Ackman Is Right On Coca-Cola (But For A Different Reason)

| About: The Coca-Cola (KO)


Coca-Cola has been thrown into a contentious battle between various sides of the Valeant controversy.

Berkshire Hathaway vice chairman Charlie Munger is critical of Valeant, calling the company "deeply immoral".

Bill Ackman countered that Coca-Cola is also "immoral".

Ackman, while slightly hypocritical, may have a point about Coke's long-term prospects.

Coca-Cola (NYSE:KO) is one of the world's most recognized brands, and certainly should not be compared to Valeant (NYSE:VRX) in any way. Somehow, however, it has been injected into a bitter battle between famed investor Bill Ackman and several respected investors, chiefly Charlie Munger of Berkshire Hathaway (NYSE:BRK.A). In response to Munger's criticism of Valeant, Ackman suggested that Berkshire's long-time ownership of Coca-Cola was "immoral", because its product harms the public. Bill Ackman's words are not going to change anything about Coke or its stock price. However, there are some key issues that could have an impact on the company's revenues and margins in coming years.

It is common knowledge that Coke sells sugary beverages, and that most of its products are detrimental to human health. One 12-oz can of Coca-Cola is 156% of the daily recommended amount of sugar suggested by the World Health Organization. While that has slowly shifted consumption away from soda, it is not news to investors. What are of value to investors are the shifting legal and political dynamics of the underlying commodity in all Coca-Cola products.

The first concern is the current litigation regarding what constitutes sugar. In Western Sugar Cooperative vs. Archer Daniels Midland (NYSE:ADM), the leading producers of refined sugar are suing the leading producers of high-fructose corn syrup (HFCS). Besides the damages sought by both sides, the litigation will result in the US court determining if HFCS is legally the same as sugar.

Some background

In the 1970s, food and beverage producers began searching for lower-cost alternatives to sucrose, or normal table sugar. What they found was a product championed by Cargill and other corn refiners known as high-fructose corn syrup. HFCS offered a lower-cost means of sweetening many products. The savings allowed producers to lower costs or retain higher margins. In 1997, a Mexican court determined that HFCS was not sugar, as traditionally known. In the wake of this decision and general public uneasiness towards corn syrup, major food manufactures began moving away from corn sugars and back toward traditional sugar.

Coca-Cola's flagship product has resisted the urge to move back to traditional sugar, but if a US court determines that HFCS is not sugar, public pressure could persuade many other brands to move to higher-cost sugar.

The impact could come at the right time.

If the public becomes even more adverse to HFCS, Coke may need to switch back to traditional sugar - a move the company is currently testing with Coca-Cola Life. Oddly, a Republican presidential candidate recently began making statements regarding the issue of sugar subsidies.

Senator Ted Cruz (R-TX) recently derided other candidates over their support for sugar subsidies. Cruz, who receives considerable donations from corn refiners, has suggested the USDA should do away with sugar subsidies. He is not alone - in fact, dozens of conservative political groups are mounting an orchestrated effort to eliminate sugar subsidies. Many Koch-backed groups, including the Club for Growth, have pushed legislators to pass an amendment to the curb the program. Sugar subsidies are the only agriculture program that was not reformed in the last farm bill. An attempt to reform (i.e., lower) subsidies was thwarted 221-206 in 2013. In 2015, a bi-partisan group of lobbyists began an all-out assault on US sugar subsidies, placing them in real risk.

Removing these subsidies would be a crushing blow to sugar refiners that would result in lower prices for raw sugar.

An Iowa University study concluded that ending US sugar subsides would reduce the commodity cost by 33%. International sugar prices have averaged 50% below US sugar prices over the past decade. Ending these subsidies sounds like a fabulous prospect to lowering Coke's commodity costs, right? Not really.

Coca-Cola uses three key sweeteners in its 3,600 beverages: sucrose (sugar), HFCS, and artificial sugars (sucralose, acesulfame potassium, etc.). Internationally, the company sweeteners its core beverages with sugar. In the United States, however, due to the higher price of sugar from the various tariffs and sugar subsidies, it uses HFCS.

If sugar subsides are eliminated, or scaled back, it would allow domestic brands to compete with coke on price. Today, beverages using table sugar have higher input costs, and thus tend to have higher sale prices, reducing demand.

Non-alcoholic beverages are price-elastic. Lowering prices greatly increases demand. A decline in COGS will lead competitors to lower their prices. If other manufactures are suddenly offering products at similar prices as Coke's trademark carbonated beverages, it is likely that Coca-Cola will see market share loss. North America currently represents 20% of the total volume, but has the lowest margins, at 11%. Coca-Cola has little room to lower prices if it wants to compete.

While I would hesitate to suggest making an investment decision based on rhetoric in a presidential race (especially considering the source), the attention could cast some unwanted pressure on the subsidies in question. Sparking the interest of politicians can, at times, be damaging. The sugar industry has a strong federal lobbying network, but the lobbyists for large corn refiners are gearing up to be equally as powerful.

The company's current P/E is 21x 2015 EPS. That means Coca-Cola trades at a premium to the S&P 500. Investors should discount the bid for KO given the realistic uncertainty. If the P/E is lowered to the same level as the S&P (17x forward earnings), Coca-Cola's bid would be reduced to $33.80, or 20% below current levels.

The elimination (or reduction) of sugar subsidies is a positive for US producers of sugar-sweetened products and US consumers. Coca-Cola would lose significant market share if sugar subsidies were removed, because other beverage producers in the US could (and would) lower their prices, causing Coke's trademark beverage business to lose market share. The other option would be to lower prices and eviscerate already low margins in North America. Enough political pressure during a heated political season could give power to the lobbying groups which seek to end the aforementioned subsidies. Lower sugar prices may be a sweet deal for consumers, but not for Coca-Cola shareholders.

Disclosure: I/we 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.

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