Is Tax Reform The Only Remaining Upside For Coca-Cola?

| About: The Coca-Cola (KO)
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Summary

Lower soda consumption appears to be here to stay and soda taxes make it unlikely that Coca-Cola will see significant revenue upside in the near future.

Instead, Trump’s tax cuts are likely to be the biggest boost to Coca-Cola’s earnings in the near term.

Analysis suggests that Coca-Cola stock would be worth around 11% more under a friendlier tax regime and combined with a 3.5% dividend yield, would give investors close to a 15%.

Analysis

Lower Soda Consumption Due to Taxes Linked to Healthier Lives

A recent study shows that a 'sugar tax' imposed in Mexico resulted in a nearly 10% drop in the consumption of sugary drinks. With excessive sugar consumption associated with higher risks of diabetes, stroke and kidney failure, more jurisdictions are imposing sugar taxes. To wit, the United Kingdom is set to impose a sugary-drinks tax in April of 2018 and Seattle may soon be implementing a 2-cent per ounce charge on sugary soda in the near future.

Naturally, the further proliferation of soda taxes would be an unwelcome development for Coca-Cola (NYSE:KO), which has already witnessed a 30-year low in US soda consumption. In that sense, it isn't surprising that industry groups have challenged soda taxes on the basis of their negative impact on small businesses.

Coca-Cola sees the writing on the wall and is already in the midst of reformulation efforts to reduce the sugar in its soda portfolio, which accounts for around 70% of its revenues. The signs are encouraging: in its 4th quarter earnings release, Coca-Cola disclosed that Coca-Cola Zero Sugar saw double-digit growth in its case volumes in Western Europe.

Low Growth but Solid Dividend

Coca-Cola's net revenues declined by 4% in the 4th quarter of 2016 and by an average of 1% a year over the last five years. The decline in Coca-Cola's revenues is more telling on a per share basis because Coca-Cola has instituted share buybacks over the past four years. Specifically, Coca-Cola's revenue per share had slipped by 8.4% to $9.59 by the end of 2016 from a high of $10.47 in 2012 - when its share count was 4.6% higher.

The decline in its revenues have also hit Coca-Cola's profits: earnings per share fell from $1.97 in 2012 to $1.49 in 2016 - a slippage of 24.4%. During the same span, earnings contracted by just 1.3% for the S&P500.

Despite this, Coca-Cola remains a solid dividend play for investors seeking a steady return. The stock is currently paying a 3.5% dividend yield, which is superior to that of both the Dow and the S&P500. It also happens to be better than that of its peer group, which pays just 1.85% on average. That said, one reason Coke's dividend yield has remained attractive is that its share price hasn't moved much, having risen by just 20.4% in the trailing 5 years compared to nearly 70% for the S&P500 and 58% for the Dow.

Are Lower Taxes All It Has to Look Forward To?

While Coca-Cola has accelerated its refranchising efforts - it has reached a definite agreement to fully refranchised its operations in the key China market and is likely to complete its US refranchising by 2017, this is unlikely to help earnings growth since by creating a more efficient and diversified supply chain, it sacrifices margin - indeed, Coca-Cola's EBITDA has contracted by nearly 5% in the last 5 years, just as its refranchising efforts accelerated.

In our view, it will be many years before Coca-Cola's reformulation efforts are able to shift the balance of its revenues to depend on non-sugary drinks, leaving it open to attrition from consumers who prefer healthier lifestyles. Moreover, Coca-Cola's own guidance for 2017 suggests that its revenues will grow by just 3% on a non-GAAP basis while its comparable earnings-per-share will decline by anywhere from 1 to 4%.

For obvious reasons, none of these yet consider the possibility of lower taxes giving Coca-Cola a boost. In 2016, Coca-Cola's effective tax rate was around 19.5% but this included the fourth quarter when it paid no taxes due to write-offs and other adjustments. In the prior three quarters, its effective tax rate averaged about 22.4%, which is close to the 23.3% rate it paid in 2015. Coca-Cola's effective tax rate is less than the typical US corporate tax rate of 32% because of its geographic spread of earnings - it derives just 24% of its net revenues from the United States.

Under the Trump Administration's tax proposal, which would lower the US tax rate of 15%, we calculate that Coca-Cola's effective tax rate could fall to around 9.6%. How significant would this be? If we take Coca-Cola's 2016 pre-tax income of $8.14 Billion and apply our estimated rate, its tax bill would have shrunk from $1.59 Billion to $780.6 Million - or less than half.

All else being equal, that would have meant that its diluted Net Income per share would have risen by 13.3% from $1.49 to $1.69 per share. That would have been $0.02 better than what it earned in 2015. If we go by Coca-Cola's Non-GAAP numbers, our lower tax rate estimate would have resulted in earnings of $2.24 per, which was 17% better than the $1.91 non-GAAP earnings it reported and $0.23 higher than the non-GAAP earnings it reported for 2015.

Conclusion

We anticipate that Coca-Cola will report non-GAAP earnings of $1.85 per share for 2017 (i.e. 3% lower than in 2016), which is slightly below the consensus of $1.87 per share. However, this does not consider a lower tax rate. If we apply our 9.6% tax rate estimate, Coca-Cola could report 'Trump Earnings' of $2.16 per share, which would handily beat the consensus 29% and would likely result in a significant price appreciation since the market tends to focus on the headline comparable period-over-period earnings rather than the specifics.

If we use Coca-Cola's current forward earnings ratio of 21.8-times as the multiple for its tax cut-boosted earnings, we would arrive at a target price of $47.05 per share, which is an 11.4% premium to the current stock price. Adding Coca-Cola's current dividend yield to this gives us a total return of nearly 15% - not a bad return for a stock that's only risen by 20% in the last five years.

In that sense, while Coca-Cola's fundamentals remain fairly unexciting, we do believe that the stock has upside in the event that Trump is able to pass his tax agenda through Congress. This being the case, we encourage investors to keep an eye on Coca-Cola and use dips in the share price as potential entry points. We don't expect the tax cuts to be implemented this year but our upside analysis would hold even under such a delay.

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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.