At this time, I would like to welcome everyone to The Coca-Cola Company's financial modeling call. Today's call is being recorded. If you have any objections, please disconnect at this time. All participants will be on the listen-only mode until the formal question and answer portion of the call. Participants will be announced by their name and company. I would like to remind everyone that the purpose of this call is to talk with investors. Therefore, questions from the media will not be addressed. Media participants should contact Coca-Cola's media relations department if they have questions. Now I would like to introduce Mr. Tim Leveridge, Vice President and Investor Relations Officer. Mr. Leveridge, you may begin.
Good morning, everyone. Thank you for being with us today. I'm also joined by Lee Coker, our Director of Investor Relations. Before we begin, I'd like to inform you that you can find webcast materials in the investors section of our company website at www.coca-colacompany.com that support the prepared remarks today. This conference call may contain forward-looking statements, including statements concerning long-term earnings objectives, and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent SEC report. Some components of the outlook we'll be talking about today are on a non-GAAP basis. Please see the earnings release we filed earlier today and the schedules we posted on our investor page for more information about these measures. Following prepared remarks this morning, we'll turn the call over for your questions. Let's begin.
The purpose of this call is to go over the outlook we've provided today in more detail to help you better construct your 2017 and 2018 financial models. We recognize that there are a lot of moving pieces in our business over the near to medium-term horizon, and we therefore want to be as transparent as we can as to how to help you model out the various elements in your financial models for our company. We'll plan to cover two main points. The first is the timing of the various structural items, and then we'll do a deeper dive into the impacts they'll have on the P&L. We have about 20 minutes of prepared remarks, and then Lee and I will open up the lines for your questions. Turning to slide four on the deck. Hopefully, you all have that in front of you.
It'll be important to follow along as we're going through the remarks. I'm going to pick back up where we left off from the earnings call earlier today. You'll recall a similar slide from that presentation with the waterfall of the various drivers of EPS. We'll be happy to take questions on the overall outlook when we get to Q&A, but the focus for this morning, for the prepared remarks at least, will be on the middle column and focusing on the five to six points of structural headwinds of PBT. We'll then cover off on implications for 2018, along with some commentary on the balance sheet impacts as we think longer term. Moving to slide five. Before getting too deep into the numbers, I think it's important to level set on the timing of when the various refranchising transactions will impact our financials.
Let's start with the two transactions that closed in 2016 that we'll be cycling this year. In May of last year, we merged our German bottling operations with CCE and CCIP to form Coca-Cola European Partners. As that transaction closed in the second quarter of 2016, the impact from that transaction will extend through the second quarter of 2017. In Africa, we merged our South African bottling and canners assets with SABMiller and SABCO to form CCBA at the very beginning of Q3 2016. As such, the year-over-year impact will be seen in the operating results through the second quarter of 2017. On that note, I'd like to reiterate what Kathy mentioned this morning about Coca-Cola Beverages Africa. The total outlook we've provided today does not include any impact from the transition of ownership of CCBA or the acquisition of any other ABI territories.
With that said, we expect these impacts to be minimal as we intend to account for these as discontinued operations, given our intent to refranchise as quickly as possible. Turning on to the ongoing refranchising in North America. We closed transactions throughout last year and expect to significantly increase the transactional closings in 2017. As they will be closing throughout the year, you will see the year-over-year impact from these transactions extending into 2018. Finally, we announced in the fourth quarter of last year a definitive agreement to refranchise our company-owned bottling operations in China. While this transaction is still pending regulatory approval, we've modeled the transaction to close at the end of the second quarter. Therefore, we would expect the structural impacts to begin in the third quarter of 2017 and continue through the first half of 2018. Now let's move on to slide six.
Let's walk through the consolidated financial impact based on what we've provided in our outlook this morning. We've said it a few times, but as a reminder, this represents our best estimates as of today and therefore the timing is subject to change. For that reason, we're providing the total expected structural impact in both 2017 and 2018. Therefore, you can effectively model what any changes in timing this year means for the next year. To say it in another way, changes in timing in 2017 will have a corresponding impact in 2018. In addition, for most of the guidance we will providing, especially at segment-level impacts, we will give you our estimates of relative impacts to the overall revenue and PBT ranges.
This is to allow you to adjust your assumptions by segment if we ultimately need to update the total structural impacts at both revenue and PBT for the full year as we move through the year. As things move, we'll keep you updated so that you can adjust your models accordingly. Another clarification to simplify how to look at things, I will sometimes be describing our structural forecast in terms of our operating segments or in terms of geographic segments. For purposes of this conversation, the geographic segment that I'm referring to is simply the combination of our EMEA, Latin America, North American, Asia Pacific, and corporate operating segments. Do not worry, we're not creating a new operating segment for you at the model. It's just simply a way to talk about it.
