Coca-Cola: Probably Fair Value

by The Compound Investor

Coca-Cola (KO) stock last featured back in the summer. At the time, Atlanta-based Coke had been battered by COVID. Its share price sat around the $43.60 mark, which was 20% lower than at the start of the year due to some fairly significant disruption to its business. More specifically, its on-premise activity – half of overall business here – has suffered due to the precise nature of the crisis. The at-home channel can only offset that to a certain extent.

As you would expect, the above means that consolidated financial figures look pretty poor this year. Net sales clocked in at $24.4b over its first three quarters, a circa 11% decline excluding currency changes. That led to comparable operating income of $7.4b, a circa 4% drop on a currency-neutral basis. At $1.48 per share, earnings per share (“EPS”) came in 6% lower on a comparable currency-neutral basis. Other than a viral pandemic being pretty bad for bars and restaurants, I am not sure the numbers really tell us that much.

Like a lot of folks, I am more interested in the ‘normalized’ business. Here, Coke enjoys significant advantages due to its strong intangible assets and dominant market position. The two are connected of course, but ultimately expressed in a highly profitable business model in which the firm sells concentrate and syrup to bottling partners. The bottlers then add the soda water and deal with things like packaging, distribution and so on. Though the firm does also manufacture finished goods, this activity represents less than 20% of total worldwide unit case volume. The concentrate operations are inherently more profitable and lower cost, a combination which helps Coke post ROIC in the high-teens region (and even higher if excluding goodwill from the balance sheet).

Negativity

Negative articles on Coca-Cola stock have been common in recent years. Typically, the bearish view includes the following three points. Firstly, that Coke suffers from a poor outlook in terms of its growth prospects. Secondly, that this issue is then exacerbated by an overvalued stock. The third point – actually more of an offshoot of the first point but anyway – is that the firm is now paying out too much of its profit by way of cash dividends.

(Source: Coca-Cola 3Q20 Results Presentation)

In terms of points two and three, it is not hard to see where folks are coming from. I mean, the stock closed out yesterday at around $53.10 per share. The firm expected underlying earnings power to run at around the $2.25 per share mark pre-COVID. The firm also currently pays out $1.64 per share by way of its annualized cash dividend. Quick math therefore puts the normalized price-earnings ratio (“PE”) at around 23.5, and the payout ratio at 75%. Again, it is easy to see why that looks concerning.

As far growth is concerned, much ink has been spilled on the subject of carbonated soft drinks (“CSDs”). Health conscious consumers, mindful of excess sugar consumption, are seen as a major headwind. This certainly looks the case in mature markets. In the company’s North America segment, sparkling beverage volume growth has essentially flatlined over the past five years. Coke’s lackluster reported-EPS growth is seen as further proof that its glory days are over.

Outlook

I remain more optimistic. Firstly, mature markets do indeed present an issue. There, the firm has relied more on price and product mix to drive stable sales. The rise of smaller product offerings – welcomed by the consumer as healthier – offers the firm a route to higher sales and margins without much volume growth. Here in the UK for example, trademark Coca-Cola products now come in 150ml and 250ml offerings at higher unit volume prices. Ironically that takes the firm back to its early days, when fountains and the 6.5oz glass bottle were the only show in town.

(Source: Coca-Cola Investor Overview Presentation)

Moreover, not all of Coke’s markets are mature. Most profit comes from abroad these days, and a chunk of that comes in developing markets where Coke has room to grow in both absolute and per-capita terms. Its vast distribution network also supports potential growth avenues. These include distribution deals with third party firms – high margin for Coke as a kind of toll booth operator.

With the above in mind, organic growth has not been so bad here. The reported figures look worse, but largely due to unfavorable foreign currency fluctuations against the USD. For instance, organic revenues increased 6% last year, and 5% the year before that. This is consistent with management’s target of annual top line growth in the mid-single-digit region. Those targets also see EBIT growth in the 6-8% per annum area, with EPS growth running a point ahead of that.

(Source: Coca-Cola Investor Overview Presentation)

On those numbers, Coke stock is not expensive. The headline PE ratio is misleading as the business delivers significant economic value as a result of its superior profitability. It should trade at a premium headline valuation, all other things equal. This also supports a higher payout ratio, though the current figure pushes that to the limit. Quick math then suggests that growth at the lower end of the target range justifies the current share price. For that reason, the stock appears fair value right now.

Note

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