Manufacturing A Better Entry-Price Into Coca-Cola

| About: The Coca-Cola (KO)

The Coca-Cola Company (NYSE:KO) is the world's largest beverage company, and it owns or licenses more than 500 nonalcoholic beverage brands. The company owns four of the world's top five nonalcoholic sparkling beverage brands: Coca-Cola, Diet Coke, Fanta and Sprite. Consumers around the world enjoy 1.7 billion servings a day of beverage products bearing Coca-Cola Company trademarks. The company's unparalleled manufacturing, distribution and marketing programs allow the company to leverage its scale advantages into introducing new products to consumers throughout the world. The barriers to entry to compete with Coca-Cola in these areas are as high as just about any durable competitive advantage that I am aware of.

The Coca-Cola system sold approximately 26.7 billion, 25.5 billion and 24.4 billion unit cases in 2011, 2010, and 2009 respectively. Unit case volume outside the United States represented approximately 80% of the company's worldwide unit case volume for 2011. Coca-Cola identified early on that the company's formula which had worked so well in the United States would very likely work throughout the globe, but it was essential to be the first-mover to stay ahead of the competition. Because Coca-Cola has performed so well for so long, it is very difficult to acquire this company at what is obviously a bargain price. Even when Warren Buffett started buying Coca-Cola in the late 80's, analysts were skeptical of the multiple that he was willing to pay, relative to many of his previous investments. Coca-Cola is probably the best business that Warren Buffett ever bought due to its unassailable moat, huge long-term growth runway, and extremely high returns on invested capital, which all have allowed the company to be extremely shareholder friendly.

Coca-Cola's robust long-term growth is based on three distinct objectives. The company has continuously entered new markets utilizing its advertising and distribution heft, to win the number 1 or number 2 market position. Secondly, as emerging market consumers attain more disposable income, per-capita consumption has steadily increased. Lastly, Coca-Cola has been able to increase prices at a rate that is greater than cost-inflation. While China, Russia, India, and Brazil are some of the key frontiers in the Cola Wars, through sheer execution the company has steadily gained market share against PepsiCo Inc. (NYSE:PEP) (see article) in its most mature market, North America.

My personal drug of choice is Diet Wild Cherry Pepsi, after years as a Diet Coke drinker, and while I have tried many times to reduce my consumption for obvious health reasons, it has been exceptionally difficult, and in truth I've been unsuccessful. Cola is unique of course in that there really isn't an aftertaste, making it much easier to drink multiple servings of it, as opposed to juice or other competing products. This addictive element gives Coca-Cola some of the same advantages as the tobacco companies (albeit a safer product) in that even as per-capita consumption decreases in some mature markets, price increases can ease the pain. In addition, the company's financial heft and best in class distribution allow it to acquire emerging, more health conscientious brands. While it is doubtful that any of the acquired brands are likely to have the same success as Coca-Cola, the combination of legacy and new products should allow the company to continue earning impressive returns on invested capital. This variety is especially important in markets like China where tastes are quite different, and the most successful companies such as Yum! Brands Inc. (NYSE:YUM) have been able to shift offerings to a more local feel to maximize profits.

At $38.38, Coca-Cola trades at 17.1 times forward earnings, and the stock offers about a 2.61% dividend yield. Amazingly, Coca-Cola still posts a return on equity greater than 25%, even after being in business well over 100 years now, and if it weren't for the capital intensive bottling business that was recently reacquired, ROIC would be in excess of 20% as well. Coca-Cola has been conservative in buying back stock which makes sense due to the fair valuation, but if the stock were to decline the company has the resources to be more aggressive. Because the market has run up nicely in 2011, including shares of Coca-Cola, prudence makes a lot of sense. An investor interested in Coca-Cola could either sit in cash, or sell puts with the hopes of getting in at a cheaper price. One strategy that could make sense is what we at T&T Capital Management (OTCQB:TTCM) uncreatively refer to as the hybrid strategy.

Buy 100 KO shares at $38.38

Sell 1 $35 January 2014 KO put for $2.50

Sell 1 $$40 January 2014 KO call for $2.25.

In this strategy, 3 things can happen assuming an investor holds the options until expiration.

1) The worst case scenario occurs if Coca-Cola expires below $35 at expiration, in which case the investor would 200 shares of KO at a breakeven price of $34.32, or 10.5% below the current price.

2) If KO expires above $35 and below $40, the investor will make$475 from the options expiring worthless, and the dividend, plus or minus any appreciation or decline in the stock.

3) Lastly if KO expires above $40, the investor will make$637 plus the dividends, and will end up with cash at expiration with no shares.

In an IRA where, generally speaking, no leverage can or should be used, this strategy is less attractive due the low implied volatility of the stock, as opposed to in a margin account where less cash would be required to initiate the position. FYI, we generally don't recommend using margin unless you are working with an experienced professional, and even then we employ very little. Having an adequate cash reserve for better buying opportunities certainly makes sense with the market having appreciated, but in today's low-interest rate world, this strategy of manufacturing enhanced income, at the risk of buying a wonderful business at a reasonable price certainly isn't a bad alternative.

Disclosure: I am long PEP. 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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