These explanations are intended to give you a better understanding of how to factor our structural changes into your financial models at the segment level. Let's turn to slide seven, starting with the 2017 net revenues. As we said on the call, we expect an 18- to 19-point headwind from structural items. This headwind is composed of four elements. First, the largest contributor is the reduction to net revenues in the bottling investment segment, or BIG, as we refranchise these operations to third parties. Second, the reduced revenues in BIG come with a corresponding reduction in eliminations. Third, year one intercompany profit eliminations will flow through as a benefit in several of the geographic segments. Fourth, sub-bottling payments will benefit the North American segment. We'll cover each of these four topics in more detail as we move through the call.
At income before tax for 2017, we expect a five- to six-point structural headwind. In addition to what I just described at the top line flowing to operating income before tax will be impacted by incremental equity income and the portion of sub-bottling payments for our North American businesses that come through the P&L at the interest income line. Building off this base of understanding, let's now take a closer look at how these refranchising transactions will impact our P&L. Turning to slide eight. Starting first with BIG, probably the simplest to understand is when we divest bottling operations, we'll see a reduction in net revenues and operating income. In the geographic segments, the refranchising transactions will result in tailwinds at revenue and operating income. However, that tailwind in the geographic segments is really driven by three components.
First is sub-bottling payments, we also have intercompany profit elimination benefits, finally, the deconsolidation of our Coca-Cola Canners bottling operation in South Africa. Let me go through those in a little bit more detail. The first is on the sub-bottling payments. For most of our North America refranchising transactions to date, we've entered into sub-bottling payment arrangements for the intangible assets associated with the refranchised territories. These payments are initially flowing through the North America segment at roughly an even split between net revenue and interest income. In addition to sub-bottling payments, the geographic segments will see a favorable impact from intercompany profit eliminations at the consolidated basis.
To illustrate this favorable impact, because this is a topic that I understand can be a little confusing, but to better illustrate this favorable impact, it may be helpful to consider our 2010 acquisition of the North American operations of CCE. The benefits we're seeing today are effectively the opposite of the headwinds we experienced at the time we brought CCE onto the books. When CCNA and CCE profit streams were combined, a certain amount of profit was eliminated in the consolidation process. That was because when we sell concentrate to our company-owned bottlers, we're not able to recognize the concentrate revenue or profit until the bottling partner has sold the finished products manufactured from the concentrate to a third party. In effect, the concentrate profit in the bottler inventory must be eliminated for consolidation purposes.
As company-owned bottlers are refranchised to third parties, this elimination is no longer needed, and therefore, it is reversed during the period in which the transaction closes. This reversal results in a one-time profit increase in the P&L flowing from revenue down to OI in the relevant geographic segment. Given the number of transaction closings in 2017, this amount will be rather significant, especially in the North America segment as we go through the year. You'll see the impacts in other geographic segments coming from those transactions, albeit to a lesser extent than that of North America, given their relative sizes. Finally, the favorability in the geographic segments I've just described is partially offset by the deconsolidation of our Canners bottling operation in South Africa. This operation was previously included in the EMEA operating segment and was contributed to the formation of CCBA upon closing of that transaction.
The impact of the Canners deconsolidation will be a reduction to both net revenues and operating income for EMEA through the second quarter of 2017. Finally, the last element to consider is equity income. As you would have seen over the past two quarters, the formation of CCEP and CCBA has resulted in incremental equity income. In addition, the refranchising transaction in North America with Arca Continental will also have a structural impact from an equity income perspective. This transaction, which includes the refranchising of territories in Texas and parts of certain neighboring states, will result in incremental equity income by virtue of a 20% stake in AC Bebidas, an entity that will encompass Arca's entire beverage business, including its Latin American and U.S. territories. Now let's move to slide nine.
Now that we've talked you through the various elements across the segment, let's put them together at the total level, starting first with revenue. What you see on the slide are two of the pieces I just referenced, the impact to BIG and the offsetting impact to the geographic segments. It is also important to consider the impact to revenues on eliminations as a result of these transactions. When we have company-owned bottlers, the sales of concentrate to those bottlers are booked in the relevant geographic segments, but then removed in consolidations through eliminations, which is presented within the segment P&L. As you think about modeling the impact of refranchising, you will need to reduce the net revenues of BIG, but you will also need to reduce the amount of eliminations along with it.
In terms of correlation between the BIG revenues and the amount of eliminations to model, looking at history will be a helpful approach. Historically, the revenue offset and eliminations has run about 24%-25% of BIG net revenues. However, this figure over the last few years has been higher than it was prior to the CCR move at the time when BIG was primarily composed of bottlers in emerging markets. It's important to keep this history in mind as you model the structural impact and eliminations. As we complete the refranchise, we'll move back to a bottling investment segment that is primarily composed of bottlers in lower net revenue per case markets, and that'll impact the amount of eliminations that you model in.
Finally, remember that the revenue eliminations are an offset to consolidated revenues. A reduction in the amount of eliminations is actually a positive to consolidated net revenues. The chart presented on slide nine helps to show the 18%-19% decline in net revenues relative to what we just said. In short, the BIG revenues will decline more than the total of 18 and 19-point structural headwind. This will be offset by the reduction in eliminations that I just referenced, and to a lesser extent, the impact from the intercompany profit eliminations and sub-bottling payments. Net-net, these factors come together to form the estimated 18 to 19-point headwind. Moving now to the bottom line, let me summarize the comments I made from slide eight.
