As the year comes to a close, a look at some of the biggest laggards of the Dow Jones Industrial Average (NYSEARCA:DIA) illustrates some of the storylines that accompany the stocks. As the market hits all-time highs, only a handful of large-cap companies have sat out the rally. Nike (NYSE:NKE) suffers from overvaluation and competition. Pfizer (NYSE:PFE) lacks earnings growth and is part of a sector under political pressure. Disney (NYSE:DIS) must contend with shifting trends like cord-cutting, media/entertainment industry fragmentation, and a content bubble via ESPN. Justified or not, these are the stories of the Dogs of the Dow.
Enter Coca-Cola (NYSE:KO), another notable underperformer this year. Despite strong global brand recognition, the company struggles to maintain significant growth in the beverage/soft-drink sector. Trends shift, and carbonated beverage sales in North America continue to decline as consumers opt for other options like water, juice, cold-brewed coffee and teas, or energy drinks. Keep in mind Coca-Cola's portfolio has grown over the years as the company attempts to reflect the changes in consumer tastes and trends.
Despite these strong brands, Coca-Cola's stock cannot seem to gain any momentum. Declining soda sales as well as broad market competition in the beverage sector tell the Coca-Cola story, and revenue growth exemplifies the narrative. Last quarter, KO reported Q3 earnings with revenue of $10.63 billion, down (-7%) year-over-year. In the past five years KO has reported sales growth of 4.8%, which helped create valuation problems despite the stock's underperformance. Consider KO's PEG of 13.71, and other ratios that raise caution flags.
It's not to say that Coca-Cola isn't aware of these headwinds, and on December 9th the company announced new leadership plans. James Quincey moves into the CEO position replacing Muhtar Kent, who ran the company since 2008. Under Kent, the company moved to acquire bottling partners after decades of separate operations, and in 2010 bought the North America operations of bottler Coca-Cola Enterprises. Clearly the goal is to control bottling, and optimize operations in order to increase profitability. Many analysts predict Quincey to ink more deals in the future, but the company needs to find ways to take market share in a declining soda market. A recent article from Fortune describes the trend (emphasis mine):
In the core U.S. market, carbonated soft drinks sales have slid for 11 straight years, hurting all the major players as consumers are drinking more bottled water, flavored waters, juices and other beverages they deem healthy. Coke hasn't been immune from that trend: last year Diet Coke volume slipped 5.6% while the namesake brand's drop was 1%. Analysts and beverage experts agree this trend will almost certainly continue, and there has been criticism from some that the company has been too slow to diversify beyond carbonated soft drinks, which still contribute 75% to sales. Beyond diversifying through deals or internal innovation, Coke needs to try to win market share in a declining market."
In the past five years, KO's return of 23.40% severely lags the S&P 500 (NYSEARCA:SPY) performance as well as main competitor PepsiCo (NYSE:PEP), which is up nearly 60% in the same time frame. It should be noted that sales and revenue growth at PEP remain flat: +1.7% the past five years, and down (-1.9%) year-over-year. PEP trades at 20x next year's earnings, assuming the company meets estimates, and carries significant debt (LT Debt/Equity = 2.30). Soda drinks and junk food sales continue declining in North America where health-conscious trends have moved as far as taxing soda. Both companies have successfully expanded their respective brands globally, and significant growth opportunities still exist despite recent sales declines abroad.
As indicated in the chart, revenue growth for KO keeps sliding as sales decline. Diversifying beyond carbonating drinks seems like a no-brainer, but merely taking out the bubbles and buying up similar juice and water brands leaves much to be desired. Consider competitor PepsiCo's takeover of Frito-Lay brands years ago, and looking at their portfolio tells a slightly different story than that of Coca-Cola's, which has much to do about each stock's performance.
Obviously it all looks like junk food, but PepsiCo's portfolio broadens its revenue stream, and helps the company weather stormy trends like declining soda sales. Coca-Cola's product offering pales in comparison, and bulls need new CEO Quincey to consider some acquisitions that will move the needle in terms of sales and revenue. However, M&A activity works both ways, as suggested in the aforementioned Fortune article:
Of course, Coke itself could become a target. Analysts have said beer giant Anheuser-Busch InBev (NYSE:BUD), which recently swallowed SABMiller, could look to Coke or PepsiCo next."
Dividend Vs. The Bond Rout
Coca-Cola remains a Dividend Champion, and its history of dividend growth is not in jeopardy despite the revenue declines. However, the stock now feels pressure from another source, rising bond yields. The recent Bond Rout continues as the FED finally raised interest rates, the dollar strengthens, and Gold (NYSEARCA:GLD) falls. A quick look at U.S. Bond (NYSEARCA:TLT) performance versus KO (blue-line) illustrates that investors see no real growth for the company in the short-term.
The parallels between bond prices and KO seem obvious from the chart, which raises a couple questions. Is Coca-Cola a fixed income proxy, and how long can this Bond Rout go? As bond yields rise the KO dividend looks less attractive given the company's recent growth record. Also consider the flight to safety that occurred late last year and the first half of 2016, which left many consumer staple and utility stocks trading at obscene valuations. Bond yields at the time hit historic lows, but since Brexit that trade started unwinding as exemplified in the charts.
Closing the Gap
Identifying market laggards, as investment opportunities may seem like a good strategy, after all the goal is to buy low and sell high. However, dogs are dogs for a reason, and Coca-Cola faces product headwinds that cannot be fixed from repackaging the same product, or improved marketing. Consumer trends point towards healthier snacks and beverages, and the company needs something more from new CEO James Quincey other than consolidating the bottlers. Quincey needs to get in front of trends, and that starts with the product offering. This is not an easy task, and Quincey should consider a bold acquisition rather than relying upon product development. Great selling snacks and beverages exist in the marketplace, many produced by small companies with little distribution or leverage. Quincey should be searching this space for opportunity, rather than attempting to mimic successful products on their own, and 2017 promises to put KO on the clock should the stock continue to underperform.
The story at Coca-Cola doesn't serve shareholders, and the headwinds are mounting up. The dividend remains a solid feature, but not enough to buy the stock at this juncture. On a technical level, KO crept above its 20-day and 50-day moving average, but resides well below its 200-day, which has started sloping down. This is what a downtrend looks like, and only fools call a bottom in stocks. Investors interested in a long position in KO might consider selling an out-of-the-money cash-secured put. If the stock seems overvalued at $40, than sell the put at the $30 or $35 strike price, and either collect the premium or get long the stock at that price, depending on what happens next.
If options are not your thing, then consider scaling-in to a position, meaning don't buy a full position with one shot. Scaling-in, or averaging down, means buying more stock if or when the stock price drops below your initial buy level as to reduce the overall cost basis. Sometimes this strategy gets condemned as throwing good money after bad, which is fair. However, KO pays that dividend, and remains a relatively safe, low-beta (0.65) stock with worldwide brand appeal. The story isn't over for Coca-Cola, and new leadership waits in the wings. Bulls need Quincey to make something happen, and M&A seems a good place to start. How this story plays out over next year is anyone's guess, stay tuned.
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