The stellar performance of McDonald’s stock has been one of the more interesting stories in the blue chip dividend space over the past few years. Back in the 2012-2015 period you could have balanced a spirit level on the share price chart it was that flat. The stock just didn’t want to move at all. Perhaps unsurprisingly the tone of articles on financial media sites was often pretty negative toward the company and its future prospects. The short version often boiled down to the combined impact of healthy eating, intense competition from other players in the restaurant sector and the board’s attempt to cover the plaster with financial wizardry (e.g. mass share repurchases funded by debt).
In fairness there is something in that narrative, and I’ve been somewhat critical of excessive stock buybacks despite being a shareholder myself. That said it’s amazing how quickly investor sentiment can change once a company posts a few quarters of solid figures. In the case of McDonald’s the company’s overall revenue continues to slide, but that’s mostly due to shifting restaurants from company managed outlets to franchised ones. The flip side of that particular coin is that profit margins have increased dramatically at the same time. Throw in some pretty decent like-for-like sales growth, plus the aforementioned generous shareholder return program, and we’ve got the recipe for some serious positive share price action. If my numbers are correct the stock has returned around 23% per annum since the beginning of 2015.
Could a similar situation now be playing out with blue chip favorite Coca-Cola? Well, just like McDonald’s in the 2012-2015 period Coke stock has had an unremarkable past few years. Indeed it has delivered shareholders returns of just 4.6% per annum since the start of 2015 (versus 15% per annum for the Dow Jones Industrial Average). As you’d expect bearish financial media articles have been ten a penny, with much of the narrative once again centering on healthy eating trends (sugary drinks in this case rather than hamburgers and fries).
While it’s certainly true that Coca-Cola is battling headwinds in the beverage industry, and I base that on per-capita consumption and declining soda volume trends, a lot of the fear seems to be overblown. For example, the headline figures for the 2012-2016 period show that annual earnings per share dropped from $1.97 to $1.49. Now ordinarily a near 25% drop in profits over a five year period would be enough to frighten a long-term shareholder into thinking that the underlying business was seriously deteriorating. However, according to the company’s internal figures operating profit grew by an average of 8.5% per year over the same period. The explanation for that divergence lies with massive foreign exchange effects plus assorted structural charges. In other words the situation isn’t really all that bad on the ground.
Whenever I’ve written about Coke in the past it has usually been with a focus on value rather than analyzing what’s happening with the underlying business. In my opinion folks are too quick to blame the latter for issues that relate to the former. For instance, since the turn of the century there have only been two whole years in which the average annual price-to-earnings ratio was below 17. As you can see from the graph below there have only been very brief instances in which Coke stock represented anything remotely resembling a good deal. And much of that came by way of the extreme circumstances associated with the 2007/08 financial crisis.
If you look at historical investment returns from paying in the 15x-20x annual earnings range you’ll find that actually Coca-Cola tends to have done pretty well – much better than the share price chart suggests. For instance, in early 2006 there was a brief window in which the stock was just under 20x earnings. Between then and now it has returned just shy of 10% per annum, which is actually around 1% per annum better than the S&P 500 managed over the same period (assuming dividends reinvested in both cases).
So why do I reference McDonald’s above? Well, in that case you had a relatively lengthy dead money period in terms of the share price, but crucially the valuation was actually in the sweet spot range. It spent most of the 2012-2015 period trading at around 16x-18x annual earnings. New-found exuberance on the company’s future prospects has sent that figure to around 24.5x estimated fiscal year 2017 earnings.
What about Coca-Cola? Well, fourth quarter results released last week were largely, and possibly surprisingly, positive. Organic growth was up 6% during the quarter, with the company reporting positive growth figures in all of its reporting geographies. As for FY 2018, organic revenue is expected to be up 4% with comparable earnings-per-share expected to be up by around 9%. Granted, the upshot of this ‘growth’ is simply to cancel the ‘losses’ from prior years, but it does show that Coke’s business is humming along profitably (albeit unspectacularly in terms of growth).
The bad news is that unlike McDonald’s back in 2015 Coke stock is still stubbornly over 20x earnings on the basis of estimated 2018 results. That’s the major stumbling block for anyone scratching their heads at why there hasn’t been any major movement here. Despite the limited room for valuation multiple expansion I’d say long-term annual growth in the 5%-7% range on a starting dividend yield of 3.5% is still an okay outcome for such a stodgy and reliable business.