For bottling investments, as you look at the total impact to PBT, it really reflects two components of divested operating profit that is partially offset by incremental equity income. In the geographic segments, net favorability at income before tax will result from intercompany profit elimination benefits and sub-bottling payments, partially offset by the divestment of our Coca-Cola Canners operation in South Africa. In terms of relative size of the structural impacts by segment, we would expect the bottling investments impact to be about 1.3 to 1.5 times the consolidated structural outlook we provided at PBT. Prior to moving on to 2018, let me spend just a few minutes highlighting the impacts on gross margin from refranchising for 2017 and beyond. We recognize that gross margin has been a challenge to model in 2016 and has thus complicated the ability to analyze our underlying margin trends.
At CAGNY last year, we talked about how refranchising would yield about 700 basis point improvement in gross margins once we finished refranchising. Which makes sense, as the bottling businesses we are divesting typically have a gross margin of between 35%-40% relative to our much higher consolidated gross margin levels. In 2016, we did not see this impact, primarily due to the phasing of transactions in terms of distribution rights versus production plants in Coca-Cola North America. As we look out to 2017 and 2018, we expect to see much more of a structural benefit to gross margins as the plants in Coca-Cola North America should transfer at the same time as the distribution rights. Therefore, as you model the removal of bottler revenue, a 35%-40% gross margin to pull out along with it is more appropriate.
When you model out this impact, this is very important, is not to forget the intercompany sales elimination, as this will impact consolidated net revenues but will have no impact on consolidated gross profit. If eliminations are not taken into account, the resulting reduction to consolidated net revenues will be too high, which would yield implied margin expansion greater than what you should expect. Now let's turn to 2018 on slide 11. At this time, we estimate a 16 to 17-point headwind in net revenues and a one to two-point headwind on income before tax. The nature of the structural impacts for 2018 are similar to 2017 in terms of segment and P&L line item impact. A notable exception is the intercompany profit elimination flowing through the geographic segments.
As I mentioned before, the benefit from the reversal of the profit elimination is one time in nature in the period a transaction closes. Therefore, we will lap that benefit in year two, resulting in a headwind when looking at year-over-year growth rates. Let's flip to slide 12. A couple of other points to consider as you model 2018. First, based on our current hedging programs on hard currencies that extend into 2018, and assuming no change from today's spot rates, we would expect a low single-digit currency headwind on income before tax in 2018. Second, given changes to our geographic business mix, the impact of currency and bottling transactions, we're currently forecasting a 2018 underlying effective tax rate of 26%.
Similar to our 2017 tax rate forecast, this outlook does not take into account any potential tax reform in the U.S. or in any of our other tax paying jurisdictions. Moving to slide 13. Before we move to Q&A, I'd like to give just a few considerations for 2017 balance sheet purposes. At CAGNY in 2016, we presented a way to think about our invested capital balance going forward as we progress through refranchising. Specifically, we referenced the impact in terms of the CCR asset base, the China transaction, CCEP, and CCBA. Let me provide an update to that perspective through a reminder of what has happened today and what we expect to happen over the next couple of years. For CCEP, that transaction closed in the second quarter of 2016.
As a result of that closing, we recognized a net gain of approximately $1.3 billion, which was added to our investment in equity affiliates. The CCBA transaction closed at the very beginning of Q3 2016. Upon closing, we recognized a relatively minor net loss. As a reminder, this does not include any impact from the transition of ownership of CCBA or any of the other ABI territories. During 2016, we moved a portion of the CCR asset base off of our books in the closing of refranchising transactions and will continue to do so as we complete the refranchising in North America. For 2016, we reduced the CCR asset base by approximately $2.5 billion. This is in addition to the $2 billion we moved off the books in 2015. It is also important to consider the impact of the Arca transaction on that CCR asset base.
As part of this transaction, we will effectively swap our Southwest operating unit assets for a 20% stake in the newly formed AC Bebidas, the beverage business of Arca Continental. While refranchising of the Southwestern U.S. territories to Arca will reduce the CCR asset base, we will be recording an incremental equity investment on the balance sheet in their place, similar to what we did for CCEP and CCBA. This investment will be determined by the market price of Arca stock at the time of closing. Until the transaction closes, we cannot accurately estimate what the net impact to invested capital will be. However, the best way to think about it is the removal of $12 billion of CCR net assets that we referenced at CAGNY last year will come down by the amount of equity investment we book for AC Bebidas.
Moving on, the refranchising of our company-owned bottling operations in China will have an impact on the balance sheet in invested capital. We currently expect these transactions to close in the first half of 2017, depending on regulatory approval. We expect the cash proceeds of this deal to amount to approximately $1 billion and will be part of the company's cash prioritization process going forward. Prior to opening the lines for Q&A, I'd like to remind you that these slides I've gone through can be found in the investor section of our company website. Also included in the slide deck posted on the site will be appendix slides that present summary charts of the total outlook we provided for the full year 2017, first quarter 2017, and full year 2018. We hope that you find these resources useful as you work through your financial models following this call.
