One Simple Reason To Buy Coca-Cola

| About: The Coca-Cola (KO)

Summary

Free cash flow could grow by ~8% CAGR through 2016.

On a sustainable basis, dividend per share would rise by 8.7% CAGR through 2016.

Current share valuation only implies less than 7% annual dividend growth.

The share price of Coca-Cola Company (NYSE:KO) has been range bound since April in between $40 and $41. In my view, investors should take this opportunity to build up positions as the company's dividend growth prospects are underestimated by the current share valuation. In this article, I will provide readers some perspectives on KO's future cash flows and dividends.

I have performed cash flow projections from 2014 to 2016 to gauge KO's capacity for future dividend growth (see chart below).

Given KO's historically stable operating cash flow ("OCF") margin trend, my analysis started with consensus revenue estimates that predict the top line to grow from $50B in 2014 to $51B in 2016, by a 4.2% CAGR. To be conservative, I assumed a 21.7% OCF margin for 2014 which is consistent with its 3-year historical average. I projected the OCF margin to reach 22.7% by 2016 based on a consensus view that the company's EBITDA margin will expand from 28.0% in 2013 to 29.7% in 2016 (my projection is conservative in a way that the OCF margin was assumed to change very little from 2013 to 2016). For capex, I assume the figure to grow by 3% per annum through 2016 as KO has not announced any notable spending plans. Based on these assumptions, free cash flow was forecasted to grow by 7.9% CAGR from $7.6B in 2014 to $8.8B in 2016 (see chart above).

Given that KO will pay out an annual dividend of $1.22 in 2014, I estimated that total annual dividend spending would be about $5.2B in 2014 based on a 4.3B share count (discussed later). As such, free cash flow dividend payout ratio was estimated to be 69% in 2014, which is higher than 62% in 2013 primarily due to lower free cash flow in 2014. In order to maintain the free cash flow payout ratio at ~69%, annual dividend spending can grow by 7.5% per annum in 2015 and 2016. In this scenario, KO would have approximately $2.3B-$2.7B excess free cash flow per annum over the forecast period (see the first chart).

Assuming 80% of the annual excess free cash flow is spent on repurchasing shares (the other 20% is to account for minor cash acquisitions and dilution impact from equity issuance) and a 5% increase in buyback price per annum from $40, I estimated that total share count would be reduced from 4.5B in 2013 to 4.2B in 2016 (see chart below).

Given my annual dividend spending projections, dividend per share was projected to rise by 8.7% CAGR from $1.22 in 2014 to $1.44 in 2016, which is in line with KO's historical dividend growth level at 8%-9%. Further, given the consensus EPS estimates, my forecasted dividends per share from 2014 to 2016 would imply a somewhat steady earnings payout ratio at 58%-59% over the forecast period. As the free cash flow payout is also set to stay flat in my model, this analysis suggests that KO can sustain the 8.7% annual dividend growth at least over a medium term (see the second chart above). The following chart shows a quarterly breakdown of my annual dividend per share forecasts from 2014 to 2016.

Click to enlarge

Based on current annualized dividend of $1.22 per share and 10% cost of equity (the CAPM model would result in 6% cost of equity based on 3% risk-free rate, 6% equity risk premium, and KO's 5-year beta of 0.5), the Gordon Growth Dividend Discount Model suggests that the current share price of ~$41 implies a dividend growth rate of less than 7.0%, which is below my dividend growth expectation (see chart below).

In conclusion, based on the current state, KO can continue to sustain its recent dividend growth pace over a medium run without negative impact on cash flow and earnings payout trends. As this expectation is not fully reflected by the current stock valuation, investors are recommended to buy the shares now.

All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: I am long KO. 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.