I'm taking a look at Coca-Cola (NYSE:KO) today, because the stock is cheap whereas the market is not.
Coca-Cola reported earnings earlier today: you can view their press release here. The stock prices are up over 2.5% in pre-market trade, indicating that the report has been well received. Global unit case volume grew 2%. While comparable currency neutral revenues grew 2%. Comparable earnings were at $0.44, down 4%, however, these beat Bloomberg expectations while matching Reuters consensus expectations. The currency neutral comparable earnings increased 5% and that is most likely why Coca-Cola is being bid up today morning.
Coming after five quarters of disappointment, this is a welcome set of results. And this can change sentiment, which could be positive for Coca-Cola. One of the biggest investor concerns has been on growth. This earnings report does not display particularly brilliant growth, however since it beats expectations, it will help sentiment. In my view, long-term growth expectations were never a concern. The global opportunity is there for the taking, and Coca-Cola has a team well capable of rising to the challenge.
The other investor concern is over the executive and employee equity compensation plan. This is an area where very few people have been concerned. But it has been an area where I have concerns. In the release Coca-Cola says:
"The Company returned $713 million in cash to its shareowners through net share repurchases in the quarter, and we are on track to repurchase between $2.5 to $3.0 billion in shares by the end of the year."
They also present this data which is comforting in that it shows that much of the buybacks represent a return of shareholder value, rather than offsets to employee and other issuances.
The company has previously stated that it expects dilution on account of employee issuances to stay at 1%, as has been the case historically. This data might make people feel better in that they are well on track to meet that objective. But this data should also not be surprising: the problem on dilutive issuances is not today, but tomorrow. The problem is the downward revision of performance targets for 2012 to 2014, which if achieved could lead to a dilution of as much as 14.2%. And that has not changed: and it is unlikely to change. However, in my view, if 10% of comparable earnings is used to buy-back shares, it will offset the dilutive impact of employee issuances.
In the rest of this article, I present why I believe Coca-Cola is undervalued despite concerns over growth and the executive and employee equity compensation plan.
What has hurt sentiment on Coca-Cola?
Coca-Cola has been hurt by growth at rates below expectations. If you have a look at Coca-Cola's Q4 2013 press release, you will find that during 2013, global volume growth was up 2%. That was below expectations. Earnings excluding non-core and non-recurring items grew 3% for the year. And growth assessed after neutralizing the impact of currency was 8%.
This was a disappointment. And investors have been more disappointed because the focus has been on the decline in diluted earnings which closed the year down 3%: while 3% is not a huge decline, one of the characteristics that draw investors to Coca-Cola is the absence of cyclicality from its earnings over the course of an economic cycle. Everyone is used to the seasonal variations through the year, however, a decline or dip in the trailing twelve month earnings or revenue always gets investors concerned. In the chart below, you can see that revenue has been flat for a while now, while earnings have actually trended down.
In my view Coca-Cola will see more volatility in revenue and earnings as they expand to new markets. And the reward for acceptance of that volatility will be faster long-term growth.
Today Coca-Cola derives about 40% of its revenue from outside North America. And as Coca-Cola continues to monetize the global opportunity, I see no reason why they should not be capable of growing at a long-term rate of near 8%, in line with global potential real GDP growth of 4.2% and global inflation of 3.8%. However, based on their penetration of faster growing emerging markets at present, I would expect growth rates of near 7%, which is a healthy premium to long-term growth expectations of 4.5% in developing markets. Thus I do not share market concerns of a decline in long-term growth rates.
Executive and Employee Equity Compensation
Coca-Cola has received much negative press off late. David Winters, the CEO at Wintergreen Advisors has been very vocal in expressing his disapproval of the recent executive and employee equity compensation plan, which could potentially lead to a 14.2% dilution if performance targets were met and all awards were earned. And he is quite right to voice his concerns.
When the company reinvests in growth, one of the key areas of investment is employee incentive and retention. If part of earnings are earmarked for investment in employees, and is provided via share grants and options, then when shares are issued to employees, we will have a dilutive event. If Coca-Cola runs a buyback program to offset the dilution, it will not constitute a return of shareholder value. It will represent the payment of consideration on account of an investment in growth. While such a buyback plan does not represent a return of shareholder value, it will limit the impact of dilution as a consequence of employee issuances. The extent of any broader capital repurchase plan will reduce by that part of it which relates to buybacks to offset employee and other issuances, thus lowering the value returned to shareholders. This has an impact on valuation, since the value returned to owner declines.
However, if the dilution only occurs on achievement of performance target, we can expect a dilution of ownership. But perhaps we will see no dilution in comparable earnings per share, as a result of achievement of targets. Nonetheless, when executive and employee equity compensation is overly generous, it serves no purpose. You cannot motivate a person and drive growth simply by raising the reward. There comes a point where incremental rewards will no longer generate a growth or productivity premium: such incremental reward is no more than an unproductive investment or expense.