Operator, we are now ready for your questions.
Your first question comes from Vivien Azer from Cowen and Company. Your line is now open.
Hi. Good morning. Thanks for the question.
Yeah. Hey, Vivien.
As I look at slide five, in particular North America, we're going to have to build out quarters, not just for 2017, which we already have, but obviously for 2018 as well. Given some of the announcements that we heard in the fourth quarter, where you guys were accelerating some of the refranchising in North America, is it fair to say that that should be weighted to the first half of 2018?
To be clear, the announcements that we talked about, a lot of those have to do with signing definitive agreements. The actual impact on the P&L is going to start impacting when we actually close the transactions. The outlook that we gave today is reflective of our best estimates of the closings of those at this point in time. Said another way, the flow is not different than what we've discussed and what we would expect given the outlook that we gave for the first quarter and then for the full year. What we'll do, as we have been for each quarter, as we get to the first quarter call and we give outlook for the second quarter, we'll give a second quarter outlook on the refranchising impacts and the structural impacts at that point in time.
You'll be able to flow through it, and then if there's any changes to the full year structural impacts as we get to the quarter, we'll update those as well. Does that make sense?
It does make sense. That's perfect, and I appreciate the transparency on this going forward. Have you guys provided an updated number just in terms of what % of Coca-Cola North America you at least have a definitive agreement on?
Right now, we have on the well, all in, if you look at the transactions, and we announced, this was out in a press release today. If you look at the territories that have closed, that we've signed definitive agreements and LOAs, that amount is roughly about 70% of the territories for CCR. In terms of transactions that have actually closed, it's roughly about 30% of our distribution territories.
Understood. Helpful. Thank you very much.
Sure. Thanks, Vivien.
Our next question comes from Kevin Grundy of Jefferies. Your line is now open.
Hey, guys. Thanks for the question.
Sure, no problem. Hey, Kevin.
A few from me, if you want. Tim, just going back to the CAGNY slides where you guys sort of grounded us at 68% gross margins and 34% operating margin. Given all the moving parts as we're looking out here to 2017 and 2018, how should we be thinking about that? I guess, underlying improvements, structural changes, anything that you can sort of help us with there to sort of ground us with those two guideposts? Then I have a handful of follow-ups.
Yeah. I think the simple way to think about it, the headline on that with the expansion in gross margins and expansion in operating margins will absolutely flow through. You'll see that happen, frankly, a lot more in 2017 and 2018 than you did in 2016 because of what I said around how North America flowed at that point in time. It'll really start ramping up as we move through that. If you think about the CAGNY deck, what we gave was a 2015 pro forma as of those numbers. We have not updated because obviously 2016 moved from the overall consolidated level, so we have not updated those numbers as of now.
The right way to think about it is the overall magnitude of the change in both gross and operating margins, we would see that continuing to play out in 2017 and 2018.
Okay. All right. That's helpful. The tax rate, Tim, for 2018-
Yeah
steps up to 26%, understanding there's a lot of uncertainty with respect to what's going on in Washington. Barring that, is that sort of the right go forward rate? What's driving that? Is this just geographic mix in terms of where profitability is derived?
That's correct. To answer your first question, yes. At this stage, the 26% is a rate that we feel like we can manage moving forward. The reason that it stepped up is, as Kathy said on the call, it's primarily coming from the geographic mix, predominantly driven by the strength of the dollar. As our foreign earnings have actually moved down because of the foreign currency translation in U.S. dollars, the overall U.S. dollar tax base has shifted to the U.S. tax jurisdiction at a higher effective tax rate for the consolidated business. We have worked and leveraged strong tax planning strategies that have helped to mitigate some of those. The cumulative effect of the overall pressure coming from the dollar and the limitation of those tax planning strategies moving forward is forcing the tax rate up in 2017 and then again in 2018.
Okay. One last one from me. Just broader. You guys are guiding out of the 3% organic. You started off about a year ago down at CAGNY. You guys suggested the industry growth rate was 5%, the guidance was 4%-5%. What is the industry growth rate that is embedded in your guidance for fiscal 2017? Is it 3%? Is it something sub 3%? You guys generally have a pretty good track record of gaining market share. I'm just trying to understand how this category growth rate has trended, understanding that the macro is difficult, particularly in LatAm, where you guys had a lot of leverage. Just some commentary there to help me understand the industry growth rates and what's embedded in terms of market share. How much of the industry growth rate has driven the downward revision? Is it all of it?
Is some of it execution? That's it for me. Thanks.
Yeah, Kevin, great question. I think, number one, it's important to be really clear about the 3% target for 2017 and recognizing that that is a consolidated number. It includes both BIG and then our core business. Very similar to 2016 where the consolidated revenue grew 3% and our core business grew 4%, we expect in 2017 the core business to outpace the overall consolidated number of 3% again in 2017. To think in terms of comparing that from an industry perspective, it's more appropriate and it makes more sense to use the core number because obviously the mix of business and the revenue per case of BIG relative to the rest of our business skews that number. Using the core and looking at that relative to industry growth rates is a more effective way to think about it.
