It’s never fun when you wake up, check out the market, and see one of your holdings down big. That’s especially the case when it’s one of your defensive holdings. Names like Coca-Cola (KO) are supposed to be boring, right? They’re supposed to be predictable and reliable, offering slow but steady growth and a safe dividend yield. Well, this morning shares of KO were down ~7% when the market opened. The company released earnings before the bell, and obviously, the market wasn’t pleased. So, with that negative reaction in mind, I wanted to take a deeper dive into the print to see if I needed to take any action.
My Expectations for Coca-Cola
Before I break down the quarterly results, I think it’s a good idea to talk about why I own Coca-Cola and what my expectations are for the stock. Managing expectations is an important part of portfolio management (and living life as a whole). It helps to avoid surprises and irrational decisions. So, with that in mind, it’s important to note that Coca-Cola is an income-oriented play for me.
I bought KO, first and foremost, because of its relatively high (3%+), reliable dividend yield. KO is a Dividend Aristocrat with 56 years of consecutive annual dividend increases. At this point, the company is very mature. Growth is low, yet it continues to re-invent itself, focusing on efficiency in its global operations and evolving alongside the consumers’ tastes. If I had to guess, this company will be increasing its dividend for decades more to come, which is exactly why I’m a shareholder.
Cola-Cola has a strong, diverse business in an industry that is necessary to human survival, so I view the company as very defensive. I know that people oftentimes think of the company as a soda/sugary beverage play, but that is the Cola-Cola of the past. Yes, soda sales are still very important to this company, and that red and white Coke can is still the company’s flagship product. Sugary beverages may be in secular decline as we learn more and more about their detrimental effect on human health; however, KO management hasn’t been sitting idly on its heels, waiting to became obsolete. Over the years, KO has branched out into a variety of non-alcoholic beverage categories and now boasts 21 billion-dollar brands (many of which fall into the low-calorie and low/zero sugar categories).
I don’t expect huge growth out of the company. I don’t expect KO to outperform during bull markets. I do however, expect it to hold up relatively well during tough economic times, which is why I own it.
I can’t predict when the bottom is going to fall out of the market, but I can say, with relative assuredness, that people will continue to drink soda, juice, sports drinks, milk, and water, regardless of whether or not the economic is going boom or bust.
Frankly put, if this stock gives me low-single digit capital appreciation and a 3% dividend yield over the long term, I’ll be a happy camper.
So, when I look at KO’s performance, the first thing I do is check the dividend-related metrics. Do earnings per share and free cash flows cover the dividend? If so (which they do), I rarely look much further.
Sure, I’d love to see the company posting huge top and bottom line growth, because over the long term, that is what allows the dividend to grow sustainably. But I also trust this management team and the strength of the moat that KO employees have built up over the decades to allow it to compete well in the beverage market.
This is an easy stock for me to own. It’s not one that I worry about (even when shares are down 7%). It’s a stock that I plan to own for years and years because of the simple fact that human beings require hydration. I suppose if this changes, I may change my investing thesis. But in the meantime, I will continue to sit back and happily collect my dividends, grinning from time to time as I watch the stock slowly climb higher, which is a pleasant cherry on top of it all.
The first thing that really stuck out when looking at the results was the fact that KO’s revenues were down 6% on the quarter and 10% on the full year. That might seem terrible at first if you haven’t been following the Coca-Cola story as of late; however, in reality, it’s a misleading statistic.
Coca-Cola has been re-franchising its bottling plants for a while now as a measure to improve margins. Former quarters/years have the bottlers' revenues in the comparisons, so it will take a bit of time for the numbers to be accurate comps. This is why it is best to focus on all of the organic figures that management provides; these figures are focused on the operations that will be the KO of the future.
And thankfully, these organic numbers were fine. They weren’t great, but as I said in the intro, they didn’t have to be great to meet my expectations.
Organic revenues grew 5% on the year. And full-year comparable (non-GAAP) EPS was up 9%, even after experiencing a negative 4% currency headwind. So, when you take out the bottlers, it’s clear that KO’s core business is doing fine.
For the full year, case unit volume sales were up in 3 of the 4 geographical regions that KO tracks (in Latin America, volumes were flat). And consolidated volumes were up 2% on the year.
When I look at other profitability figures, I get even more satisfaction. It’s clear that the re-franchising of the bottlers plan is a good one when you see that operating margins expanded by 585 basis points for the full year. That’s pretty massive improvement for a company the size of Coca-Cola. This margin improvement was not only reflected in the EPS growth but in the operating income growth as well, which came in at +21% during Q4 and +14% on the full year.
Cash from operations totaled $7.3 billion during FY18, up 6% from the prior year, and free cash flow totaled $6.0 billion, up 14% y/y. KO’s dividend obligations are ~$6.6 billion, so they are covered by the cash from operations and by earnings per share ($2.08 EPS versus $1.56 for the dividend) but they are not covered by free cash flow.
This is a bit concerning to me, though management does guide for solid cash flow generation growth in 2019 (cash from operations is expected to increase to at least $8 billion). I can only assume that this will mean an increase on the free cash flow as well. KO expects to see operating income grow 10-11% in comparable currency terms, though the company does acknowledge currency headwinds and predicts that it will experience 6-7% headwinds in this regard.
