3 Things To Consider Before Investing In Coca-Cola Stock

  • Coca-Cola's growing dividends are not supported by corresponding growth in Free cash flows. Hence, the need for the company to accelerate its divestitures and re-franchising efforts.
  • The dollar has started to rally meaningfully again which is bearish for sales in international markets reported in USD.
  • Long-term debt has spiked which resulted in a lower credit rating. Furthermore, Warren Buffett didn't add to his position in 2015.

Coca-Cola (NYSE:KO) stock is currently trading at over $43 a share and has a current earnings multiple of 25.85. It's price to earnings ratio is well above its 5 year average of 20 but the stock has stayed stubbornly elevated this year (up 1.7%) despite the S&P 500 (INDEX:SPAL) being down over 3% YTD.

KO stock chart

Source: Coca-Cola stock price chart by amigobulls.com

The company recently announced a 6% hike in the dividend (now up to $0.35/quarter bringing the number of dividend increases to 54 years) which along with the ongoing buybacks seem to be holding up the stock in a period of high volatility in equity markets. Currently, the dividend yield is 3.25% which seems very high for Coca-Cola with its present earnings multiple of over 25. Remember share price is a multiple of the current earnings per share and the earnings multiple. As Coca Cola's share price has grown over the past few years, it had done so with falling earnings. For example, the beverage company printed an EPS of $1.97 in 2012 compared with $1.67 this year. Usually, companies cut down on dividend growth numbers to allow earnings to catch up with dividend growth percentages but Coca Cola's dividend is sacred and investors and shareholders alike expect that it will be increased meaningfully every year.

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The other major reason why Coca-Cola stock is such a winner with shareholders is because it has always been very aggressive in buying back its stock. Currently, there are 4.33 billion shares outstanding which is significantly down from 2012 levels. However, I don't know if Coca-Cola can keep up this pace if earnings and cash flow don't turn around soon and we are seeing signs of this already. Coca-Cola has provisionally guided for around $2.25 billion in buybacks this year which could end up being under $1 billion as the company issues, on average, up to $1.5 billion in stock annually. This means the steep curve in shares outstanding you see in the chart above could be about to flatten out and astute investors probably predicted this as something had to give - either dividend growth or share buybacks. If you are a Coca-Cola investor or are considering buying Coca-Cola stock, here are 3 things you need to watch out for in the next few quarters.

The first metric investors must keep an eye on is free cash flow which is crucial in the sense that there must be a good bit of daylight between this figure and the dividend pay-out. Unfortunately, there isn't as 2015 numbers tell us that the company spent $5.74 billion in dividends out of free cash flow numbers of $7.99 billion. This equates to a dividend pay-out ratio of 72% which is on the higher side (well over 50) and generally means dividend growth will be muted over the next few years. Furthermore, the continuing slowdown in the float reduction means the dividend pay out will remain elevated as its growth rate is far ahead of the decline in share count. For example, I'm estimating that only $1 billion worth of shares will be bought back (net, after accounting for stock issued) in 2016 which at $40 a share would be 25 million shares. This would bring the share count to 4.38 billion. Therefore, if we multiply this figure by the annual dividend of $1.40, we get the sum of $6.13 billion. This is a huge worry, especially when you see analysts forecasting a lower EPS for 2016. However, margins are predicted to improve, going forward, which could safeguard the margins are predicted to improve, going forward, which could safeguard the dividend. Coca-Cola plans to accelerate its re-franchising efforts and divestitures which should increase margin as long as they are executed well. Execution is vital as any problems in these areas would put too much pressure on current free cash flow of the company.

Secondly, Investors would be foolish to ignore the dollar also as roughly 55% of Coca-Cola's net sales come from outside the US. Investors have been sold up to now on a growing company as 2015, yet again, saw global volume growth - 2% to be exact. Furthermore, the company's global price mix grew by 2% in 2015 which again looks bullish on the surface. However, revenues dropped from $45.93 billion in 2014 to $44.29 billion in 2015 due to a relentless dollar that is showing no signs of abating.

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The dollar index almost dropped to the 95 level in February but it has come back with a vengeance since then and if good economic news keeps on coming out of the US, then expect the dollar index to blow past 100 in the near term. This undoubtedly will adversely affect Coca-Cola earnings in the near term which again is bearish for continued dividend growth.

Finally, investors should be aware of the company's increasing debt burden. Long-term debt spiked to $28.41 billion in the latest quarter which gives the company a debt to equity ratio of 1.11 (equity at the end of 2015 was $25.76 billion). Therefore I wasn't surprised (soon after Coca-Cola announced the 6% dividend hike) when the Standard & Poor rating services cut the corporate credit rating of Coca-Cola to AA- from AA. The rating agency is confident that current debt can be reduced through bottling divestitures, productivity and re-franchising efforts but the timing of these initiatives is still uncertain. Along with credit ratings, it was interesting to see that Warren Buffett's company BRK.A (NYSE:BRK.A) didn't buy any shares of Coca-Cola last year. Buffett stated that his stake has increased (which it has) but this only happened as a result of the float being reduced which gives Buffet a higher stake in the company. Investors should ask themselves, why didn't Buffett add to his position in 2015? Was it the valuation, the high dividend pay out ratio or the dollar? Underperformance on any one of these three metrics will lead to a fall in Coca-Cola stock price in 2016..

To sum up, Coca-Cola has been a fantastic income story over the past few decades. However, it is facing new challenges which must be overcome if it is to keep its income story going. Watch free cash flow levels as the dividend payout will surpass $6 billion in 2016. Furthermore, watch the dollar. It is rallying at present which is bearish for international sales and also watch the company's debt load. Don't assume Coca-Cola will return more capital to shareholders when bottling divestitures and re-franchising efforts gain traction. Equity has been falling due to rising debt and if the credit rating falls once again, more focus will be on this part of the company than rewarding shareholders.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
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  • I do not have any business relationship with the companies mentioned in this post.
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