Coca-Cola Cheap Considering Its Real Moat: Strategic Checkmate Power

Feb.23.14 | About: The Coca-Cola (KO)

Coca-Cola Nears 25-Year Low P/E!

Shares of Coca-Cola are presently trading at a multiple of 16.5 times ValueLine's forward EPS of $2.25, nearly the same as its average trailing-multiple during the financial meltdown. Aside from perhaps 11 months of that meltdown, KO's valuation is now at nearly a 25-year low, albeit versus its annual TTM ratios. This is a twisted statistic, but it still says a lot about the value available in the shares.

KO Now a Historical Value Relative to the S&P

Coca-Cola is in historical value territory when it trades at only a modest 7.5% premium to the S&P 500, which Birinyi & Associates estimates to be presently at 15.35 times next year's earnings. This value proposition is particularly evident when one considers that KO's 3% dividend is nearly 54% higher, and its .65 beta nearly one third less volatile than, the overall index. This narrow premium to the S&P is uncommon for Coca-Cola. Still, a relative value is not necessarily an absolute value. For that, we need to look ahead to KO's future prospects.

Better Than Buffett?

Berkshire's 1988 purchase represents an undisputed moment in time where KO's shares traded at a discount to true value. How does the beverage behemoth compare today with that moment in time? In 1988, KO had a 12.5% net profit margin and an average p/e of about 14. Today, net margins are 19.5%-nearly 55% more profitable. Crucially, the return on equity, which then stood at 34%, has now fallen to 26%. Are we to draw a negative inference from this deterioration? Not at all. It represents massive future profitability. To see why, we need to look back at Coke's long history of generating private-equity style profits from its perpetual cycle of bottler buyouts and spinoffs.

Shake Up The Bottlers and Profits Spew Out

Coca-Cola is higher-margin, higher cash-flow, lower leverage and lower beta business than its many bottlers. During market crashes it can therefore pounce on them with ease, refinance their debt, streamline operations, and then spin them off later when stock markets are frothy again. This is a recipe for constant cyclical profits, private-equity style, and Coca-Cola has been doing it for generations. This fix-n-flip has been part of KO's playbook for so long it is taken for granted that a small bottler will be bought or sold annually. But in 2010, CEO Muhtar Kent used the financial crisis and 2010 credit nadir to put this plan on steroids with the biggest bottler purchase in Coke's history, the massive acquisition of Coca-Cola Enterprises, an acquisition which has pushed down the return on equity. Temporarily, that is, until KO mercilessly wrings the inefficiencies out of CCE, launches hundreds of questionable beverages through it, loads it to the gills with debt, and then spins it off during the next bull market frenzy. The result will be a veritable money fountain. Huge capital gain on the sale, a giant lightening of KO's debt burden, and a return to fantastic return-on-asset statistics. Now is it clear why KO's lower return on assets is a blessing in disguise? Meanwhile, it affords a write-down of goodwill, sheltering profits from the taxman. It also entailed a tender of certain European bottling interests as part of the purchase price, which had the brilliant effect of swapping a hard-to-repatriate foreign cash flow stream for a convenient-to-use domestic one, which in 2010-2011 allowed KO greater flexibility with share repurchases and dividend payments. This helped reposition the company in expectation of a stronger dollar, reducing hedging costs too. Which brings us to another Coke trump card, the currency headwinds.

Dollar Down, Coke Up

Coca-Cola seems, on the surface, to suffer from a strong dollar and lose sales during emerging market downturns. This perception has taken perhaps 10% off the stock price this year as Fed tapering promises to suck money out of emerging markets and drive up the dollar. Over the short term, this is correct. But over the long term, it makes Coca-Cola's war-chest swell in relation to foreign acquisition targets, whose businesses will be weakened by the double whammy of higher import costs, higher credit costs, and reduced sales volume. The resulting low valuations allow Coke to come in with more muscular dollars and buy crucial manufacturer, bottler and wholesale operations around the world at deep discounts. A crash in China, Japan and or India will produce this generational windfall for Coca-Cola, hidden by temporary declines in dollar-denominated sales and reduced case-volumes. The strong-dollar era of the 1980's resulted in just this, as did the Russian devaluation and the Asian financial crisis. It is an old trick and Coke knows how to play it every time. So taper away, Janet Yellen.