The Coca-Cola executive and employee equity compensation plan is clearly overly generous. This has an impact on valuation in two ways. Firstly, we have a lower level of shareholder value returned on account of a decline in the adjusted payout ratio (the dividend plus buyback paid out as a percentage of earnings). The second impact is likely to be seen through a decline in the return on equity: when investments or expenses are unproductive, the return on equity must fall!
Coca-Cola however has said that "Actual dilution related to existing equity plans over the last three years has been less than 1 percent per year and is expected to be in this range going forward." I find it hard to imagine why they would permit the threat of a 14.2% dilution, if the intended or expected dilution level was 1%: surely 2% would have been quite enough!
Coca-Cola deserves investor consideration because the markets are expensive, while Coca-Cola is not
The market is expensive. If we work with a risk free rate expectation of 4.50%, a long-term equity risk premium of 5.75%, we are setting our long-term return expectations at 10.25%. This we expect from a market where long-term nominal growth can be expected at 6.25%, with shareholder value returned via a mix of dividends and buybacks of 53% of earnings. You can read more about where I get my estimates for long-term market returns, long-term nominal growth, and the equity risk premium here.
With as reported earnings for 2013 estimated at $100.20, if we use a very long-term growth expectation of 7.17%, the S&P 500 is worth 1,845.00. S&P 500 Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.17% * $100.20 * 53% / (10.25%-7.17%) = $1,845. At this price, it is likely that an investor with a return expectation of 10.25% will be satisfied. My estimate of long-term nominal earnings growth for the S&P 500 is 6.25%, based on a mix of long-term nominal U.S. growth and long-term nominal global growth. Alpha is the difference between actual returns and the risk adjusted return expectation. And if I am correct, the market is overvalued and pricing ninety-two basis points of negative alpha.
While much of 2014 lies ahead, if we use 2014 as reported earnings estimates of $119, S&P is worth 1,845 only if we have an expected long-term growth rate of 6.61%: this implies thirty-six basis points of negative alpha. If we use 2013 operating earnings estimates of $107.30,
If we use 2013 operating earnings estimates of $107.30, S&P is worth 1,845 only if we have an expected long-term growth rate of 6.95%: this implies seventy basis points of negative alpha.
And finally, if we use 2014 operating earnings estimates of $121.70, S&P is worth 1,845 only if we have an expected long-term growth rate of 6.53%: this implies twenty-eight basis points of negative alpha.
In the above comments, I have used as reported and operating earnings estimates from S&P Indices which you can download here.
As of now, I consider the 2013 as reported and operating estimates as most appropriate to assess market valuation because they represent the most reliable estimate of the trailing twelve months, and based on this I expect negative alpha of seventy to ninety-two basis points. This suggests that markets are expensive, but not terrifyingly so.
It is time for lower risk appetite or rising risk aversion levels, and for rotation out of expensive pockets of the market, to cheaper areas. Churn, not exit is what is evident. If we work with trailing twelve month estimates as at the end of March 2014, we are looking at as reported earnings estimates of $104.88, and operating earnings estimates of 109.13, the value range for S&P 500 is between 1,476 and 1,536. This does not necessarily suggest that a bear market is imminent: the implied over-valuation of 16% to 20% is very much in-line with the customary level of over-valuation during periods outside of recessions.
In my view, selling a market simply because it is expensive is not a good idea. Markets can go from being expensive to very expensive, and from being cheap to very cheap. And no one knows which it will be. But negative alpha is an important market timing tool for asset allocators - it hints that it might be time to return to allocation, by selling some of the expensive asset class, and buying another asset class.
During times when alpha expectations turn negative, it pays to listen closely to the voice of the market, for that is where we can see changing levels of risk aversion. In U.S. we have seen small and midcap stocks outperform large capitalization stocks for a long while. We have also seen growth stocks outperform value stocks for an extended duration. This signals low levels of risk aversion amongst market participation. But in recent times this has changed. There are clear signs of a shift in bias back to value from growth and from small and midcap stocks to large cap stocks. This suggests that risk aversion levels are rising. And so the more active asset allocator might also use an expectation of negative alpha to adopt a more defensive equity portfolio.
How do different market participants view Coca-Cola?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stocks sector and the stock's industry of operation.
Coca-Cola value scores are mediocre in comparison to the market as a whole, and in comparison with stocks in its sector and industry of operations. The growth scores are abysmal. Quality scores are positive in comparison with the market, but mediocre in comparison with stocks in its sector and industry of operations. Momentum is in-line with markets, but weakness is apparent when viewed in comparison with stocks in its sector and industry of operations.
Source: Alpha Omega Mathematica
AOM Model Recommendation
Coca-Cola is viewed neutrally by most stock selection and capital allocation style combinations. However investors who have a growth bias in their stock selection style shun Coca-Cola, particularly if they allocate money at sector or industry level.
Source: Alpha Omega Mathematica
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations the system assigns an AOM Score of 47% and an AOM Hold Recommendation for Coca-Cola.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, nor does it replace the due diligence we must do as investors. It is a tool which uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Coca-Cola:
Why look at Coca-Cola now?
