- Coca-Cola stock has broken out to new highs despite its earnings multiple being much higher than historic averages.
- In 2007 Coca-Cola had a similar price to earnings ratio. It took until 2010 for the share price to recover its 2007 share price of $30.
- Coca-Cola 's long-term debt has spiked in recent years to almost $30 billion which has resulted in rating agencies downgrading its debt.
Coca Cola (NYSE:KO) presently has a price to earnings ratio of 27.12 which is more than 7 points off Coca-Cola's 5-year average. In fact, you have to go all the way back to December 2007 to find the same earnings multiple when Coca-Cola stock was trading just north of $30 a share. It's human nature to invest in rallying stocks. Coca-Cola is producing less net income and revenue at the moment (compared to 2011 for example) but its share price is almost 40% higher.
Obviously, since the market is forward looking and since the company has returned to bottom line growth ($1.24 billion in net income reported last quarter compared to $770 million in the fourth quarter of 2014), it has given Coke a higher valuation at present. The company also raised its dividend recently for the 54th consecutive year. Since so may investors have done very well with Coke down through the years, you can be sure "yield hunters" would have entered positions recently, especially after the stock has now firmly broken through its 2015 December highs.
However, many investors forget that Coca-Cola stock price actually dropped between the years 2000 and 2010 (over 2%) and the investor would only have seen a profit due to the dividend increases in that time period. In fact, a $20k investment in January 2000 would have increased to $24,399 by January 2010 resulting in a 2% annualized return. Now here is the kicker. In 2000, Coca-Cola had a much higher p/e ratio than its historic average which led to poor returns in the following decade. Could lightning strike twice? Let's go back to 2007 when as I mentioned Coke had a similar earnings multiple (approximately 27).
If we look at the long-term chart of Coca-Cola below, we can see that it took Coca-cola stock almost 3 years to regain the $30 mark which illustrates that any investor looking to go long now must be prepared to hold the investment for a considerable period of time. Furthermore due to the high earnings multiple and subsequent drop in share price in 08 and 09, the float actually increased from 4.662 billion shares in 2007 to 4.666 in 2010.
Current equity levels are similar to 2007 but long term debt has skyrocketed to $28+ billion (from $3.2 billion) which means Coca-Cola for the first time in this century has more long term debt than equity, which will keep away value investors if the trend continues. Therefore, investors should be mindful of this debt (which has been downgraded) when attempting to calculate future share buybacks and dividend increases.
Furthermore, the payout ratio has spiked from 53% in 2007 to 83% currently which means that dividend growth has outpaced net income by some distance. In fact, the dividend has gone from $0.82 in 2007 to $1.32 in 2015 whereas net income only rose by 22% from $5.9 billion in 2007 to $7.35 billion last year. Unless we see substantial weakness in the dollar from here or a spike in earnings, I cannot see meaningful share buybacks or big dividend increases in next few years.
Bottling divestitures will help cash flow but if the Fed continues to increase interest rates (which should strengthen the dollar), that $28+ billion debt load is going to eventually end up being difficult to service. Currently, Coca-Cola is not finding it difficult to service its debt. Coke has to watch it. Coca-Cola doesn't want the rating agencies to downgrade it again.
The current quarterly dividend of $0.35 means the annual pay-out will come to $1.40. Now Coca-Cola has guided for around $2.25 billion in net share buybacks in 2016 and if we add this to the dividend pay-out which most certainly will be over $6 billion (depending on how many shares Coca-Cola buys back), we now are well over $8 billion in shareholder commitments in 2016.
Coca-Cola delivered $8.1 billion of free cash flow last year and analysts expect 2016 revenue and adjusted EPS to decrease again which is worrying. Yes, the balance sheet will be strengthened in the near term by the sale of production facilities and re-franchising but investors will be looking at core growth in dollar terms and not solely in volume like the company likes to report each quarter.
To sum up, Coca-Cola has literally "sold" to the market that through productivity and cost saving initiatives, emerging market growth and a bigger mix of faster-growing beverages in its portfolio, it can get back to 5% top line growth. This seems very ambitious at this stage considering the $4+ billion wiped off sales since 2012. Furthermore, Coca-Cola has to achieve this with most of its free cash flow being returned to shareholders every year and with a present earnings multiple of 27+, it would be prudent to stay on the sidelines for the time being.