If you look at the growth rate in 2016, that number was right around 4%. We expect in 2017 for it to again be in that 4% range, driven primarily because of the macro environment, especially in developing and emerging markets, that that's how we see 2017 playing out. Embedded in our assumptions is a level of market share expansion, but overall growing relative to that 4% is the right way to think about it.
Okay. Thanks for the time, guys. Appreciate it.
Sure, you got it.
Our next question comes from Lauren Lieberman of Barclays. Your line is now open.
Thanks. Good morning.
Hey, good morning, Lauren.
Just want to ask the phasing of productivity, if you can provide any color on what's remaining and how to think about that over the next three years, and also reinvestment rates of that saving.
Sure. If you look at what we've announced to date, and Muhtar referenced that, is we have about, call it, we did a little bit more than $500 million in 2014, another $600 million in 2015, another $600 million last year. That gets you to a little over more than $1.7 billion on our $3 billion program. That gives you, call it, $1.2 billion, $1.3 billion remainder for the balance of the next three years. You're talking a run rate of about $400 million a year. That's what we expect and have built in as we think about 2017. In terms of reinvestment rates, obviously we've talked a lot about the step-up in marketing we did from 2014 through 2016. We feel like we are now at a space where we do not need to drive incremental marketing moving forward against our base level.
Therefore, you're going to see more of the productivity in 2017 drop to the bottom line, and that's built into our overall guidance as you think about our outlook for 2017. Probably the simplest way to think about it is you take that net revenue number and drop it down to an OI growth rate. We guided to 7%-8% PBT, but recognized in that PBT number was a couple points of headwind below the OI line. Probably the best way to think about OI growing, call it 9%-10%. You're seeing a lot of that productivity flow to the bottom line.
Okay. Kathy had mentioned also the stranded overhead that's being worked on concurrently.
Correct.
That's like another $200 incremental to that $400 million. We should think about another, I think she said, what, 200 basis points of benefits here?
Yeah. The $400 that I just referenced does not include the $200 million of stranded cost removal.
Okay. Great.
I just want to be abundantly clear, not just for you, but for everyone on the call.
Yes.
The 9-10 OI growth that I referenced would include the couple points of stranded cost removal as well. Just for abundance of transparency.
Okay, great. On the 34%, again, grounding at 34%, just to make sure I was clear on your explanation there. One is that that was off of a different base that didn't include any kind of margin progress or productivity benefits experienced since. When you meant rate of change, it was sort of apples-to-apples 2015 to today. I should theoretically adjust that higher for any kind of operating margin progress you've seen outside of structural.
That's correct. You also have to factor in FX into that assumptions as well.
Okay.
FX, as you know, has been putting a lot of pressure on margins because of the differential of our international versus North America operating margins.
The fundamental point of what you said is accurate in that when I said the magnitude of change, meaning the magnitude is, again, the CAGNY presentation was assuming we took the business as of 2015 and pulled out the businesses we were selling. That base number, if you will, is going to continue to grow at an underlying. You've got to factor in currency and all of that within that.
Yes.
You're still going to see a significant step-up in operating and gross margins as we pull the rest of those businesses out.
Last thing, sorry. If I was grounding myself to that 34%, and then also knowing all the things you said that I then need to go back and adjust for, if you will, would I be thinking about that end state now being at the end of 2018? Or is it kind of like mid 2019 because there's still flow-through impacts of structural, just given the timing of closures in 2017?
No, the right way to think about it is that we intend to be done with the refranchising as of the end of 2017. Starting in 2018, the operating margins are going to be on that steady-state basis. The year-over-year growth rates-
Yeah
are going to continue to be impacted, but the margins are going to be at the steady state in 2018.
Okay. My full year 2018 can ground to 34%?
Yes.
Okay.
Yes.
All right. Thank you so much.
You got it. Okay.
Your next question comes from Caroline Levy of CLSA. Your line is now open.
Thanks. Good morning.
Hey, Caroline.
Hi. Thanks. Can you tell me what the gain in 2017 will be from the writing up of the concentrate inventories?
The simple answer is it's a couple points that are going to flow through at the consolidated level.
A couple of points of earnings growth, operating growth?
Yes, of operating income growth.
Okay.
As I mentioned on the call, that's primarily going to flow through the North America segment.
Multiples of that in North America.
Yeah, exactly. That's exactly right.
And-
That's one of the reasons, frankly, we wanted to call it out, because as this starts playing out, you're gonna see growth rates in North America at the OI and PBT level much higher than the run rate's been. We just wanted to ground people to expect that, because we knew eventually we were gonna have to explain it.
Yeah.
We wanted to take the time to explain it upfront.
There are no other markets like China or South Africa or whatever, where you'd have the same thing?
There are. You'll see it in China, and it'll flow through in China. It's gonna be much smaller, because obviously the relative size of the transactions are much different. In the other territories, you'll see it. Africa is a bit unusual because the benefit you would've seen is offset by the Canners deconsolidation, or is more than offset by Canners. For CCEP, that's actually already happened. That was booked in 2016. We didn't get onto this in detail on the script because it gets even a little bit more confusing. In the case of CCEP, we did benefit from the Germany refranchising, but it was more than offset by having to do a similar type of elimination for all of CCEP. You basically have to do the same thing for equity investees.