Firstly, Coca-Cola is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, Coca-Cola pays a dividend of $1.22 per share which provides a dividend yield of 3.15%, which is a significant premium to the broad market dividend yield. This too provides defensive characteristics to the stock. Thirdly, Coca-Cola enhances its defensive character by returning a generous amount of capital to owners via buybacks.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 0.70 for Coca-Cola. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock relative to weekly closing prices of the S&P 500 at 0.50, and I adjust it to 0.86 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock.
The coefficient of determination for Coca-Cola is 27.12%. This suggests that only 27.12% of the price movement in Coca-Cola is explained by movements in the market: the residual price movement is based on company specific factors. This low coefficient of determination suggests that the market related risks are low. And because company specific risks can be diversified, Coca-Cola is a great pick for most portfolios at the present time.
Cyclicality and Coca-Cola
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late cycle, stocks in the consumer staples sector continue to outperform. If I am right, this is positive for Coca-Cola investors.
You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance today I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, if Europe, other developed markets, or emerging markets shift into early or mid-cycle condition, U.S. companies from defensive sectors may well underperform as money-flows shift overseas, or to sectors which are more sensitive to the economy.
Analyst price expectations
Recently Coca-Cola traded at $38.73. From Yahoo Finance we know that nineteen analysts expect an average price target of $44.10 (median $43.00), with a high target of $52 and a low target of $40. This is a wide dispersion in expectations, which suggests risks are high. With the price below the low analyst target, the bears have the upper hand.
We might believe that Coca-Cola is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Coca-Cola is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a stand-alone basis and regardless of broad market valuations.
Mathematically, the worth of Coca-Cola is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 0.86, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Coca-Cola, we should be targeting a long-term return of 9.445%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. In the case of Coca-Cola, historic trends indicate that the economic cycles have little impact on revenue and earnings.
I am comfortable using $2.08, the 2013 earnings excluding non-core and non-recurring items as an estimate of sustainable earnings.
Twenty-six analysts included on Reuters data estimate average earnings of $2.10 (High: $2.31, Low: $2.15) during the year ended December 14, while twenty-five analysts estimate that it will rise to an average of $2.24 (High: $2.33, Low: $2.07) for the year ending December 15. Three analysts assess long-term growth rates at 6.4% on average, with a high estimate of 9% and a low estimate of 4.7%.
I am looking for 7% nominal long-term growth, and arrive at this estimate by applying a 17.5% return on equity to 40% of profit which I expect will be retained to re-invest in growth. Reuters reports a trailing twelve-month return on equity of 26.03% and a five-year average of 30.48% for Coca-Cola. I have lowered the forward return on equity estimate on account of the executive and employee equity compensation plan which I see as a large unproductive investment in growth.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution on account of employee and other issuances.
Historically, on average, over the past fifteen years, Coca-Cola has paid out approximately 60% of earnings via dividends. And they have paid out an average of 10% via buybacks, net of dilution on account of employee and other issuances. The impact of the buybacks net of is best seen through the reduction in share count over the years. This chart presents the declining share count over the past ten years.
In percentage terms, share count has reduced 7.18% over ten years. That is a reduction in average annual diluted shares outstanding at an annualized rate of 0.70%.
As a result of the overly generous executive and employee equity compensation plan, I expect no return of shareholder value from Coca-Cola in the coming years. The entire buyback program will go towards offsetting the dilutive impact of employee issuances, and thus no value will be returned to shareholders via buybacks. Accordingly, the adjusted payout ratio is the same as the dividend payout ratio of 60%.
If we use a very long-term growth expectation of 6.03%, Coca-Cola is worth $38.73. Coca-Cola Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.03% * $2.08 * 60% / (9.445%-6.03%) = $38.73. At this price, it is likely that an investor with a return expectation of 9.445% will be satisfied.
The growth estimate implied by the current market price of 6.03% is low. Alpha is the difference between actual returns and the risk adjusted return expectation. If Coca-Cola grows at a long-term rate of 7%, we have growth alpha of ninety-seven basis points. And an investor buying at present levels can expect a long-term return of 10.415%.
An investor with a shorter time horizon might do quite well too. A price target of $52 implies confidence in long-term earnings growth rising to 6.88% from 6.03% at present. An expectation of this level is well within the realm of possible outcomes. Coca-Cola Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.88% * $2.08 * 60% / (9.445%-6.88%) = $52.
To cut a long story short, Coca-Cola is priced at a level which offers ninety-seven basis points of alpha, compared with the S&P 500, which prices between seventy to ninety-two basis points of negative alpha. This indicates that Coca-Cola creates alpha relative to the S&P 500 of between 1.67% and 1.89%. This might seem small, but with the magic of compounding it grows to be a substantial amount. It represents 16% to 18% over the total long-term market return expectation of 10.25%.
If you use the above formula, do read this explanatory note.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.