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This article is part of a series looking at investing in soft drink companies. Each article will investigate price targets, analyze the company's current and future prospects, and compare it with other companies in the industry.

Thesis

Coca-Cola (NYSE:KO) is looking solid for a 2013, and we believe the company is a good buy on recent weakness as an entry for an investment. We upped our price target on KO despite weaker sales as the company is showing positive trends in profitability, will benefit from a rebound in China in 2013, and continues to show strong consistency in growing equity value through dividend increases and stock buybacks. For 50 years, KO has increased its dividends with another 8.5% increase in 2012. The company is very attractive for an income investor, and we believe that the stock is showing good value as well that should attract value investors as its PE has dropped below 20.

One of the most appealing aspects of the KO business is the fact that the company continues to perform significant share buybacks. This year, alone, the company has reinvested $3B into share buybacks, and recently announced a new $19B, 500M share buyback plan to return more value to investors. The company continues to reinvest cash into share buybacks. That deal was part of the reason we saw such a strong uptick in our price target as the number of shares will drastically decrease over the next several years.

One of the issues facing the company, though, is the continued decrease in volume of soda sold in North America, which Coca-Cola has called one of its "growth markets." Total volumes of soda consumption fell in 2011 by 1%, and it is expected that the trend will continue in 2012. The key for KO is the ability to continue to diversify its portfolio of products offered to appeal to consumer trends. Teas, sports drinks, waters, and juices have replaced the unhealthier carbonated sodas, so its important that KO does well in these areas. We believe the company is taking the necessary steps as displayed in the last quarterly report. The company saw a solid 2% rise in sales volumes in Powerade sports drinks and Fuze tea drinks. The company has also done well with introducing drinks like Coke Zero and mini-cans of their drinks to appeal to those trying to cut down on soda.

Another reason we really like KO for 2013 is the company's exposure to Latin America, China, and potential profitability increases. China has started to see some economic rebound, and KO has a strong presence in the Asian nation. Coke will definitely benefit from a rebound there in 2013 as well as Latin America. The company announced it is increasing its investment in Latin America through a $1.3B investment in the country, which comes on the tails of a new plant there worth around $200M. Finally, the company should see its profitability levels increase after it acquired Coca-Cola Enterprises, which is KO's bottling business. That acquisition will help the company reduce expenses and increase productivity, thus increasing profits and equity value.

The global leader in beverages is a great Buy right now with lots of value, potential in 2013, and strong income potential. On this weakness, KO is a great Buy.

Rating: Upgrade from Hold to Buy

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

KO

$51

$43

Buy

Hold

$40/$56

Price Target

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it with current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

11310

10420

11100

11500

13160

Taxes

2714

2501

2664

2760

3158

Depreciation

2000

2040

2140

2230

2321

Capital Expendit.

-2976

-3000

-3100

-3150

-3256

Working Capital

480

480

480

480

480

Available Cash Flow

7140

6479

6996

7340

8587

We see 2013 as a strong rebound year for KO and around 16% gains in operating income in the next five years. We see the tax rate averaging around 35%. Capex should continue to increase as the company has to continue to innovate and invest in new markets and new products with competition very high. Working capital is averaged for the past 10 years.

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for KO: 6.00%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9434

0.8899

0.8396

0.7921

*

PV of Available Cash Flow

6735

5766

5874

5814

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2%-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you the cap rate.

Cap Rate for KO: 3.0%

2016

Available Cash Flow

8587

Divided by Cap Rate

3.00%

Residual Value

286220

Multiply by 2016 PV Factor

0.7921

PV of Residual Value

226713

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

24190

PV of Residual Value

226713

Cash/Cash Equivalents

9615

Interest Bearing Debt

32730

Equity Value

227788

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

227788

Shares Outstanding

4490

Price Target

$51

In the end, we have found that KO is worth around $51, which we believe accurately reflects the company's five-year projections.

Profitability

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

23.5%

23.1%

Gross Margin

60.5%

61.1%

Return on Equity

21.7%

22.0%

2012 has seen operating margins increase while gross margins and return on equity decreased. None of the moves was very significant for KO, but the drop in ROE and gross margin does show some of the weakness it has had in Europe and Asia. How do these number compare with the competition?

Pepsico, Coke's biggest rival, has operating margins of 15%, gross margins at 52%, and ROE is at 21%. PEP offers snack foods as well as drinks, so it is not a direct comparison, but KO is offering a much stronger premium in profitability to PEP. Dr. Pepper Snapple has operating margins at 18%, gross margins at 58%, and ROE at 24%. Once again, KO outperforms in profitability. Recent comer Monster Beverage offers 28% in operating margin and 52% in gross margin as well as 31% ROE. Cott, finally, offers 5% operating margin, 13% gross margin, 8% ROE. As we can seen, KO is at the top of its industry as far as profitability, showcasing its ability to pass prices on to willing consumers, showing strong elasticity of demand and a strong economic moat for the company.

Value

Current

Industry Average

P/E

19.8

21.5

Future P/E

17.3

N/A

Coke's value is fairly strong with its PE ratio below its industry average and sitting below 20, which we look at as an indicator of value. We would expect KO to operate at a slight premium to competition and the industry, due to its solid growth levels as well as strong yield. PEP has a 19 PE along with 16 future PE. MNST operates with a 29 PE and 22 future PE. DPS has a 15 PE and 14 future PE, and COT has a 24 PE and 12 future PE. We can see KO sits in the middle of the pack. The stock is not a value stock by any means, but we see its future PE at 16 as showing a nice amount of growth in share price in 2013.

Source: Investing In Soft Drinks, Part 1: Coca-Cola Best Of The Industry, Will Increase 35% In 2013