We published our research on Coca-Cola (KO) last year in which we concluded that it was a fairly valued blue chip company. At the same time, we saw that it was at least performing better than its soft-drink peer PepsiCo (PEP) was, particularly because Coca-Cola had a stronger management team. This led to Coca-Cola's share price significantly outperforming PepsiCo's since Indra Nooyi became PEP's CEO in October 2006. We were even pleased that two of our reports received recognition for the high quality content and insightful analysis about the company. We understand that Coca-Cola and Pepsi are fairly valued and seldom present investors with a buying opportunity for the following reasons:
- Both firms have a solid track record of financial performance and generate gargantuan free cash flows in excess of capital expenditure requirements
- Both companies are leading consumer staples products as opposed to consumer cyclical items like automobiles and houses
- Both soft drink makers have a solid track record in creating and harvesting value for shareholders via dividends and share repurchases
- We would not recommend investors short Coca-Cola or Pepsi.
- If they are concerned that the price of these companies would decline due to a market correction, they can always short the SPDR S&P 500 ETF (SPY)
Source: Morningstar Direct
Whenever we enter into a position, we try to buy it when the share price represents a discount to fair value of 20% or more. We reduced our fair value price per share for Coca-Cola from $42.65 to $40 based on our estimates for its future revenues, EPS and dividends and as such, we would prefer to wait until Coca-Cola's share price reaches $32/share. We also try to buy it when it is ~20% off its 52 week high and $32/share would represent a 20% discount from its 52 week high. We are also implicitly targeting a price to earnings ratio of less than 15X based on its estimated forward earnings for FY 2014. We acknowledge that KO had a higher PE ratio in the 1990s, however; the following factors justified the PE ratios of 20X-44X EPS then but not now:
- Coca-Cola was led from 1980-1997 by the legendary visionary Roberto C. Goizueta.
- Warren Buffett did not become a stockholder until 1988 and very few people knew who Warren Buffett was or why he bought Coca-Cola.
- Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) did not begin selling Class A shares until 1990 and Class B shares until 1996.
- Coca-Cola's dividend payout ratio was 40% or less during the 1990s but is ~55% now
- Coca-Cola had more room to grow in emerging markets then versus now.
- Coca-Cola sold off stakes in its bottler operations in the 1990s but bought Coca-Cola Enterprises's (CCE) North American bottling division in 2010.
- We began formally covering Coca-Cola and PepsiCo in June 2012 and we can confirm our thesis that both companies were fairly valued as both firms have been profitable but underperformed the S&P 500.
Source: Morningstar Direct
We are not surprised that Coca-Cola's shares underperformed the S&P 500, as it was fairly valued then and now. However, we were surprised that Coca-Cola's share price underperformed PepsiCo's share price as Coca-Cola's operating and financial performance was stronger than PepsiCo's. We were not surprised that PepsiCo underperformed the S&P 500, however; we were surprised it generated a total return of 21.2% since we began covering it. PepsiCo's operating and financial performance has been flat since Indra Nooyi became CEO and we think that PEP's share price already reflects these positive catalysts listed below.
- Donald Yacktman's eponymous firm built a 23M share position ($1.9B) over the last 12 months.
- Nelson Peltz's Trian Fund Management has built a 12M share position (~$1B) in the last 12 months.
- Investor speculation based on a potential deal involving PepsiCo and Mondelēz International (MDLZ) or PepsiCo spinning off Frito-Lay and other food operations.
- Investor speculation on PepsiCo replacing Indra Nooyi as Chief Executive Officer, which will eliminate PepsiCo's biggest weakness.
Coca-Cola had stable unit volume growth and steady adjusted operating growth on a constant currency basis, however, currency headwinds chewed up KO's revenue and profit growth. KO's adjusted EPS grew by 4.2% in Q3 2013 ($0.53) versus Q3 2012 ($0.508). The company grew its adjusted operating income by 2.1% and reduced its shares outstanding by 1.9%. Adjusted currency neutral revenue increased by 4% and reported revenues declined due to currency issues as well as the deconsolidation of its Philippine and Brazilian operations. Adjusted currency neutral cost of goods sold increased by 6% and adjusted currency neutral SG&A was flat. This resulted in an 8% increase in year-over-year adjusted currency neutral operating income during the quarter and 6% year-to-date. Coca-Cola's EPS of $0.53 met the analyst community's consensus quarterly EPS estimate.
