The Coca-Cola Company (NYSE:KO) has been long cherished as a dividend growth darling and, most notably, a prized holding in the portfolio of Warren Buffett. Unfortunately, over the past decade, a combination of macroeconomic headwinds and mistakes by management has slowed down the beverage giant. But I am optimistic. Coca-Cola has recently taken action that points to higher growth and higher margins. In the future, the dividend champion may be back on the right side of market returns.
Over the past decade, the tide of consumer tastes has been turning. Soda sales in the U.S. have been declining, and are now at a 30-year low. Consumers are beginning to become more cognizant of the health effects of soda, and not just in the United States. Other countries are taking action against soda, such as Mexico, which passed a "Soda Tax" in 2014. The increasing scrutiny on unhealthy beverages has provided Coca-Cola with challenges and revenues have flattened off in recent years.
Coca-Cola has disappointed investors for some time now - for reasons including both lacking performance and overvaluation. Since 1995, shares have underperformed the market by almost 2% (assuming reinvested dividends). To make matters worse, the company is borrowing money to fund buybacks/raise the dividend while the dividend payout ratio continues to rise as the dividend now consumes about 75% of earnings.
The payout ratio cannot rise much further without harming the dividend growth rate of the stock, which has been around 8-9% over the past decade. As an investor with a long time horizon of 30+ years, I look at where things are going - not where they currently stand. Coca-Cola, while by no means out of the woods, is taking action that I think could turn the ship back into the right direction over the long term.
Just this last month, there was a shake up on the Coca-Cola board. It was announced that CEO Muhtar Kent will step down from his position in May, and will be succeeded by COO James Quincey. Additionally, Howard Buffett, son of previously mentioned Warren Buffett, has decided to leave the board as well. While Quincey is not a true outsider, the change of direction represents a long-needed need for change for a management team that has grown far too conservative (in this investor's opinion).
The exit of Howard Buffett also helps remove some of the large shadow that Warren Buffett casts over the company as a high-profile shareholder. These changes could give Coca-Cola the "courage" to be a bit more bold with possible acquisition strategies. As some have pointed out, this could make it easier for management to sell Coca-Cola, which I hope isn't the case. I still think that the stock is most valuable to investors if the company is able to maintain a high margin, positive cash flow, and growing dividend. After all, Coca-Cola is a legendary dividend growth stock. It's raised its dividend for 54 consecutive years, building wealth like clockwork for generations of investors. $10,000 invested in 1981 with no additional capital (dividends reinvested) would be worth over $1.3M today.
In face of downtrends in soda consumption in developed markets, Coca-Cola has completely revamped its advertising focus in order to stabilize its sparkling brands and return them to growth. Spending in the neighborhood of $4B on advertising, Coca-Cola is refocusing on the brand itself, instead of specific products. The balance of consumer spending power is shifting towards the 19-34 age crowd, and Coca-Cola appears to be keen on this. Notice a theme? Coca-Cola is focusing its primary advertising efforts on the young crowd, in an effort to drum up interest in a group that is developing an awareness to the negative health effects of sugary beverages.
It is a bit too early to pass judgment on the success of this campaign. While units by case volume are up 1% YTD, the true result will take a few years to become evident. Brand reputation may point to positive returns, as Coca-Cola's marketing record speaks for itself. The Coca-Cola brand is the fourth most valuable brand in the world (according to Forbes). Simplifying marketing efforts, and creating a brand "funnel", which the portfolio flows through, will create an opportunity for the consumer to connect with the brand and make their own product choices.
In addition to philosophical changes, the company is making some prudent fiscal moves in order to boost margins, and lean up operations. Coca-Cola is re-franchising its bottling operations, basically reversing the $12.3B mistake made in 2010 to take ownership in its bottling operations. This action is basically making Coca-Cola a smaller, yet more profitable business. The company would focus on its "core" business which would be centered around manufacturing the syrups and concentrate. By end of 2017, over 90% of net revenues will come from this side of the business. Coca-Cola is also going through a process that most companies go through as they mature - cost cuts. As the company "grows" smaller, it is continuing to restructure its operations and transfer jobs out of the company as part of its bottling re-franchising to shed costs. These actions are expected to save Coca-Cola about $3B by 2019. Even though revenues are taking a large hit, the margin increase will negate the downsizing, factoring in the savings from cost cuts. This will result in adjusted cash flows that are essentially the same as they were prior to re-franchising. The higher margins will enable the cash flows to grow as top-line improvements begin to be realized.
The growth initiative of Coca-Cola expands outside of re-invented marketing campaigns. Coca-Cola is pushing smaller serving sizes as an alternative to traditional two liter and 12 ounce serving sizes. This "in moderation" logic is resonating with consumers. The great thing about this is that Coca-Cola is making more money because it is up-charging for these smaller portions (possibly around $.10 per ounce). This will help appease those looking to be responsible diet wise - someone who didn't want to buy a two liter for it to go flat after one drink (by spending a week in the fridge) will enjoy having individually packaged "servings".
Where are shares valued today? At just under $42 per share, Coca-Cola is trading around 22x 2016 earnings. Over the past 10 years, shares have traded at a median valuation of 20x earnings. Sometimes, the PE ratio can be misleading, and this could be one of these instances. Coca-Cola generates the majority of its revenues outside of the United States. With the US dollar trading at its strongest in over a decade, the company's earnings may be suppressed. Given its consistently rising dividend, average yields can be evaluated to give a sense of value. The $1.40 in annual dividends that Coca-Cola pays to share holders is a 3.37% yield at current prices. Over the past decade, the median yield is 2.79% which would imply that Coca-Cola's shares are trading at a discount.
Because the actions Coca-Cola has taken to boost earnings growth have not had time to flesh out, I believe there should be an additional discount for share holders and, therefore, shares are still a bit too rich. I would like to see the dividend yield breach the 3.50% level, which would result in a buy price of around $40. Shares crossed that level at the beginning of December 2016 and I'm hoping it happens again, so that I can deploy recently acquired capital.
If you get the value right, Coca-Cola can deliver over the long term. Coca-Cola is reinventing itself and improving margins. Assuming the advertising and operational changes work, the "new look" Coca-Cola can grow its earnings, reduce debt and protect its tradition of growing the dividend at a rate above inflation. Bearish on Coca-Cola in the past, I am really encouraged by the actions the company is taking given its missteps and stagnant attitude over the past years. Now, it's time to execute.
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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.