Coca-Cola Still a Sell
(Guest Commentary - April 6, 2006)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks and evaluating companies, it is that time of the month again – the time when we bring in our regular guest commentator Mr. Bill Rempel for a quick discussion of his methods and thought processes. In this commentary, Bill is going go into a detailed discussion on the historical financials and prospects for Coca-Cola (KO). Being a value investor, Bill is definitely not bullish on the stock.
This author first wrote about KO in my March 3, 2005 commentary – concluding: “While I believe Coca-Cola is a very strong brand and should be a part of every investor's long-term core holdings, I do not believe it is a good time to buy at this point. The growth in the stock price of KO was neither due to luck nor coincidence – it was due to Goizueta's shrewd management of the stock price, Keough's salesmanship of the company, and Ivester's financial genius – along with a roaring bull market more than anything else. Despite the lack of leadership in Coca-Cola during the last seven years, part of the old dream of KO being a growth stock has still hung on – for far too long. For KO to be an attractive stock once again, this author will need to see a more compelling valuation, such as a stock price of $25 to $30 a share. At some point, however, I believe KO may be a glamour stock once again (as it still has a lot of potential in China and India where only a total of about 850 million cases of Coke finished products were shipped in 2004, compared to 20 billion cases for the entire world), but not until some of the weak hands have been shaken out from the stock.”
Without further ado, following is biography of Bill:
Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “What I Like About Liz” for his last individual stock commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) in back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.
Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
This month I'll be treading over sacred ground when I do an examination of the prospects for Coca-Cola from a technical, fundamental, and valuation perspective.
First of all, there is really nothing in the technicals of KO that looks at all encouraging to me.
The 10-year chart shows a dramatic decline in the price of KO. The peak in 1998 shows a clear negative divergence with the PPO, RSI, and CMF, and since those highs, KO has lost about 1/2 of its value. Along the way, there has been a great amount of “overhead supply” built up. “Overhead supply” just means a great deal of buyers are upside-down in their purchase – after being upside down for so long, one can expect them to want to sell as soon as they can come close to breaking even. It would take a heck of a catalyst to overcome the above chart. The real story, however, comes in a much simpler chart.
Now, I really think you've gotta be kidding me. KO trading for almost 50 times earnings at its peak in 1998? KO trading for almost 100 times earnings in mid-2000? Now granted, KO earned $1.42 in 1998 and later fell short with earnings of $0.98 and $0.88 in the subsequent years, but there are two key issues here: first, the P/E ratios were valid and not a chimera caused by earnings close to zero, and second, the P/E ratios were just stupid. Revenues and earnings for 1996 through 1998 were flat, and growth prospects couldn't have been fantastic, but KO was priced for explosive growth!
To illustrate this point, assume a Discounted Cash Flow model with two stages, a five-year growth stage and a remainder wherein growth reverts to the S&P 500 historic mean of 6%. Further, assume a discount rate of 11.5%, which is the historic average gain of the S&P 500. What growth rates justify different P/E ratios under that scenario?
- 10% five-year growth justifies a 22 P/E,
- 15% five-year growth justifies a 27 P/E,
- 20% five-year growth justifies a 33 P/E,
- 25% five-year growth justifies a 40 P/E,
- 30% five-year growth justifies a 48 P/E.
So KO was priced for 30% annualized growth, even though at that time it was a $200 billion market cap company and the number one non-alcoholic beverage company in the world? The results are part and parcel of the unrealistic valuation, and probably Warren Buffett's biggest investing mistake was not selling out of KO when it was clear the ride was down. Was it clear? When a slow-growth company is selling for 50 times trailing, and earnings start to fall, even the most die-hard value investor should think that taking a 15% capital gains hit is worth it.
Although KO rebounded in late 2004 through early 2005, this stock did not participate in the broader rebound of the market. Market lows were made in April of 2005, at the exact time that KO was peaking. Since that time, we've had a definite downtrend confirmed by PPO and RSI. Of note is how the volume peters out every time the stock price comes near the resistance levels.
Clearly the market is settling in on lower P/E levels to be associated with the low expectations of growth. But as discussed earlier, even a multiple in the 20's is irrational given the prospects for growth.
The relative stoutness of resistance is obvious in the six-month chart. Even though the recent rise in the stock price had good confirmation from multiple indicators, the stock fell from $43 as if it had been shot. My current technical prognosis is that KO makes a decent short trade on any approach to $43, barring changes in news or fundamentals.
Trying to assemble a competitive analysis for KO is difficult, because there really are no competitors to KO, other than PepsiCo (PEP). The S&P 500 lists several companies in the segment, but those that aren't merely bottlers to KO or PEP are incredibly small when compared to those giants, and aren't in the same class. Like it or not, this is a duopoly.
