Here's Why I Poured My Coca-Cola Shares Down The Drain
Summary
- Coca-Cola has seen its annual dividend raises dwindle to meager penny raises while also seeing share float reductions dwindle.
- Having increased debt load, interest expenses, and leverage significantly, I find that management is challenged by its promise of maintaining its dividend king status reducing flexibility and marketplace options.
- The payout ratio is hovering around 80% measured on free cash flow with limited possibility of reducing that significantly and adversely impacting future potential hikes.
- Being consistently priced at forward P/E 20+, I conclude a mismatch between market price and what the company can offer its investors reducing the attractiveness of its stock.
- Coca-Cola will be here many decades from now, but there are other options within consumer staples who provide a better outlook for income investors looking for dividend raise maximization.
Investment Thesis
Like many others, I’ve owned Coca Cola Company (NYSE:KO) shares with the expectation of seeing rising dividends tick into my account. Having seen Coca-Cola provide shareholders with a penny a quarter raises for the last two years, I finally decided to review the position I’ve held since 2013. Considering the expansion in debt load, unchanged free cash flow, and elevated payout ratio above management target. I’ve reached the conclusion, that Coca-Cola can no longer deliver on its most famous promise, significant dividend hikes but will most likely maintain penny raises. The company is married to its most famous investor trait – being a dividend king with 50+ years of interrupted dividend hikes, but will the investor community accept penny raises as the new normal and can a company, no matter the strength of its brands, really trade at forward P/E 20+ if all investors can expect are penny raises. To move the needle and create revenue streams to fuel future dividend raises, management will be challenged by its promise to the world versus its pressured free cash flow and mature business.
Introduction
I bought my shares in Coca-Cola back in 2013 at $41.63 per share leaving me with a gain of 29.5% not including dividends paid during the period. The SP500 has returned 148.5% during that same timeframe. Now, I didn’t purchase Coca-Cola shares back then expecting it to outperform the general market, so that is unrelated to why my investment thesis is broken, but considering the investment a growing income position, I did expect the company to deliver on that parameter. My reason for offloading the shares is simple, I no longer see a trajectory where the company can continue that journey meeting my expectations. I assume many others ventured into Coca-Cola shares with the same expectations, maybe these thoughts will resonate with you?
When I bought my shares, the company reported EPS of $1.9 with a dividend of $1.12 per share for a payout ratio of 57%. The free cash flow (FCF) per share, however, stood at $1.79 for an FCF payout ratio of 62.5%. I viewed Coca-Cola as an income play, and one I expected to keep in my account for decades. Eight years have gone by, and I rarely review my position as I’m very confident in the brand and the fact that Coca-Cola will still be here twenty or thirty years from now. However, having reviewed it a couple of times during the past year, I’ve come to realise the company can no longer meet my expectations, and I’m no longer able to construct the logical arguments that should form the foundation of my investment thesis. It’s a hard pill to swallow, as I must admit I’ve also become emotionally attached to my shares, which for a while hindered me reaching this exact conclusion. I’m an avid consumer of their products going back all the way to when I was a little boy turning in coupons in relation to the Olympic Games of 1996 in Atlanta so that I could obtain a nifty backpack. I had that backpack for years, but becoming emotionally attached to one’s shares is counterproductive, and we must recognise when it is time to let go.
“The first rule of compounding is to never interrupt it unnecessarily.”-Charlie Munger
Those words stated by Charlie Munger are very wise indeed, and something I always try to stick to. I investigate both pro’s and con’s thoroughly before initiating a position, so that I can leave it untouched for years (hopefully decades) and let time do its magic along the way, but it is of course also dependent on a realistic assessment of that asset having the properties that make it eligible for satisfactory compounding. I believed Coca-Cola had those back in 2013, and in recent years I’ve come to doubt it, until now where I’ve reached the conclusion that the outlook isn’t interesting enough for me despite the fact that Coca-Cola is an enormously strong brand with incredible reach.
Given Coca-Cola’s status as a “dividend king” I’m certain the first thing on top of management's mind in the morning is, ‘we must maintain and expand the dividend’. As such, I’m certain they would rather burn down the house before giving up on that mission. The re-pricing of Coca-Cola stock should they one day fail, would be very significant as they would no longer meet expectations of a majority of the investment community who hold Coca-Cola stock, and can you imagine being the CEO of Coca-Cola who was the one to give up on 50+ years of glorious dividend raises? It would be the equivalent of being ranked as the worst president in US history, and no one wants that. As such, I don’t believe the dividend is in danger, but I do believe we are looking towards a stretch of very meagre raises. Planning to hold my position for decades, I believe there are better alternatives.
