While perusing the transcript from The Coca-Cola Company's (NYSE:KO) most recent (Q2 2016) earnings call, I was struck by a comment made by Chairman and CEO Ahmet Muhtar Kent. During the call, Ahmet Muhtar Kent mentions that Coca-Cola has
continued [its] progress towards transforming [the] company to a higher margin and return business...
While I was in the process of mentally filing this statement into my overfull folder of boilerplate CEO-speak, it started to pique my interest. In particular, that word "continued." To wit, Coca-Cola has been a high margin machine for most of its illustrious existence. But, something insidious has been happening over the course of the 2000s: Coca-Cola's earnings quality has been steadily eroding.
To investigate this phenomenon further, let us recall the DuPont return on equity (ROE) decomposition. At its core, ROE is the result of multiplying the following three quantities:
- Net profit margin: (net income)/revenue
- Asset turnover: revenue/assets
- Equity multiplier: assets/(shareholder equity)
Due to cancellation, this of course reduces to the equation ROE = (net income)/(shareholder equity). This simple relationship answers the question: how much profit is getting generating off of retained shareholder equity? But, don't let its apparent simplicity deceive you, it can elucidate otherwise hidden features. Observe the following figure:
Let's pick this apart a bit. The Return on Equity has stayed relatively stable around 30% (the 2010 accounting-related spike aside). There is nothing to be concerned about there. But, how are the constituent pieces that produce ROE faring? Not nearly as well, it seems. Net margin and asset turnover have been trending down while the equity multiplier has been trending up.
Overall, this is a worrying trend. If two companies have the same ROE, then the company with smaller equity multiplier is much stronger. In this case, the comparison is not between different companies but rather the same company, Coca-Cola, over the course of the last ten years.
Coca-Cola's story has always been about superior management and earnings quality. However, the margins have long been deteriorating, which the company has compensated for with more leverage. At the same time, Coca-Cola is trading at rich valuation as measured by price-to-earnings ratio.
What does this tell us? Perhaps we can find an edifying comparison in the most nostalgic of places: PepsiCo (NYSE:PEP). The narrative has long been that Coca-Cola is the industry leader in beverages and that Pepsi had to be more resourceful by finding revenue in lower margin products. There is no question that both companies have been phenomenal investments. Let us look at PepsiCo's return on equity.
By the profitability metrics given by return on equity, Coca-Cola has been superior. Indeed, though Pepsi currently has an overall higher ROE, the behemoth Coca-Cola's business operations are still comfortably ahead of PepsiCo due to a 80 basis point advantage in return on assets -- that is, (net income)/assets. PepsiCo's higher ROE is due to a much larger equity multiplier (i.e., more leverage). Comparing these companies inter-temporally; however, it is clear that the Coca-Cola or PepsiCo of a decade ago were much stronger companies.
Can Coca-Cola reclaim the formal glory of its decadal doppelganger? This remains to be seen. CEO Ahmet Muhtar Kent says yes, though it's his job to do so.
Disclosure: I am/we are 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.