossible task.

Under Neville Isdell, who took over in mid-2004, Coca-Cola has gone through a mini-management shakeup -- as part of Isdell's "manifesto for growth." He's brought in outside talent to run important divisions in Europe and Asia, and shifted managers in the U.S. It's all part of a cultural change that has Coca-Cola taking risks, making forays into energy and sports drinks, flavored water and healthier noncarbonated fare like juices.

"They misunderstood the opportunity in noncarbonated beverages, and I think they have made some pretty good strides to change that," says Eric Schoenstein, co-portfolio manager of the Jensen Portfolio (JENSX), which holds Coca-Cola stock.

Among the changes:

• Coca-Cola has launched sports and energy drinks Powerade Option, Full Throttle, Vault and Tab Energy.

• The new Coca-Cola Blak, a blend of Coke and coffee, represents a foray into the premium coffee craze dominated by Starbucks (SBUX, news, msgs).

• Coca-Cola has tried variations on old classics -- like the diet drinks Coca-Cola Zero and Diet Coke Sweetened with Splenda.

To some, all this smacks of a "me too" approach that still marks Coca-Cola as a company that's simply too slow to lead in an industry where scrappy upstarts create the most intense buzz.

"Coke continues to reinvent existing products," says Kevin Miller, director of marketing at Old Orchard Brands, the No. 2 brand in frozen juice concentrate after Coca-Cola's own Minute Maid. "I think they are the victim of their own success."

But Coca-Cola's distribution system can push products into more than 200 different countries (around the globe, consumers drink more than 1.3 billion servings of Coca-Cola products a day), so it may not be so bad to be the company that innovates just a little and imitates a lot.

The key thing, says Morningstar analyst Matthew Reilly, is that Coca-Cola has finally realized that "they can't just push Coke on everyone. They have embraced the idea that catering to consumer tastes is a big deal." Reilly recommends investors buy the stock anywhere under $46 a share.

The change is showing up in the numbers. Unit volume increased just 2% in North America last quarter, but noncarbonated drinks were up 7%. Revenue increased 8%, but the shift toward higher-margin niche drinks helped push operating income up 24%. "We were pleasantly surprised by Coke's ability to improve its product mix and profitability," says Reilly. You see a similar strength in the noncarbonated sector worldwide. Globally, noncarbonated beverages increased by 11% in the first quarter, while carbonated soft-drink volumes increased by 3%.

Financial strength

The company generates huge amounts of cash flow and has $4.49 billion in cash, or about $1.90 per share. It has net profit margins of 21% and a return on equity of 33%. "Any elementary financial textbook would tell you this is a fabulous company," says Stephen Leeb, manager of the U.S. Global Investors MegaTrends Fund (MEGAX, news, msgs), which holds Coca-Cola shares. "This is a company that has the wherewithal to finance virtually anything, within reason. I don't know whether Coke Zero is the answer or whether other drinks are going to gain a foothold, but they can afford to be adventurous."

Coca-Cola also sells the kind of basic products that consumers keep buying even as the economy slows down, making Coca-Cola an attractive "defensive" name in these uncertain times, says David Tuzzolino, consumer staples analyst at Mellon Financial's private wealth management group, which also owns Coca-Cola shares. Tuzzolino expects a 12% total return annually from the company in the medium term -- 8%-9% earnings-per-share growth and 2.8% dividend yield. "I think they can do that regardless of what the economy does," says Tuzzolino.

Foreign markets

Coca-Cola doesn't need to innovate to win in high-growth emerging markets. Carbonated soft drink consumption is still in the early stages in places such as China, so Coca-Cola can just ride the wave as more consumers discover their mainstream fizzy drinks.

Besides China, India is a key emerging market. Carbonated drink sales have been hammered there by concerns about pesticides showing up in soft drinks -- charges denied by both Coca-Cola and PepsiCo (PEP, news, msgs). The controversy will some day blow over, and Coca-Cola will see solid growth in India over the next three to five years, predicts MegaTrends manager Leeb.

Recent weakness in some developed markets will reverse, too:

• Sales turned sour in Germany in the past two years because of a restrictive bottle-return law that made it hard for the company to sell drinks through discount chains. But the issue is being resolved, so Coca-Cola should see sales in Germany pick up, says Marc Davis of Tradition Capital Management. Coca-Cola may also see a boost in sales as a sponsor of the World Cup soccer championship, which begins June 9 in Germany.

• Analysts expect Coca-Cola to be able to fix a marketing mess with its Georgia brand coffee in Japan.

Then there's the dollar. As the dollar get cheaper, Coca-Cola -- which gets 70% of its sales from overseas -- will get an added profit boost.

I'll pick Coca-Cola

With this column, I'll add Coca-Cola to my Company Focus portfolio in our expert picks section, and we'll see how it does from here.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column. Brush is an award-winning New York-based financial writer who has covered business and investing for the New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.