Raising dividends by a penny doesn’t really impress me when we are talking about a company which consistently trades in a range where its dividend yield is somewhere between 2.5-3.5% depending on market ups and down. That might do for a company such as AT&T (T) where the yield is consistently north of 6.5% where you can’t find that many alternatives who you can trust to maintain their dividend when trading at those yields. However, companies in the consumer stables sphere trading at a yield of 2.5-3.5% are plenty, and investors are therefore fully justified in preferring those who not only maintain but also expand their dividend the most over an extended period. It’s that ability, which I call into question when considering Coca-Cola’s fundamentals today versus when I originally bought the stock.
The Problems Core
As an income play, I want to see the company deliver on increasing EPS, increasing dividends, and increasing FCF per share.
Authors Own Creation
I’ve constructed an overview of how the dividend per share has developed since when I bought my position back in 2013. Back then, management secured healthy annual raises of high single-digit growth, but as can also be seen, that annual raise had dwindled into a single penny per quarter since 2017. Doing so will keep up with the ‘dividend king’ status, but will continue to erode to the point where it will struggle to keep up with inflation. There is of course the possibility of Coca-Cola suddenly experiencing a surge in their FCF, but more on that later.
A similar development can be observed when looking at the shares outstanding. Management has consistently been pouring cash into reducing the float, but also at a reduced rate as the years have progressed to the point where that trend has reversed. I would however be careful in suggesting that management is done reducing the float based on a single occurrence.
Coca-Cola has done a lot to restructure and improve its operating model throughout the recent years and I also believe they have managed to do so successfully as evident by the rising operating margin and re-established free cash flow. Despite managing to do so, the payout ratio when measured on FCF, has climbed above 80% compared to 60% when I originally invested. As a consequence, management has also resorted to slimming the organisation, having seen its staff reduced a number of times with the most recent communication back in August 2020 with the expected impact of reducing expenses in the range of $350-550 million. However, having seen its revenue reduced from $46.8 billion in 2013 to $33 billion in 2020 (A consequence of divesting), they are harvesting more from a smaller cake – not something you can do forever. It is always healthy to trim the fat, but if you can’t grow the business, you will eventually exhaust those options. Now, management is guiding for a payout of 75% which means the current level is only slightly elevated, but no matter the guidance, once payout is hovering around this level, it leaves little space for significant hikes. Do remember, that other actions also require cash. On the positive side, management is guiding for high-single-digit EPS growth, meaning shareholders hopefully will be able to once again experience more significant dividend hikes, but I see at least one other issue that will demand a share of the free cash flow.
The Debt Load & Reduced Revenue Pie
I find several important observations when considering the fundamental development for Coca-Cola from 2013 until 2020. I’ve listed a select number of accounting metrics below and included their annual %-development.
Authors Own Creations: Financial Statements, Seeking Alpha.
Coca-Cola has seen its long-term debt more than double during the period but at the same time, total debt has only expanded by 20% as management has reduced short-term debt at the expense of increasing long term, and then adding 20% on top. Overall, however, the company has increased its debt load during that time, not in itself a problem. Net debt (debt minus cash) has doubled to $33.5 billion. As a consequence of its increasing debt load, the company has also experienced its interest expense rise by 210% from $0.4 billion to $1.4 billion.
At the same time, revenue has decreased from $46.8 billion to $33 billion. It should be mentioned that this is a natural consequence of its bottling divesture but also due to currency headwinds as Coca-Cola is very much a global company. I mentioned the rising operating margin which has expanded from around 21% to just below 30% which appears to be its natural plateau. Unfortunately, due to the reduction in revenues, the company has ended up with a slightly reduced operating income as the increased operating margin isn’t sufficient to cover up the reduced revenues. In total, the operating income is reduced from $11.1 billion to somewhere around $10.2-10.6 billion (not including the Covid-19 year of 2020 to cut the company some slack).
What matters when wanting to increase the dividend, is the free cash flow, and I find it rather difficult to expect that to increase significantly given that the debt load has also been increased rather significantly over the years, which will erode the free cash flow via interest expenses as highlighted above. I’d suggest taking a glance at the Q1-2021 performance (p. 8), where interest expenses surged by 129% YoY and carved out $442 million that could have been used otherwise.
The market consensus is to see the dividend increase from $1.68 in 2021 to $1.74 in 2022 and to $1.82 in 2023. Both of those hikes would constitute a 0.2 percentage point increase compared to the current yield. The market consensus is also an expansion of free cash flow to $9.4 billion in 2022 and $10.1 billion in 2023 while slightly decreasing its leverage from Debt/EBITDA 2.82 to 2.26 by 2023. With a float of 4.323 million shares and a dividend of $1.68 per share it equals $7.2 billion in dividends annually. Market consensus is $9.1 billion in free cash flow for 2021 equalling a payout 79.8% for 2021. Should management succeed in elevating free cash flow to $10.1 billion by 2023 as expected by the market, a 79% payout ratio would mean a dividend of $1.88 per share which is a 12% difference from $1.68 per share. If management can lower the share float by 1% annually, it would still only allow a dividend per share of $1.89 before reaching 80% once more. As such, the company could only hike the dividend by mid-single digits but would then forego its target of a 75% payout ratio effectively meaning it has to guide for a higher payout ratio or stick to the penny raises.