The benefit from Germany was offset by the overall impact for CCEP. That's why you didn't see it really hit the P&L at a significant level when you look back at the 2016 numbers for EMEA.
Okay. Just to clarify, with Arca, will you be at 27.5% ownership or 20.5% ownership total?
We'll have a 20% ownership in AC Bebidas, and we'll still continue with our existing ownership at the parent company level, which is 8%.
Okay. Could you just break out interest expense, which moved up a lot, even though there is some income from the bottler sub-bottling payments? What happened in the quarter so that we can understand what to expect going forward? What should we look for interest expense net in 2017?
Hey, Caroline, it's Lee. I think if you look at Q4, I don't think that's a good number to use as sort of a run rate for 2017 on quarterly net interest expense. Part of what you saw in the fourth quarter was, for lack of a better word, a sort of a one-time impact related to some hedging activity in swaptions. I think going forward, it's hard to say exactly what the interest expense is going to be. It'll definitely be a 2 points of headwind, or I'd say 1-2 points of headwind, but I would not look at the Q4 as a good proxy for next year. I'd say maybe looking at about half of that was one time, and half of it was sort of ongoing interest expense.
That 1%-2% headwind in interest expense, going forward, would be net of the sub-bottling payments coming in there?
No, excuse me. To be clear. The 2-point headwind, and this is what I talked about when we got to the differential between the 7-8 PBT ex structural number, and we said there's about 2 points from below the line coming from net interest and the all other line item. As Lee mentioned, call it a 1.5 points of that is coming from net interest. That does not include the benefit from the sub-bottling payments in the period that they come in. That is in structural impacts, which we just walked through on the call. In the 5-6-point overall PBT headwind, there is a benefit from the sub-bottling payments in the year that they come in. Now, the growth, once they're in the base and they keep growing, that does impact the underlying net interest number.
The one-time step up is actually flowing through structural impact.
Thank you so much.
You got it.
Our next question comes from Amit Sharma of BMO Capital. Your line is now open.
Hi. Good morning, everyone.
Hey, Amit. How are you?
Good, thanks. Just a couple of quick questions. As we are looking at 2018 and perhaps even beyond that, what should the revenue, we should be modeling for the BIG division once all of this refranchising has completed in North America and in China as well?
We haven't broken that out because obviously those base businesses are gonna be growing between now and, let's call it 2019, as we get to year-over-year. I think we've given you enough at the structural impact line at the headline numbers to get to a pretty good ballpark range. I think if you take the structural impacts we've given, plus the incremental details we gave on the call. Obviously, the BIG segment impact is going to be above in 2017. It's going to be above the 18%-19% impact. It's going to be more than that. You factor in another impact in 2018. That should get you in the ballpark of what the number should be.
That makes sense. If I'm thinking the OI margin for BIG is the elimination of the North America business. Does that depress that margin structure even more, or should I still be looking at a relatively flat margin sale?
Yeah. I think probably the better way to think about it is what's going to be left.
Yep.
You're going to have primarily India as the biggest driver in that, then Southeast Asia. You would imagine in territories where we're in a growth mode overall, that margins are going to look different than they are in more developed territories as they're reinvesting in the business and growing it for the future.
Got it. Then one just on the call, James sort of talked about trying to overcome the strong dollar. What should we read from that statement? Is that something you're going to do something differently if we are in a structurally stronger dollar environment?
Yeah. It's a great question, and I think the simple answer is that the fundamental message that James was saying is that we obviously ultimately have to drive US dollar EPS growth or comparable EPS growth. That is what we're valued against and ultimately what our PE is set against. His point was we certainly need to manage our business for the long term, and that includes having to manage at the local level, recognizing that we compete with local players. Therefore, we have to keep in mind what local inflation levels are that sometimes move with US dollar currency and sometimes don't. We've got to factor that in. When we see a period of such long-term US dollar currency growth, then we have to take other corporate actions to drive and manage the business accordingly.
Without going in and saying we are going to do X, Y, and Z specifically, what I can say and what he's clear on is that he understands that in the face of headwinds that may be out of our control, we need to do everything within our control to help offset that.
Without asking you for details on it, would that include changing your marketing spend in some of those markets or at a consolidated level, along with corporate actions or corporate expense line?
Yeah. Certainly, we're taking a hard look at every dollar we spend. As James referenced in terms of decisions, even in, probably simplest example is to think of the fourth quarter. Although those were really more around in-marketplace spend against pricing initiatives, it still holds true from a marketing perspective as well, as where we do not think that we're going to get a return on our investment, in the near or medium term associated with that, then we'll make decisions to either redeploy into other markets where we think we can get a better return. If we don't see that opportunity, then that would drop to the bottom line, and then look for opportunities in the future as macros get better or situations and dynamics in the marketplace change.