Operationally For Coke, The Strong Dollar Doesn't Matter

A strong Dollar strategically aids Coca-Cola, as described above. But what about operations? Ask yourself, operationally speaking, are the foreign earnings really worth intrinsically less if the Dollar goes up? Consider, Rupees Coke earns but needs to immediately reinvest in India lose no value when the Dollar strengthens, except in the rare case that imported U.S. goods need to be purchased. In general, a Rupiah earned still buys a Rupiah's worth of purchases. So as for reinvested cash flow, the forex differential makes little difference. The surplus, 'free cash flow' Rupees on the other hand, could be converted into other currencies and used elsewhere. When these need to be converted to Dollars, real value is lost. But in most cases, Coca-Cola does not need to convert these into Dollars. The funds may be needed in South Korea, Mozambique, New Zealand, Norway or Peru. In these cases, the Dollar strength is irrelevant. Rather, the local currency/Rupiah pair is relevant, and some of these will have weakened, not strengthened, against the Rupiah. The real bottom line is that only the small portion of forex earnings which MUST be converted into Dollars or spent on U.S. goods are impaired by a strengthening Dollar. This turns out to be very little, and it is offset by the many cases where some local free-cash-flow strengthens against a foreign-currency investment obligation or opportunity elsewhere. This small operational impact of a strong Dollar is then further diminished by KO's forex hedging. What is left of the currency impact? Practically nothing. The more volatile global currencies become, the more KO can simply arbitrage its free-cash flow among them.

Cash Flow: The Real Moat

Each of the above discussions boil down to one thing: the real long-term moat for Coke is, surprisingly, not merely its brand, nor its secret formula for cola syrup. Rather, the durable competitive advantage nowadays resides is Coca-Cola's torrential free cash flow, combined with its low-cost leadership position in marketing, manufacturing and distribution. These are long term advantages which turn each economic upheaval to Coca-Cola's favor vis-à-vis its bottlers and its smaller competitors, generation after generation, in one market after another. Because of these advantages, the worse things get in some country, or some currency, the better positioned Coke gets there, because it is axiomatically less distressed than the local competitors and bottlers, advertisers and even governments. In this way, Coca-Cola makes its biggest strides in times and places of crisis. It is always the most flush company when cash becomes king, and management is therefore to be judged not by how the current marketing campaign is doing, or whether brand Coca Cola products are lagging, but rather how various crises are being strategically and tactically exploited for maximum long term advantage. A financial panic in America? Buy out all the American bottlers. Voila. An entire generation of new profits virtually guaranteed. That is my kind of management. A hard landing in China next year? We should only pray for it. Just thinking of the over-leveraged leading brands of Chinese beverages which will fall like a ripe harvest into Coke's hands makes a long-term shareholder drool.

Coke's Cash Flow Secret Formula…Hint: It's 70% Water

If torrential free cash flow is the moat, what drives the moat? Mainly the high margins inherent in being both the lowest-cost operator and highest price seller in the business of…selling water. KO primarily sells water, or sells additives which then sell water. Water is the main ingredient of orange juice, tea, coffee, soda, and of course, bottled water. Whatever beverage is primarily water, the former advantage comes from operational and distribution scale, the latter comes from the brand and marketing scale. Can KO continue to find profitable ways to sell water over the next investing lifetime? Of course. By adding sugar syrup? Maybe but maybe not. It doesn't matter. Coca-Cola is in the water business and will sell it more efficiently at better prices than nearly anyone else whatever the additive, for an investing lifetime.

KO Shares Probably a Buy at 16.5 Times Forward Earnings

Would an investor be willing to pay an 8% premium to the S&P for this kind of durable competitive advantage? Oh, and there's also the brand. The question almost answers itself. That's why I'm long KO and am accumulating more. Go Muhtar Kent. Go Go Pemberton. On Candler, On Goizueta, On Buffett and Woodruff. Long, and Long live, Coca-Cola.

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