Recent performance highlights for the company include the following:
- All global markets enjoyed positive constant currency neutral operating income growth except Europe (0%) and North America (0%).
- Key drivers of volume growth were India (6%), China (9%), Vietnam (21%) and Thailand (8%). These countries helped offset a tepid 1% volume decline in Europe.
- Volume growth from non-carbonated beverages (3%) outperformed sodas and other traditional soft drinks (1%).
Highlights from the relatively faster-growing non-carbonated beverages product line include the following:
- Tea Volume enjoyed 5% growth due to growth in key brands such as Gold Peak and Honest Tea in North America, Ayataka green tea in Japan and Fuze Tea, which Coca-Cola expanded across multiple markets worldwide during the quarter.
- Energy drinks grew by 4%.
- Packaged water grew by 5% led by Dasani, as Coca-Cola continues to focus on innovative and sustainable packaging and marketing programs.
Coca-Cola continues to return cash to shareholders. In FY 2012, the company spent $3.1B to repurchase 57M shares (net of share issuance by employee equity compensation programs). In FY 2013, Coca-Cola increased its dividend by 9.8% and spent $2.8B in net repurchases in YTD 2013. Coca-Cola's cash flows cycle is seasonal in that it typically employs up to $2B in the first fiscal quarter of a calendar year in the form of working capital and recovers it in the fourth quarter of a calendar year. Coca-Cola generated $10.65B in operating cash flows during FY 2012 and spent $2.17B on capital expenditures and acquisitions net of asset sales for $8.48B in free cash flows. This enabled Coca-Cola to return $7.67B to its shareholders in the form of dividends and net share repurchases. Coca-Cola has generated $6.57B in free cash flows in YTD 2013 and returned $5.24B in cash to its shareholders in the form of dividends and net share repurchases during the period. Coca-Cola is targeting $3B-$3.5B in net share repurchases in FY 2013 and we especially like that management quotes share repurchases on a net of share issuance basis.
Source: Morningstar Direct
Although the company has $36.2B in outstanding indebtedness, that is partially offset by $20.5B in liquid marketable cash and securities and $11.5B in equity method investments and investments in bottling companies. We maintain that we would prefer see the company pay a $4.50/share special dividend based on its gross cash and securities holdings or make larger annual increases than merely 10%. The $4.50/share special dividend would represent 12% of KO's market cap and would unlock value for KO's shareholders. We can see that the company generates strong enough cash levels to service its current debt load and we would prefer the company reward its shareholders with a richer dividend instead of repurchasing stock at such a rich price. At least KO and PEP's dividend yield is higher than the S&P 500's and both firms have the ability to create "homemade dividends" through stock repurchase programs.
Source: Morningstar Direct
In conclusion, we believe that both companies are fairly valued. We like that both companies have well-known value investors among their Top 20 institutional shareholders. (Berkshire Hathaway backs Coca-Cola, Nelson Peltz prefers PepsiCo and Don Yacktman has 28M shares in Coca-Cola and 23M shares in PepsiCo). Other than that, we believe the companies are fairly valued relative to the long-term growth rates that we expect both companies to achieve. Coca-Cola has a forward PE of 17.3 and a consensus LTG of 7.8%. Pepsi's forward PE of 17.5 is slighter higher than Coca-Cola's forward PE of 16.8 and its consensus LTG of 8.4% is slightly higher than Coca-Cola's 7.8%. We believe that investors should realize that they are paying a rich price in order to access the dividend streams of Coca-Cola and Pepsi and as such, we maintain that these shares will perform in line with the major market indexes.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no commercial or pecuniary relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.