No matter how I view it, it appears to me that Coca-Cola doesn’t have a whole lot of wiggle room to hike the dividend except for sudden massive increases in revenue-driving improved free cash flows or more cost-cutting exercises to squeeze even more out of the same machine. One is unlikely, and the other is potentially unhealthy for the long-term sustainability of company operations. If the only tool available, is price increases pushed downstream, I would have a hard time expected continuous high-single-digit EPS growth.
Stuck Between A Rock And A Hard Place
Business Life Cycle, source
Evidently, Coca-Cola is somewhere in the maturity stage, which most likely doesn’t come as a surprise to most. There is no problem in being a mature company, and I think Coca-Cola holds advantages from its portfolio of brands and reach that makes it a perfect fit for a mature company. Unlike telecom, it isn’t restricted to a limited regional customer pool but has a global reach and holds an actual brand advantage considering the global recognition of its products. No matter those facts, it does come down to the company’s ability to create free cash flows and being 129 years old, it does become ever harder to push more Coca-Cola products across the counter.
For Coca-Cola to extend its life cycle, it would most likely require a significant acquisition to somehow diversify its revenue streams. The company has conducted a number of acquisitions or controlling purchases in recent times in other companies such as Costa Coffee (£3.9 billion acquisition), or Monster Beverage (MNST) with a 20% stake. However, to really move the needle, it would probably have to be something large. But where does Coca-Cola go from here with acquisition plans within its own industry as it would most likely face monopoly issues as happened in its attempt to acquire Huiyuan Juice Group back in 2008, and how much more leverage can the balance sheet withstand?
It could also look to its closest peer, PepsiCo, Inc. (PEP), and try to diversify via an acquisition allowing it to enter snacks & foods, but I’m uncertain if that would be a strategic fit for Coca-Cola who has been so focused on its niche for decades. It would be like a horizontal integration and would require an expansion in capability and skillset than what the company knows today, despite being known as an excellent value chain operator. Divesting its bottling business, management has actively decided to forego vertical integration. Nevertheless, beyond the problem of identifying a strategic fit, I think the balance sheet is more of an issue as there is limited room to increase its leverage despite the fact that the brand is naturally worth a lot more than the registered goodwill on the balance sheet. If the company should want to activate the elephant gun, would it then have to accept reducing its dividend to free up cash to meet its financial obligations as a result of increased leverage?
it seems to me, that strategically, the company is between a rock and a hard place.
A Few Thoughts Concerning Leverage
I won’t dive too much into its current valuation as I think that is often discussed. Coca-Cola typically trades at a premium and I think that is fair given its unique brands, reach, and inclusion in a number of large ETFs. I have no doubt, that Coca-Cola will still be here, probably long after I’m gone and I’m only in my early 30s, but somewhere along the road, I believe management will be forced to accept that either the dividend must yield or the share price must. If we continue experiencing these penny raises, the company will soon have the dividend increase profile of a company like AT&T (a penny a quarter raises since before 2011) at which point I would suspect the share price would have to give in as also seen for AT&T. Even continuing the one penny a quarter raise for Coca-Cola, constitutes another $160-180 million in dividends paid for the company annually.
There may come a point, where it will be difficult to justify the company trading at forward P/E of 20+ when it struggles so intensely to lift its revenue and for a couple of years in a row have failed to deliver on its one promise; those juicy dividend hikes. One can ask, how a continued trend of penny raises will be received by the market, I doubt it would allow the company to trade at this current metric.
Conclusion
We arrive at the conclusion. Eight years ago, I thought I would hold my Coca-Cola shares for decades, but the company has reached a point where I can no longer feel assured that the dividend will see significant hikes effectively making the share unattractive. Having doubled its long-term debt since 2013, increased its interest rate expense by 210% in the same period with it increasing 129% YoY as reported in Q1-2021 and its leverage having reached debt/EBITDA 2.82, I deem that the company has seen its flexibility and options at hand dwindle drastically. Significant acquisitions will be difficult but might also be necessary if the company wants to move the needle, but being the very symbol of consistent dividend raises, management is stuck between a rock and a hard place in terms of finding the revenue streams that will fuel dividend hikes for the future. Despite improving its operating margin and the market consensus of continuing that trend, shareholders might only experience low-single-digit dividend hikes for the coming years as has been the case since 2018 if management wants to stick to its payout ratio target of 75% with it currently being slightly elevated compared to that target. Coca-Cola has consistently been trading at forward PE ratios of 20+, which is fair for a world-class company, but will the stock market accept penny raises as the new normal for Coca-Cola. It pains me, but it is time to pour my Coca-Cola stocks down the drain and look elsewhere in the consumer stables space.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (287)
Please everyone! I wonder if everyone will keep selling KO for PEP & BRK.B?
I am counting on it. LOL
made the wrong decision AGAIN!The JOKE is that they SOLD COKE for being 'WOKE'
