- Coke rallied far too much after its third quarter earnings. It had a slight beat on earnings and volume was up but both of these metrics shouldn't have justified nearly a $2 move in the stock.
- The stock sells at a premium due to its history and income growth story. However the longer the stock stays in $40's with reducing earnings, the more likely it is that astute value investors will start to vacate and look for greener pastures.
- The stock is an example for earning extra income by selling some covered calls.
Coca Cola (NYSE:KO) stock is now trading at just under $42 a share after reaching almost $44 a share at the tail end of October when it announced its latest set of earnings. Coca Cola stock may have topped out here as it couldn't pierce through resistance last month which was its 2014 highs (see chart). Furthermore if the present decline continues in the S&P 500 (INDEX:SPAL), I see next support for Coca Cola stock at its 50 day moving average of $40.78 a share.
Coca Cola stock is a dividend aristocrat as it has a 53 year record with respect to raising dividends and is currently paying out a yield of 3.17%. Furthermore its 3 year dividend growth rate is almost 10% which is another reason why yield investors flock to this stock. However after looking at this stock again and after observing recent price action, upside may be limited from here especially in the near term.
Coca Cola stock went ex dividend on the 28th of last month and is paying out on the 13th of November. Therefore any investor holding the stock from around the 25th of October will be guaranteed the dividend. In addition to the dividends, it may be the time to bring in some extra income through monthly covered calls until Coca Cola stock comes back to trade near the lower part of its range. Let's discuss.
Firstly although the company came out with a small beat regarding its earnings in the third quarter, revenue and operating income were down compared to the second quarter of 2014 and also Q3-2014. This is why I was surprised the stock rallied so much after earnings. Volume growth came in at 3% but this number was nowhere near enough to offset the currency problems that company has been experiencing for a while now. Why? Well 60% of the company's net revenues came from international markets in fiscal 2014.
Furthermore things could get worse before they get better. The company has already guided that strengthening of dollar will continue to be a headwind for Q4 with the projected top-line being around 7% lower and operating income being 11% lower. However the company reported its Q4 guidance 3 weeks ago. Just look at the chart below to see how the dollar has rallied violently from then until now.
100 on the dollar index seems inevitable at this stage especially when you see Europe on the verge of announcing more QE which should put more pressure on the euro. Ever since the dollar started to strengthen meaningfully against other currencies, Coke has been active in hedging activities, but thus far, these activities don't seem to be bearing fruit as all we here every quarter is more currency headwinds.
High Forward PE Ratio
Therefore I would advise shareholders to not read too much into volume numbers in the next earnings report. The strong dollar may be here to stay especially if the Fed hikes interest rates next month. I just cant see the company's forward price to earnings ratio of 20 holding if the dollar stays strong. Paying 20 times earnings for a company that will almost most certainly report negative EPS growth is not sustainable.
Nevertheless this is what happens with companies that sell at a premium and Coke is certainly one of them. Any decline in the share price usually attracts yield investors in hoards. However the longer Coca Cola stock remains elevated with declining earnings, the more premium will be priced into the stock. This is why I recommend investors sell some covered calls now because the reward in my opinion outweighs the risk.
In saying all of the above, this company has still many things going for it. The "still" range is growing by leaps and bounds and ongoing cost cutting measures will ensure that the company will fulfill its promised share buybacks as well as increase the dividend over time. However this company has to do something quickly with respect to the dollar. Its volumes may be increasing but they are worth less in present dollars meaning its EPS and revenue growth are negative both compared to Q2 of this year and Q3 of 2014.
To sum up, although I really believe Coke to be an excellent stock for dividend purposes, I don't see much potential in the share price rallying from here. Investors now seem to be latching onto its volume metric (which did increase in Q3) but 3% still is not enough to drive this company forward meaningfully. Its 2016 p/e ratio is over 20 which seems too high for a company reporting negative earnings growth.
Furthermore the dollar has really rallied since the company issued guidance which confirms to me that Q4 may be worse than analysts are forecasting. Sell some out of the money calls against your stock (similar to renting your shares) to avail of more income. This is a good strategy when the respective stock is trading nears the highs of its range.