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The two companies are surprisingly similar in terms of valuation (numbers from Yahoo!Finance), and I think most would be hard-pressed to call either stock a “value.” On the surface they look very strong financially, with solid returns and limited debt, but we know that surface appearances don't always hold true, and no matter how strong the company, it is possible to pay too much for the shares.
Below are some selected financial metrics, calculated for KO. Note that I use EBITDA + Changes in Working Capital + Net PPE - Interest Expense, Deflated for 35% Income Tax Rate as my working definition of Free Cash Flow.
This is a company that shows growth in earnings and revenues that is mediocre at best – the S&P 500 long-term average is 6% annualized, and KO can't even get that over the last four years. The five-year number is impressive, 18.3% annualized, but that number is from nadir to zenith. The nine-year numbers for EPS growth and revenue growth are 4.3% and 2.4%, respectively. Note that much of the difference between revenue growth and EPS growth is due to a 4% reduction in outstanding shares, resulting from a buy-back. Now, any way a company can deliver earnings to shareholders is good, but I'd prefer an actual margin expansion or growth in revenues over a buy-back.
It's certainly nice to note that the margins and returns are holding up very well, and that liabilities and interest payments are well under control. Additionally, the company has a negative reliance on financing cash, preferring to repay debt, repurchase stock, and pay dividends rather than borrow money. Nice. I can't find anything to complain about in that box of metrics … other than the lackluster growth. It's also hard to imagine that a $100 billion dollar company with $23 billion dollars in sales has much room to grow … and revenue growth over the last decade has been well below what one would expect, given population growth and inflation combined.
One thing that has been growing is the dividend, which was $1.15 on a TTM basis. Nine years ago, that dividend was $0.515 on a TTM basis, which represents about 9% annualized growth in dividends. If you compressed that into a dividend yield, you'd find that the div yield has tripled from 0.9% to 2.7%. Now that sounds impressive, and is actually the opposite of what interest rates have done over the same period (Federal Funds, 10-Year Treasuries, and 6-month CD's all yield the same or less as they did nine years ago). However, when you consider that they yield on 6-month CD's is around 5%, the yield on cash is close to 5%, and the dividend yield on the S&P 500 is 1.8%, it doesn't sound so impressive anymore.
The dividend certainly seems safe. It represents about 40% of operating cash flow and the payout ratio is 55% per Yahoo!Finance. Unfortunately I don't see much chance of the dividend increasing in per-share terms. The gross margins are fairly high, so a large percentage of operating cash flow is converted to earnings – there's not room to improve that ratio. With the payout ratio already pretty strong, it's hard to see KO becoming an income stock pick, but I'm not an income investor, so I could be wrong there.
For KO, the dividend should be looked at as one component of total return, but certainly not a reason to buy.
Pausing for a second to compare the growth in dividend per share to the repurchase of stock, I calculated from the cash flow statements the relative amounts of cash used in repurchases as a percentage of the amount used for dividends. Over the last five years, that ratio has risen steadily (15% in 2001, 35%, 66%, 72%, and 77% in 2005). The company bought back 46 million shares at an average price of $43.26 in 2005, but the outstanding shares per MSN Money haven't changed. Someone's math doesn't add up –judging by the 10K it is MSN that is off. Moving from 2,487,000,000 to 2,393,000,000 shares in four years is about 1% a year, and moving from 2,429,000,000 in one year is about 1.5% a year. If they were able to keep that up, which is doubtful considering the amount of cash consumed, then it might expand earnings slightly (2 percentage points higher on growth in revenues of 2 percent?). The company expects to spend about $2 to $2.5 billion on share repurchases in 2006, representing a bit more than 2% of the outstanding if the price stays at $40 per share.
I have to question the wisdom of the share repurchases, however. When a company has shares that don't reflect the full value of the stock, a share repurchase makes inherent sense. However, if the stock is already fairly valued, or overvalued, then repurchasing shares represents a waste of money. Of course, it's always easier to end a voluntary repurchase program than it is to lower a dividend, and the amount of cash used last year in repurchases could have raised the dividend yield to 4.7% potentially, but if it's not maintainable for a long period of time (which I think it might not be), there is a considerable political risk for the board to move to either a variable dividend or to lower a dividend once raised.
Share repurchases in and of themselves don't result in dramatically higher future dividends. If the repurchases end when the program does (it started in 1996 and expires in 2006), then a 2% buyback results in the 2.7% dividend yield "expanding" to 2.8%. Several years of buybacks give incremental gains. The way to increase the dividend yield is to increase the dividend (or lower the share price). The company may not be able to make continued dramatic increases in dividend, and probably won't try, for political reasons.