Just one more for Tim. You earlier talked about maybe the incremental spending between 2014 and 2016 on marketing that's sort of gone away and the base is steady. I think about all the statements about one brand strategy, is that now in the base? If we think that you push a little bit harder on the one brand strategy, that's not going to lead to any incremental spend?
Don't forget, we've significantly increased our marketing spend over the last three years. That is now in our base dollar spend. It's about how do we effectively deploy that against all of our brands in our portfolio. We stepped up and we significantly supported our, when I say one brand, there's two elements of that, obviously. There is the one brand that has to do a little bit more with the visual identity and moving the brands together. Then there's the actual Taste the Feeling campaign launch. The Taste the Feeling campaign launch in 2016 was supported by a very robust marketing platform across the board.
As we continue to drive that campaign as well as look to roll out the one brand strategy in other markets, we'll pull all the levers and look to understand what is the best use of those dollars. The point being is we have a good, strong marketing base as of now. It now then comes down to marketplace by marketplace decisions on how to best deploy against the portfolio of brands.
Got it. Thank you so much.
You got it.
Our next question comes from Brett Cooper of Consumer Edge Research. Your line is now open.
Hey, guys. A few from my side.
Hi, Brett.
Straight overhead costs, where do they sit today?
They are in the BIG segment.
Okay. Is there any way that you can quantify or give us a sense of sub-bottler payments, how much they are, so we can understand the moving pieces?
The simple answer is we're not breaking those out specifically. We've given you the total offsetting impact to PBT of all of those elements. We're not breaking them out specifically because obviously then that has impacts, because it's against multiple bottlers that are involved. Starting to give individual sub-bottling payment estimates is not in the best interest. You have enough at the consolidated level to know how to plan out the overall PBT impacts.
Okay. Last one from my side. For 2017, you're saying 9%-10% OI growth. It includes two points of stranded overhead, two points of write-up, and then some piece of a roughly four-point productivity benefit. We're talking about organic sales up 3%. I think you guys said earlier, more price than mix and flattish commodities. Why is there not more leverage in the model?
Let's start first with the 3%. All right? We've talked 3% top-line revenue. That is going to drive some level of operating margin expansion associated with it, and we saw it this year as well, to your point about there's pricing associated with that built into it. You layer on four points. Let's assume that it's a couple points. You layer on another four points of productivity. At that point in time, you're at 9%-10% OI growth. There's a little bit of reinvestment taking place in the business, that gets you back down. When you take the 9%-10%, you back off the couple points of stranded cost removal, you get that flowing through. You're seeing the combination of both the productivity plus the top line driving. You're seeing that flowing through into, okay, let's start with, say, a 9%-10%.
Even if you back off a couple points, you get to 7%-8%, you're still seeing four to five points flow through between the combination of pricing and then the productivity flowing down to the bottom line.
Don't I always also take out the two points from the write-up of inventory?
No. That's an offset to the structural impact number.
That will not be in your underlying numbers.
No.
When you say 7%-8%, that's not with the write-up.
Yeah, exactly. Thank you for asking that question because that's very important to clarify. That two-point benefit of the intercompany profit benefit that we talked about on the call, that is netting against the overall 5- to 6-point structural headwind.
All right. Perfect. Thanks. That makes a lot more sense.
Okay. Got it.
Our next question comes from Steve Powers of UBS. Sir, your line is now open.
Hey, good afternoon.
Hey, Steve.
I just have one, and you've done a great job, I think, of clarifying kind of the P&L moving parts. On cash flow, when you presented at CAGNY last year and talked about the transition to Future State Coke, in addition to calling out the $800 million of structural impacts to EBIT, you also said free cash flow would be, excuse me, more minimally impacted, I think only about $400 million. Yet, this past year in 2016, free cash flow fell by $1 billion more than that, if my numbers are correct. I'd just like some clarification on what's going on there in 2016, and should we expect free cash flow to recover back to or above that $8 billion level over the next few years? If not, why not?
Yeah. I think, number 1, it's probably important to break out and talk about 2016 because there's elements of 2016 on the base business that have impact. Number 1 is we had a significant impact from currency flow through that in 2016. We also had some pretty significant pension payments that were made in 2016 that flowed through operating cash flow that impacted that number overall. There were some offsets to that number that were not tied to the refranchising specifically. As you think about it going forward, the overall premise of the fact that the free cash flow is going to reduce at a lower level than the OI still holds.
That's still the right way to think about it, and importantly, from my perspective, the way I think about it is we're going to see not only a significant increase in the operating margins, we'll see a significant increase in the free cash flow margins, because the other element that you have to play into that number is the CapEx. As we think about 2017, the overall CapEx guidance is still somewhat elevated versus what we talked about at CAGNY, and that's simply because of the timing of the refranchising, especially in the plants. We'll still have a certain base level of CapEx that's going to play through, and that's why that CapEx number for 2017 is still higher. Ultimately, as we move to 2018 and we've completely refranchised, that CapEx number's going to come down pretty significantly from there.
