- Divesting of Coca Cola's bottling territories should affect operating margins positively going forward.
- Asia and specifically India is growing meaningfully. Furthermore consumption is low at the moment and growth levels should continue for the foreseeable future.
- Smaller offerings are more profitable and also making Coca Cola look better in the eyes of health bodies.
Coca Cola (NYSE:KO) hasn't sold off as much as the S&P 500 since the start of trading in 2016 and in one respect, it is understandable since this stock has always sold at a premium due to its income growth history and dividend aristocrat status. However the question remains if Coca Cola's current valuation is justified especially when you consider the company's negative growth trends both in its top and bottom lines. Coca Cola's EPS in the latest quarter came in at $0.33 on $11.23 billion in revenue, compared to an EPS of $0.48 on $11.94 billion in revenue in the third quarter of 2014. Coca Cola bulls should remember that the company will do around $3 billion less this year in sales (around $45.2 billion) than in 2012 and its price to earnings ratio 4 years ago was substantially lower (Under 20 compared to over 26 currently). Furthermore the price at the end of 2012 was around $36 compared to north of $41 today. What's the takeaway here? In the last 10 years or so, Coca Cola valuations have never been higher. Is Coca Cola stock worth almost 20 times forward earnings considering its negative growth in dollar terms?
Bulls will point to product volumes (goods being sold) being up in recent quarters but basing an investment decision on volumes alone is risky in my opinion as the dollar could remain strong indefinitely against other currencies. Furthermore even when you factor in the strength of the US dollar, the company is still shrinking as net revenue declined by 5% in the last quarter whereas organic revenue (currency neutral) only grew 3%. Coca Cola needs new avenues to grow its business in order to steady the ship and I believe it has them at its disposal.
Firstly Coca Cola wants to re-franchise 66% of its bottling assets in North America by the end of 2017 and a good majority of the final third by 2020. I believe this is a good move, as operating margins have been slipping meaningfully for Coca Cola since 2012 and bottling operations have been one of the culprits here due to low margins that are inherent in bottling operations. Coca Cola has to get back to operating margins in the mid 20's and divestitures in this area would definitely help. Coca Cola achieved operating margins of over 26% in 2009 which produced net income of $6.8 billion on revenues of $31 billion. This year revenues will come in at around $45.1 billion ($15 billion more), but will only produce the same net income total as 2009. Getting operating margins consistently over 20% has to be Coca Cola's major initial goal in 2016 and 2017, more so because it's impossible to predict whether the US dollar will continue to be strong against other currencies or not over the long term.
Although carbonated soft drinks consumption has been consistently declining in North America over the past few years, global beverage volumes were up in this category in third quarter earnings, which surprised many analysts. However, I see this trend continuing going forward. Why? Well, believe or not but Coca Cola's consumption in emerging markets is very low and India for example, is showing robust growth in its top and bottom lines. Coca Cola's Indian subsidiary reported 22% year on year growth in sales and a whopping 43% year on year growth in net profit for 2015. Furthermore when you take notice of the present consumption rates of Coca Cola in India (8 times less than the global average), it is evident that there is ample room left for the Coca Cola brand to grow in India and Asia despite health concerns adversely affecting growth levels in Coca Cola's home market.
Speaking of the company's home market, Coca Cola has definitely responded well to the change in sentiment towards its CSD range (especially diet sodas) by concentrating more on smaller offerings which are doing very well. Smaller bottles and packs grew by double digits in the third quarter and now make up 15% of the company's carbonated drinks in the US which helps Coca Cola on two counts. Firstly these smaller bottles and cans have a higher price per unit meaning that over time if this figure can grow to 20% or more, you are going to see these new sales driving higher profitability which Coca Cola desperately needs at present. Secondly, there's the health argument which suits Coca Cola's smaller cans and bottles perfectly. There is no doubt that information concerning health concerns about consuming too much sugar is going to expand in the next few years. Further, if the 230ml can becomes the new norm for Coca Cola consumption in North America, you are going to see profits higher in this division which will give the company time to slowly start integrating more fast growing "still" beverages into its portfolio over time.
To sum up, I believe the dollar will dictate the direction of this stock especially in the near term. If the dollar continues to strengthen, I can not see positive EPS growth in the foreseeable future. Continued dollar strength should make the stock drop back to at least its 200 day moving average (see chart) where one would think investors would start buying.
In saying this and barring a breakdown in the dollar, the stock is not cheap and the only reason to consider this a long term hold would be for the increasing dividends and share buybacks.