When I first purchased shares of The Coca-Cola Company (KO) back in 2003, I had based my purchase decision on four factors. The company had a strong and sustainable competitive advantage, a strong financial position, was trading at a reasonable valuation, and had good future prospects, particularly the ability to expand significantly into emerging and developing markets.
My current analysis of KO’s future prospects (see here) assumes that growing per-capita income in emerging and developing markets will likely result in growing per-capita consumption of non-alcoholic ready to drink (NARTD) beverages, and that the company’s strong competitive advantage will allow them to maintain or grow global market share.
On November 17th-18th 2009, KO held an investor conference where they unveiled their 2020 Vision, which is to double system revenues by 2020, while at the same time increase system operating margins. Although system revenue includes revenue from both KO and its bottlers, I would expect KO to participate in this growth to at least the same extent as the bottlers, based off of the company’s history. If Coca-Cola meets these targets, they expect to create cumulative cash flow of $130 to $150 billion by 2020, of which they plan to re-invest around $35B back into the company. Using the low end of their projections, this leaves $95B available for dividends, share buy-backs, and acquisitions.
Assuming that, as in the past, Coca-Cola manages to create more value from its acquisitions than could be obtained through share repurchases, then their 2020 vision implies returning over 75% of the company’s current market capitalization to shareholders over the next ten years.
Moreover, it is a pretty good bet that Coca-Cola’s competitive position will be just as strong in ten years as it is now, and consequently a 16X earnings multiplier might be a conservative estimate for the company’s valuation in 2020. If the company doubles its earnings as per plan, then this implies a 2020 market capitalization of $224B.
If we make the simplifying assumption that the $95B in cash is returned to shareholders uniformly over the next ten years, then this would imply a 14% internal rate of return.
But how likely is it that Coca-Cola can meet this target? Doubling revenues over ten years implies a 7.2% revenue compounded annual growth rate (CAGR). From 2000 through 2009, Coca-Cola grew their revenue at a 6.0% CAGR. But as you probably know, revenue growth eventually becomes self-limiting as an industry saturates its market. With this in mind, it might be something of a stretch to reach the 7.2% annualized revenue growth rate.
In order to meet their 2020 target, Coca-Cola is depending primarily on growth in emerging and developing markets. During their 2020 Vision presentation, the company presented a UN projection showing that the global middle class will grow from 1.2B today to 2.2B by 2020, as well as historical evidence showing a strong correlation between a country’s per-capita expenditures and per-capita NARTD consumption.
Based off of this growth, Coca-Cola expects total industry annual volume to grow at a 4% annualized rate and total industry value to grow at a 5% annualized rate, from $600B to $1,100B. The 1.2% difference could come from two sources – an improvement in product mix and market share gains.
The following two charts illustrate the continued potential for volume growth. Although the first chart shows a slowdown in volume growth in certain markets, the markets with lower per-capita consumption (see second chart) are still growing strong.
Moreover, per-capita consumption in emerging markets could increase by almost ten times before it hits levels seen in markets such as the United States and Mexico.
Still, even if Coca-Cola falls short on the revenue side, there is a potential for considerable margin expansion. Historically, although volume growth in emerging markets has been high, emerging market margins have remained well below the company’s global average.
During their Q4 2009 conference call (see transcript here), Coca-Cola talked about how economies of scale relate to operating margins. When per-capita consumption of the company’s products approaches 100 (the global average is currently 86), operating profit growth begins to significantly outpace revenue growth. In their Q4 conference call, they gave Mexico as an example where 15-20 years ago, volume growth rates were high, but operating margins low. Today, the company’s Mexican operations have achieved economies of scale (their per-capital consumption exceeds that in the U.S), and have high operating margins.
Currently, emerging markets per capita consumption is around 25, and operating margins in these countries are well below the company average. Looking at the example of China, Coca-Cola expects case volume to triple between now and 2020, which would put it close to the global average of 85, which would lead to considerable margin expansion. This growth seems feasible, considering that volume has grown at a 19% rate from 2002 through 2008 - extrapolating this rate forward ten years would imply over a 5X growth in volume, and as we can see from chart 2, the Chinese market is nowhere near saturated.
In summary, I believe that Coca-Cola has a good chance of meeting their 2020 vision, which makes the company a bargain at its current price – assuming you have the patience to hold onto the company’s shares for at least ten years. As a matter of fact, I think you would be hard-pressed to find another company with similar growth potential and limited long-term risk.
Disclosure: Author holds a long position in KO