Therefore, you're going to see the free cash flow number move up accordingly. That's why 2017's a little bit hard to look at just in and of itself, and it's better to think about where we're going to be in 2018 and beyond. At that point in time, you're going to have a business with a very strong free cash flow margin. As we drive top line growth against that, and knock on wood and anything else I can get hold of, a dollar that stops moving against us at the rate it has been, it's going to be a highly cash generative business that's going to flow through.
Okay. That's helpful. Getting back to 90%-100% free cash flow conversion is something we should expect, right? This 2016 was an aberration in that regard?
Yeah. There were certainly, with the pension payment alone, I would say that's not going to continue. We'll have pension payments from time to time, but that's not something that you would model in at that level into 2017.
Okay. Just one last thing. As I think about the moving parts, I get the CapEx comes out. You also lose a good deal of depreciation and you're replacing some operating profit with equity income, which doesn't necessarily carry with it cash. Where do we make up the difference? Is it just better working capital is going to plug a hole as we transition?
There's an element of working capital in that. Obviously, the CapEx number's going to come down. Obviously, depreciation, D&A goes down, comes out with it, as you mentioned. The working capital number is one of it. At the end of the day, with the guidance that we gave, you're still going to flat see free cash flow coming out of the P&L. That's what we talked about at CAGNY, and you're going to see that for sure. Again, I don't want anyone to lose sight of the whole reason why we did this was not to end up with higher margin business. It's to, number 1, get back to the core of what we do well and then drive accelerated top-line growth through the combination of the bottlers being in the hands of those that we're refranchising to, putting focus against that.
Separately, us focusing on what we do best, which is driving our consumer-centric portfolio. All of that put together drives an overall better cash flow outlook.
Great. Thank you very much.
You got it.
Our next question comes from Bill Chappell of Truist. Your line is now open, sir.
Hey, thanks.
Hey, Bill.
Good afternoon.
Oh, afternoon. Yep.
Just a simple, if you look at the 30% of the unsigned territories, what's the timeframe from an LOA to a close? Is there any chance that some of this falls into 2018?
As of now, the outlook in the U.S. is that we would intend to have all of those closed by the end of 2017. Now the timing between DA and closing is going to vary. There's not a standard number just to give you. The 30%'s been closed, but again, we have a lot that have reached the DA stage. There's just a matter of moving to the close. Then we obviously have to manage the timing of those relative to the overall pace and change for the year, the seasonality of the business, et cetera. The Gantt charts that the teams have in front of them are, as you can imagine, number one, very detailed, and number two, they're very comprehensive. Everything, as of now, is pointing to a successful close by 2017.
Is there a chance it slips to 2018? Of course, there's always a chance. The team has the right plans in place, and we're, at this stage, confident that that's going to happen.
Just going back to Vivien's question, I think what you're saying is there's very little chance of me being able to model this quarterly in 2017.
I think it would be very tough.
Just-
I think probably the best thing to do is to have a full year number and then wait for us to give you guidance on the next quarter.
Got it. Just want to make sure we're on the same page. Thank you.
Our last question comes from Bill Schmidt from Deutsche Bank. Your line is now open.
Hey, guys. Thank you so much for doing this.
Yeah, you got it.
Hey, just a very quick question. How much flexibility are the bottlers going to have on retail pricing once everything is closed? I know it's not necessarily a fair question, but I ask because it seems like once this is done, you guys have no commodity exposure and they bear the brunt of it. As you get changes in oil-based commodities and things like that, are they going to be able to pass it through? Are you guys still going to have pretty good control and say over the retail price points?
Yeah. No, I want to be crystal clear that we do not dictate retail pricing from a Coca-Cola Company perspective. Just first and foremost. As we think about it overall is, and this is how it works across multiple territories, that's part of the franchise process is we work together to define where and what the overall consumer outlook is. We work together to think about the right price pack architecture, and then make recommendations to the bottlers. Ultimately, it's their decision to implement those and take pricing to the retailer per those agreements that they reach. In the U.S., as we've talked about before, we do have arrangements where we have a national customer approach, and that allows us to think holistically about how we're working with our customers at the national level. That is led by the North America team.
Again, that's done in conjunction with the bottlers.
Okay. That's super helpful. Actually, I lied. Just one on-- Do you have any sense for what the pro forma cost of goods sold is going to look like? I'm trying to figure out what you guys are going to buy now that all the sort of bottle stuff seems like it's off your P&L.
Yeah. If you factor in at this stage, I think we have the updated slide in our investor overview. Our overall raw material impact for COGS, I'll have to double-check. I want to say it's $4 billion, but I need to reference that. It is on our website. I can get back to you on that, Bill, but it's around that range.
Okay. All right. That's super helpful. Thank you, guys.
You got it.
All right. Bye-bye.
All right. Thanks, Bill.
Now I would like to turn the call back to Tim for your closing remarks.
Yeah, you got it. I know there may be other questions. Do not hesitate to call us post the call. That will conclude the call. We hope the content's been beneficial and helpful for you as you think about the models. As always, as I mentioned, please don't hesitate to give us a call. We'll be happy to help. Thank you for your continued interest, your investment in our company, and joining us today. Thank you very much.
That concludes today's financial modeling call. You may disconnect at this time, and have a good day.