Shares of Coca-Cola (KO) have returned 6.6% over the past 12 months. At $36.36 per share, the stock has dropped by 10.6% from its 52-week high of $40.67 achieved in July. I believe the recent pullback presents a buying opportunity as KO's tempting valuation and predictable dividend growth prospect provide investors a solid margin of safety. In this article, I will elaborate on the analysis that supports my opinion.
KO's valuation is attractive based on the company's healthy financial performance relative to the peers' (see comparable analysis table below). Sell-side analysts on average predict KO's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 4.4%, 6.5%, and 8.7%, respectively, over the current and next fiscal years. These estimates are slightly below the averages of 5.4%, 7.0%, and 8.7%, respectively, for a peer group consisting of KO's primary competitors in the consumer beverage sector. In addition, KO's EBITDA margin is forecasted to expand by 1.2%, largely above the peer average of just 0.6%. On the profit side, all of KO's profitability margins are considerably above the par, and the company's capital return metrics such as ROE and ROIC are only marginally below the averages. KO carries an above-average level of debt as reflected by the firm's higher debt to capitalization and debt to EBITDA ratios. In terms of liquidity, KO's robust free cash flow margin of 13.5% substantially outperforms the peer average of only 6.8%. Due to the high profitability, the firm was able to maintain a strong interest coverage ratio. Both KO's current and quick ratios are above the par, reflecting a healthy corporate balance sheet.
To summarize the financial comparisons, given KO's in-line growth potential, the company's strong global presence, industry-leading margin performance, and superior free cash flow producing capability should warrant a decent premium valuation over the peer-average level. The current stock valuations at 12.6x forward EV/EBITDA, 17.0x forward P/E, and 1.97x PEG represent just an average valuation premium of 10.9% over the peer-average trading multiples, suggesting that the current stock price is likely somewhat below the intrinsic valuation (see comparable analysis table above). It should be noted that KO's 1.97x PEG is markedly lower than the PEG ratios of 2.11x and 2.73x for Nestle (NSRGY.PK) and Pepsico (PEP), respectively. These two firms represent better comparable companies as their market capitalization and global presence are fairly comparable to KO's (see table above).
In addition to the attractive valuations, KO also offers a dividend yield at 2.8%, which is safely backed by the company's strong commitment for dividend growth. Over the past decade, the dividend per share has been raised steadily by a 10-year CAGR of 9.8% from $0.40 in FY2002 to $1.02 in FY2012E (see chart below).
According to a 3-year dividend yield chart shown below, KO's yield has been trending fairly close to 2.8% since 2010. Under the current low-interest market environment, the flat yield performance may partially be attributable to a strong demand from income-oriented investors. Given the continued monetary easing, I expect that the yield demand will still persist and thus limit the yield's upside. Assuming a reasonable dividend yield range between 2.6% and 3.0%, and supposing that the annualized dividend per share would be raised by 8% from the current level of $1.02 to $1.10 in February 2013 (KO usually raises dividend in February every year), this base-case scenario would imply a stock value range from $36.67 to $42.31, meaning that the price downside is well protected by KO's expected dividend growth.
Does KO have a sufficient capacity to sustain the current pace of the dividend growth? The company's trailing net income payout ratio of 50.5% as at September 2012 is fairly consistent with the 10-year historical average at 51.7% (see chart below). In terms of the free cash flow payout, KO's annual dividend payment historically only represented slightly more than a half of the annual free cash flow, indicating that there is an ample slack for further dividend hikes down the road (see chart below).
Bottom line, in the light of KO's favorable valuations and fairly predictable dividend growth potential, the stock has a tempting risk/reward profile. As such, I recommend buying the shares now.
The comparable analysis table is created by the author, all other charts are sourced from Capital IQ, and all financial data is sourced from Capital IQ.
Disclosure: I am long KO.