Coca-Cola's Hidden Source Of Value

| About: The Coca-Cola (KO)

This article is part of an ongoing series that highlights specific companies that are on sale. It helps me to document my thought processes when I add to my holdings or initiate new positions. Please provide your feedback in the comments section below.

Coca-Cola (NYSE:KO) is currently offering investors an opportunity to buy portions of the company at $39/share. The stock has been steadily declining for the past six months since reaching its 52-week high, but has been ramping up these past couple of weeks and may provide a good entry point. Right now, KO is about seven percent off the 52-week high, hit six months ago at almost $43 per ownership interest. This few month pullback and recent ramp provides long-term investors with a good opportunity to initiate a position. Essentially, KO has earned a whole quarter's worth of profit and repurchased an entire quarter's worth of shares, yet the price is lower than it was a quarter ago.

Coca-Cola has a business model that is simple and sustainable. They produce and distribute beverages to the entire world. This includes soda, juices, teas, even energy drinks. One advantage that Coca-Cola's business model has is that they produce a large amount of syrup that is transported to the establishment that will sell soda. This is a huge advantage, because shipping syrup is much more efficient than shipping cans and bottles of mixed soda. Coca-Cola also is able to increase their prices at a rate that keeps up with inflation, passing along the devastating effects of inflation on to the consumer, not the owners. According to the 2012 Annual Report, sales volume increased by 4 percent year over year, generating record net operating profit of more than $48 billion. Daily servings increased by more than 200 million. Even the flagship Coca-Cola brand sales grew by 300 million unit cases. More than 500 new products were introduced in 2012, including over 100 low- or no-calorie products.

Despite the growth, I believe that Coca-Cola trades at a discount to its true valuation. KO currently trades at 20 times ttm earnings and under 18 times projected next year earnings. EPS is expected to grow over 6% next year. Coca-Cola reported earnings on October 15th, and sales volume were up 2% for the quarter. Coca-Cola's earnings were hurt by 2% due to foreign exchange impacts. I try to disregard FX impacts, since they will always fluctuate one way or the other. EPS for the quarter increased by 4%. I believe that KO is turning around now, and I am content to accumulate shares at this perceived discount.

Also, Coca-Cola is a cannibal! KO has been buying back its own stock at a pace that affects the bottom line. Just one year ago, there were 4.59 billion shares outstanding of KO. Today, there are under 4.5 billion shares. In one short year, Coca-Cola has retired 2% of its outstanding share volume! The company has indicated on many occasions that returning cash to shareholders via share buybacks is an important goal for management. They are using their free cash flow to buy out other shareholders, which further adds to the gains of the remaining shareholders.

With Coca-Cola buying so much of their outstanding shares, let's look at how that will affect future earnings. Analyst expectations are very low. Analysts are expecting a consensus EPS of $0.47 for the current quarter, which is substantially lower than the most recent EPS of $0.53. It doesn't appear that analysts are expecting much, if anything, from KO for the current quarter. With KO's large share buyback activity, it wouldn't have to make more in total earnings to affect the bottom-line EPS. I believe that Coca-Cola will have a positive surprise, and this one catalyst that will cause KO to break out from its downward trend and close substantially higher at the end of 2013.

Let's take a quick look at a couple of KO's competitors, Pepsi (NYSE:PEP) and Dr. Pepper Snapple (NYSE:DPS). Coca-Cola has less than half the long-term debt as a percentage of equity compared to both competitors. Debt is a drag on free cash flow as it encumbers cash for the interest payments. For every dollar spent servicing debt, that's one less dollar for dividends, share buybacks, or reinvestment. KO's gross margins, operating margins, and net profit margins are all higher than Pepsi's and Dr. Pepper Snapple's. Coca-Cola also trades at under nine times cash, while Pepsi trades at 14 times cash and Dr. Pepper Snapple trades at 86 times cash. Coca-Cola is the type of company that I want to own for the long haul.

Coca-Cola also has a solid yield for such a stable company. You literally get paid to wait. KO has a current yield of over 2.8%. During the financial crisis, Coca-Cola did not cut its dividend. In fact, it raised the dividend. Coca-Cola is a Dividend Champion and has raised its dividend every year for 51 years. Its most recent dividend hike was for 10%! KO is both a buyback king and a dividend king!

Combined with their earnings growth and share buyback activity, there is one other catalyst. On October 28th, Coca-Cola presented at the National Association of Convenience Stores conference. The company displayed twenty new products to help drive growth. These include liquid water enhancers for the Minute Maid and Vitaminwater lines, a new cold-activated can (which generated a lot of buzz at the show), and a newly-designed six pack case that can be stacked horizontally or vertically. This new product innovation is the hidden value that will fuel growth in shares of KO. As sales growth and increasing cash flow is used to buy back shares, Coca-Cola will only become stronger.

In a world of stagnating revenue growth, it is encouraging to see Coca-Cola developing new products and new sources of revenue. These innovative products will help the company with new channels for sales. For example, Coca-Cola has new technology that will help store owners customize their product mixes based on the demographic data that surrounds their store's location. Coca-Cola is using cutting-edge technology to analyze the demographics of the store's surrounding neighborhood and their purchasing habits, such as product mix. If the neighborhood overwhelmingly chooses to buy diet or low calorie drinks, Coca-Cola will work with the store owner to customize their product mix and offerings to be tailored to the neighborhood. This will be a more efficient use of shelf space and should translate into higher revenue for both the store owners and Coca-cola. One other new product that is made for the store owner is a bag-in-a-box fountain dispenser for Vitaminwater, which is essentially another fountain drink offering that is not carbonated.

With Coca-Cola's 3,500+ existing products, it would be easy for management to kick back and rest on their laurels. However, Coca-Cola has demonstrated their commitment to keeping the product line fresh with these new innovations. The risk of new products is that they will not be well received, which can be a waste of money at best, and devastating to the company at worst. Think New Coke. However, Coca-Cola management has been quite successful at introducing new products since the New Coke fiasco.

As these products come online, it will be interesting to watch how the bottom line grows. I believe that these new products will boost bottom-line EPS by a nickel, once they have fully come online. This may take a quarter or two to fully implement, but it will help maximize existing shelf space at retailers and provide additional shelf space for the company. $0.05 in EPS implies earnings of about $220 million. This is not a huge amount for a company of this size. Over the past 3 years, according to the 2012 Annual Report, Coca-Cola increased daily servings by more than 200 million. Think about that for a minute. On the third quarter earnings conference call, CEO Muhtar Kent stated that the company "delivered the highest number of servings ever reported in the third quarter both for brand Coca-Cola and across our portfolio." Clearly, the company's strategy for growth, including new products and technology, is working and should benefit long-term shareholders handsomely. This new product innovation should help to continue the volume growth.

As always, this article represents my opinions at the time of writing. You should do your own due diligence before making any decisions. However, I believe that Coca-Cola represents a quality company that is trading hands at a discount.

Disclosure: I am long KO, DPS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.