Now let's have some fun. One key to Coca-Cola's secret formula is realizing that you can't analyze KO and come up with a complete picture. About 15-20 years ago, the “mother ship” pursued a strategy of buying up the smaller bottling units, merging them, and then spinning them off into various publicly traded entities. The key to this plan was KO's retention of a maximum of 49% of ownership! This “49% solution” allowed KO to retain strong-arm control over the bottlers while technically no having control, which, in this investor's opinion, is a potential shenanigan. Relationships between the bottlers and KO have sometimes been rocky, and certainly are not smooth at the moment. Witness the current lawsuit involving several smaller bottlers, KO, Coca-Cola Enterprises (CCE), and Wal-Mart. So for an examination of the fundamentals, I will look not only at KO, but at the four publicly traded bottling units combined, and at all five companies combined. I've compiled the combined numbers for KO and the four publicly traded bottling units that belong with it: CCE, COKE, CCH, and KOF.
Here we start to see some oddities. While the combined growth of the group (in terms of both earnings and revenues) exceeds that of KO by itself, several other metrics show significant degradation. For example, the ROA and ROE are both a lot lower for the combined company, although they are still strong. It's also interesting to note that the bottlers are much more leveraged than the “mother ship,” as evident by the ratios of liabilities to cash flows, and by the ability to pay interest, which is moving into the danger range at 11% +. However, the single most fascinating thing about looking at the combined entity is the fact that tangible equity just about disappears.
A thorough review of KO and its cohorts should involve reading the K's, Q's, and Proxies for all five operations. This review won't include that, because quite frankly the story just isn't intriguing enough to make me think KO is "investment grade" material.
While I haven't found anything alarming in my examination of KO or of the combined entity, I haven't found anything compelling, either. It's of some interest to me that KO appears financially stronger than the bottlers they assembled and spun off about two decades ago, but much of that was probably planned by the board. Through spinning off the weakest and most capital-intensive units, while still retaining effective control, they managed to “smoke and mirror” some definite improvements in their finances relative to those of the bottlers.
The key issue is valuation – both past and present. Was fifty times trailing earnings rational in 1998? No, and that's a good explanation for the subsequent decline. Is twenty times trailing earnings anywhere near a reasonable price for a slow-growth stock with a dividend yield below that of a money market? Given that the as-reported P/E of the S&P 500 is 18.5 on a TTM basis, why would I want to pay a 12% premium to the index to get less growth and a moderate increase in dividend, when my alternatives are so varied?
What KO needs is a catalyst to fuel future earnings growth, but I can't identify what that might be. While there is a decline in consumption of soda per capita for health reasons, KO has good share in sports drinks, juices, coffees, and teas that really just makes me sense there will be a shift in revenues. The real margin expansion might come from "energy drinks" but those represent a small share of the total market, and other than that, what is there on the horizon?
At what price or multiple would KO represent a solid investment?
Given the assumptions used in the Discounted Cash Flow analysis at the beginning of this article, namely reversion to 6% growth after the first five years and a 11.5% discount rate, and using the current analysts' estimates of 8% growth over the next five years, a 20 times multiple could be seen as "fairly valued." Since the aim of investing is to buy bargains, asking for a 30% margin of safety would mean that, assuming no deterioration in earnings prospects, a suitable target price for KO would be south of $30.
Now if one assumes that the best times for KO growth are long since past us, it might behoove us to use the "continuous growth" version of the DCF. At a 3% growth in earnings and 11.5% discount rate, the "fair" P/E is roughly 12, placing a no-margin-of-safety price at $25 and a 30% margin of safety price at $18 or so. Being more lenient and placing growth at 5% forever would make the "fair" P/E approximately 16, giving prices of $34 fair and $24 with a margin of safety.
In reviewing Henry's commentary on KO done about a year ago, I see his conclusion was a price of $25 to $30 represented a "more compelling valuation." I'd have to say that $25 to $30 would be fair at best in my opinion. I am not a big believer in the power or value of brand, and I personally would sooner hold shares of an index ETF as part of a core holding than hold shares of KO [Henry's note: I believe that the “margin of safety” in KO is its brand value and its “wide moat” – but I realize that at the same time, such a recognition of its “wide moat” by executives and employees alike may result in complacency, which this company has certainly been guilty of in the past]
Many commentators have been waiting for the large caps to get their due and outperform the small caps, and the question they might have while reading this is "will KO be a buy then?" As they say in Georgia, I don't have a dog in that fight. My interest in the broader market is crash protection and short/long bias on my overall portfolio, but I judge individual stocks by their own merits, and not on the basis of macro, cap size, or sector. Is this a hole in my philosophy? Maybe. But I can't answer the question of when large caps will start to outperform or whether KO will be worth buying then, except in terms of KO's valuation, fundamentals, and technicals.
Fundamentally, my take is "don't buy." While the stock is overvalued, it is not egregiously so, and the finances don't give me great cause for concern. Technically, I would be tempted to short on approaches to $43 (preferably waiting for a bearish candle or a pullback to pile on). If one is actually compelled to buy KO by this examination, then the price targets I would set would be either at the low end of the apparent current trading range ($40 or so) or buy if the stock closes above $43 while in an uptrend.