Furthermore, management did hint at the fact that the company will basically stop repurchasing shares in 2019 (other than to offset the dilution created by company stock-based compensation - which, as a shareholder, I appreciate). I'd love to see KO management buy back tons of shares every year. However, now the stock is overvalued, so it's probably not a great time to be dedicating billions towards the buyback. Also, KO doesn't have billions to dedicate towards the buyback. Its relatively thin margin of safety when looking at dividend coverage means that stopping buybacks and dedicating excess cash towards the dividend is necessary (for the time being at least). Company management's willingness to accept this reality should further bolster the idea that the dividend is secure.
Speaking of the forward guidance, it’s this that really spooked investors and created the sell-off, in my opinion. Coca-Cola came into the quarterly results trading with a premium valuation, and therefore, had to really impress the market to maintain that. Instead, management seemed rather cautious.
Honestly, I don’t mind this. I’d much rather a management team be realistic about the economic outlook of its company (and the world at large, which is a big deal for a big multi-national like Coca-Cola) than try to sugarcoat things to make them seem better than they really are. Eventually, the chickens always come home to roost, and it appears that KO has set the company up to outperform rather than to disappoint.
Although cash from operations/operating income guide was fine, it’s the EPS growth that sparked the sell-off. KO management is only calling for 4% organic growth (which honestly isn’t that bad for this company - I’d be okay with it) and EPS growth of -1%-1%. It’s this flat EPS guide that hurt the stock. You can’t trade at a premium if you aren’t growing earnings. Furthermore, earnings must grow for a growing dividend to be sustainable. If KO was to post flat earnings for a few years but continue to increase its dividend in the low- to mid-single digit range, it would eventually run into trouble regarding its dividend safety. If the market begins to question the safety of the company’s dividend, the premium multiple that it demands will evaporate very quickly and the multiple contraction associated with this will have major downside on shareholders’ pocket books. Granted, this is all speculation, though the market prices stocks on forward expectations, and since KO’s isn’t exactly rosy, it makes sense for the stock to trade down some.
My Big Takeaway
~25x was simply too high of a multiple for KO to trade for. I think the fair value is probably somewhere in the 17-18x space. I’ll use forward EPS estimates here (giving this illustrious company a bit of the benefit of the doubt), but even so, $2.08 x 17.5 comes out to ~$36.50. This is significantly below the share price that KO closed the trading day with prior to earnings (nearly $50/share). It’s still well below the current share price of ~$45.50. In other words, I wouldn’t be surprised if there was further downside to the stock.
However, all of the doom and gloom that I read today in KO-related articles/threads seems irrationally and unnecessary. Sure, EPS might be flat in 2019, but that doesn’t mean that the company’s massive volumes are going to disappear. The 20+ billion-dollar brands that KO has built over the years aren’t going to be taken off the shelves at your local grocery story. KO will still have the world’s leading distribution network. Systems like this don’t pop up on accident; KO has invested more than $110 billion, alongside its bottling partners, in its infrastructure since 2010. The moat that the company has in this space is simply something that its competition cannot match. It will still be selling product in 200+ countries worldwide. And it will still be innovating and trying to capture market share by adapting to consumer trends. The company released 500+ new products in 2017 alone and mentioned in the Q4FY18 conference call that ~25% of its sales in India, a large growth market for KO, came from new products. In short, Coca-Cola isn’t going anywhere, and therefore, I don’t feel the need to remove these shares from my portfolio.
I will continue to monitor the company’s reports to make sure that the earnings/cash flows cover the dividend. Right now, on a forward basis, KO’s dividend payout ratio is ~75%. This is high, that is without a doubt. But I don’t think a cut is imminent. If I do become concerned about a dividend cut, I will be more than happy to sell my shares. I’ll be sure to let everyone know if my opinion changes in that regard, but I’m quite not there yet.
When it comes down to it, I don’t think that now, with the stock down ~7%, is the time to take action. Selling today would simply be an emotional overreaction to the negative news. I knew well and good that my KO shares were overvalued yesterday. If I was going to sell, that would have been the time.
However, I didn’t, because I believed that the income that the company produced was safe and reliable, and I was willing to deal with the high premium valuation because of the income my shares provide me. I don’t quite understand why KO shares are trading for ~24x earnings. However, I do know that human beings aren't going to lose their need to hydrate anytime soon, and KO remains a global leader in the non-alcoholic beverage space.
Today isn’t a boring day for the stock, but in general, I don’t think the broader narrative has changed. Management continues to focus on profitability, and while growth is slated to be slower than some thought in 2019, the company still appears to be relatively healthy. I’m content to hold onto my shares, and I’d even be willing to add to my KO position if this weakness continues and the stock falls down to my price target of $36.50 (which is still a long way down from here, and I don’t expect it to in the near term).
So, other than the negative price action on everyone’s KO shares this morning, I hope you all have a great day! If you enjoyed this piece, please stay tuned for the upcoming Seeking Alpha marketplace service that I'm currently working on, The Dividend Growth Investor Club. I'm hoping that this will be a place where income-oriented individuals can come together and discuss their ideas as we all pursue financial freedom. I'll be posting a variety of exclusive content, including single stock research, sector DGI watch lists chock-full of relevant fundamental data and sample portfolios with different target dividend yield and growth thresholds for Club members. The service should be launching in the coming weeks.