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In this article, I provide some arguments why investing in the Coca-Cola Company (KO) could compare favorably against investing in US Treasury bonds instead of holding cash as a long term protection against inflation. In my opinion, this is true of other great consumer brands such as McDonald’s (MCD), Pepsico (PEP), Nestlé (OTCPK:NSRGY) or Procter and Gamble (PG).

According to Wikipedia, Coca-Cola (KO) was once created by the pharmacist John Pemberton as an alcohol free and prohibition compliant version of his ”French Wine Coca“. „French Wine Coca“ was marketed mostly to upper class intellectuals, afflicted with diseases believed to have been brought on by urbanization and Atlanta's increasingly competitive business environment. In an 1885 interview with the Atlanta Journal, Pemberton claimed the drink would benefit "scientists, scholars, poets, divines, lawyers, physicians, and others devoted to extreme mental exertion."

Coca-Cola eventually became the world leading soft drink, one of the symbols of the American way of life and a tremendously profitable company.

Yet, Coca-Cola could become again a remedy against a looming disease of our days: inflation.

The case for inflation is quite compelling:

After decades of over spending and trade deficits, the western world is burdened with debt:

  • In the USA, the public debt as a percentage of GDP has never been higher since the end of the 40’s and the post war debt. Is it a coincidence? The subsequent 50’s were a decade of strong inflation....
  • The situation is similar in Europe, where the problem is made worse by the up-coming demographic crunch, the result of decade long low birth rates. European countries will face the heavy burden of large retirement claims, which will have to be paid by scant young generations.

There are few possible solutions to the debt problem:

  • Government spending cuts can and will be implemented. However, spending cuts will be limited since they face strong political resistance and can cause recessions.
  • Tax increases will happen as well, but only to a limited extend due to strong political resistance and similar recessionary effects.
  • As a result, Inflation is politically the least painful way to reduce the debt burden by decreasing the present dollar value of past claims.

What should we do in such a context? Have a Coke!

When cash loses value, investors should seek tangible assets. Gold, real estate, arts, stamps, wine and…stocks are examples of potential spots to “store value”. But gold, arts, stamps and wine do not pay dividends and while real estate can provide some safety, the long-term inflation protection provided by real estate can be questioned, especially in regions of declining populations.

In this context, stocks are an attractive asset class. But not any kind of stock! Against inflation, an investor should choose stocks with pricing power, high ROE, international exposure and non-discretionary products.

Pricing power: enables the company to raise its prices with inflation and pass the price increases to its shareholders in the form of increasing dividends.

High ROE: enables the company to replace its productive assets without loosing shareholder value. Example: if the inflation is 10%, the ROE has to be above 10% so that the company can replace its productive assets without depleting the company’s equity.

International exposure: Protects the shareholders against the loss of value of a single country’s currency.

Non-discretionary products: Makes sure that the products are sold even in tough times and throughout recessions.

Coca-Cola has it all:

  • Consumers buy Coke, (almost) regardless of price and whatever the strength of the economy.
  • Humans drink Coke from Japan to Peru. Further more, the consumption of Coke increases with the purchase power of a given country: when people get richer, they drink more Coke, which gives Coca-Cola promising growth prospects. For example, as of 2011, McDonald’s (one of the largest channels for Coke) had 12 000 outlets in the USA and 400 outlets only in China. Quite some room to grow!
  • Coca-Cola boasts an impressive 25% to 30% average return on equity (unleveraged). The company’s main assets are the brand and the recipe. The replacement cost of the recipe is 0 (remember “Coke classic”?) and the maintenance costs of the brand (advertising) increase with inflation and revenues.

Coca-Cola is fairly priced and provides stable and growing dividends:

Coca-Cola is not cheap. It is indeed fairly priced at $67 per share.

Net income less exceptional items (related to the exceptional sales of assets last year) in 2010 where $3.78 per share and the company’s historical growth has been around 9% per year for the last 10 years.

At $67 per share, a quick DCF analysis shows that the market is assuming a growth of 9% per year and a PER at horizon of 15, which is quite reasonable and corresponds to the company’s long term averages.

Coca-Cola is a dividend aristocrat and has been paying increasing dividends as far as an investor can remember.

Given the exceptional safety of its earnings and the long history of steady dividend increases, KO should be viewed as a bond yielding a coupon of 2,79%, which increases at 9% per annum. Today, 10 years US treasury bonds yield 1,85% per annum, without growth of the coupon. Source: US Department of the Treasury

Strength/Opportunities

  • Number 1 brand in the world
  • Coca-Cola is a recession proof product providing recurring revenues with almost perfect international exposure
  • Emerging countries are getting richer and should increase their consumption of Coke in the next decades
  • High return on equity, low replacement cost of assets

Risks

  • Health conscious consumers could reduce their consumption of sugar loaded sodas
  • Consumers suffering diabetes could sue Coca-Cola, just like some cancer patients are suing tobacco companies today
  • Health related taxes (like the “Soda tax” in France) could hamper the company’s profitability
  • Competitors such as Pepsi-Cola (PEP) could reduce Coca-Cola’s market share
  • Consumers of bottled sodas could choose replacement products such as Sodastream (SODA)

Other aspects of the investment

  • Few insiders are buying, with the exception of Barry Diller, Director.

Conclusion

Shares of Coca-Cola compare favorably to US Treasury bonds for long term investors seeking protection of capital and a reasonable but growing dividend income.

If you don’t like KO, the arguments mentioned above should hold for other strong consumer brands providing consumable products such as McDonald’s (MCD), Nestlé (OTCPK:NSRGY), Pepsico (PEP), Procter and Gamble (PG).

Source: Coke: An Excellent Remedy Against Inflation