Dividend Aristocrats In Focus Part 53 of 54: Coca-Cola (KO)

Coca-Cola (KO, Financial) is the world’s leading beverage company. The company has a market cap of $192 billion, $44 billion larger than rival PepsiCo (PEP, Financial). Coca-Cola is more than its flagship brand. In total, the company controls 17 brands that sell over $1 billion per year. 11 of these 17 brands are non carbonated. The table below shows Coca-Cola’s 17 billion dollar brands.

8 of Coca-Cola’s 10 most recent billion dollar brands have been non-carbonated products. The company has been cognizant of slow shifts in consumer preferences away from soda and toward waters, juices, and teas for some time and has invested accordingly.

Coca-Cola has a long history of EPS growth and dividend growth. The company has increased its dividend payments for 52 consecutive years, one of the longest active streaks. Coca-Cola is analyzed in detail in part 53 of the 54 part Dividend Aristocrats In Focus series.

Business Overview

Coca-Cola divides its beverage operations into 5 geographic segments. The company also has a Bottling Investments segment that is separate from its 5 geographic beverage segments. Coca-Cola’s 6 segments are shown below along with percent of total operating income contributed through the first 9 months of fiscal 2014:

• Eurasia & Africa: 9.3% of total operating income
• Europe: 25.5% of total operating income
• Latin America: 21.1% of total operating income
• North America: 21.8% of total operating income
• Asia Pacific: 22% of total operating income
• Bottling Investments: 0.3% of total operating income

Coca-Cola is extremely well diversified geographically. It generates nearly equal amounts of operating income in Europe, Latin America, North America, and the Asia Pacific regions. The company’s Bottling Investments segment is inconsequential to overall operating income, generating just 0.3% of the total. Coca-Cola is planning to refranchise several of its bottling investments in the US in an attempt to decentralize its organization and spread bottling risk outside the company.

Competitive Advantage

Coca-Cola’s competitive advantage is well-known. The company’s strength comes from its portfolio of high quality brands. Coca-Cola has its strongest competitive advantage in carbonated beverages. The company controls the Coca-Cola, Sprite, and Fanta brands, among others.

What some potential investors miss is Coca-Cola’s strength outside of carbonated beverages. The company has captured 1/3 of global juice growth since 2007. Coca-Cola controls well known juice brands including Simply (orange juice and other juices) and Minute Made. In addition, Coca-Cola controls several strong tea and water brands including: Vitamin Water, Dasani, and Powerade.

Coca-Cola supports its strong brand competitive advantage through advertising spending. Coca-Cola has spent over $3 billion per year on advertising in each of its last 3 full fiscal years. This comes to about 7% of revenue per year spent on advertising. Only PepsiCo can match Coca-Cola’s advertising spend in the beverage industry. There are simply no other rivals for Coca-Cola in the non-alcoholic beverage industry that can match the companies advertising spending. The more Coca-Cola spends on advertising, the stronger its brands become.

In addition to its brand based competitive advantage which is supported by multi-billion advertising spending, Coca-Cola also has a global distribution network that new entrants to the market would find very difficult to match. Coca-Cola’s brand strength and distribution network create a market that is largely dominated by just 2 players (Coca-Cola and PepsiCo). The beverage industry is different than most other industries in that it is very slow to change. Consumer tastes are slowly shifting away from sodas and toward juice, water, and tea in developed markets, but emphasis should be put on the word slowly. There are no rapid changes in the beverage industry. It is virtually unthinkable for a new technology to come along that would antiquate the current beverage business. Odds are, people will continue to drink soda, juice, water, and tea throughout human existence. This makes Coca-Cola’s competitive advantages even more valuable as they are one of the few companies that could easily survive for several more centuries.

Growth Prospects

Despite its global reach, Coca-Cola still has much room for growth. The average American consumes about 400 servings of Coca-Cola products per year. The average citizen if India consumes just 14 servings of Coca-Cola products per year, and the average Chinese citizen just 39. The US is actually not Coca-Cola’s most penetrated market. The average Mexican citizen consumes 745 servings of Coca-Cola products per year. If Coca-Cola were to bring worldwide consumption up to US consumption levels, the company would be about 4 times as large as it is now. The image below shows the growth in Coca-Cola product consumption by country from 1992 through 2012:

Source: Coca-Cola 2012 Annual Review

Coca-Cola’s growth going forward will be driven by better acceptance of its products in China, India, and the rest of the developing world. The company has already grown one billion dollar brand in China; Minute Made Pulpy. The global beverage industry is expected to grow at 5.8% per year from 2014 through 2017. Coca-Cola will likely be able to grow at least as fast as the global beverage industry going forward (not counting share repurchases).

Coca-Cola is boosting its growth through strategic alliances with innovative beverage companies. The company recently announced a deal with Monster Beverage (MNST, Financial). In the deal, Coca-Cola will acquire a 16.7% stake in Monster for $2.15 billion. The companies will also swap brands. Coca-Cola will deliver Monster Beverage its energy brands which include NOS and Full Throttle. In return, Monster is transferring its Hansen’s, Peace Tea, and Herbert’s Lemonade brands to Coca-Cola.

In addition to the Monster Beverage transaction, Coca-Cola has signed a 10 year agreement with Keurig maker Green Mountain (GMCR, Financial) to supply Coca-Cola branded products for both its upcoming cold system and its hot system. Coca-Cola paid about $1.25 billion to acquire a 10% stake in Green Mountain, and has announced it will increase its stake to 16%. The Monster Beverage and Green Mountain partnerships shows how Coca-Cola can use its large market share to capture growth from faster growing niches within the beverage industry.

Over the last decade, Coca-Cola has managed to grow revenue per share and dividends per share by about 9% a year. EPS have grown at around 7.6% a year over the same time period. Net share repurchases have increased per share growth numbers by about 1% a year. Going forward, I expect Coca-Cola to grow EPS at at least 7% a year due to share repurchases (~1%) and beverage industry growth (~6%). The company has historically grown EPS faster than overall beverage industry growth. The company will likely grow EPS somewhere between 7% and 10% a year as it gains market share in both developing and developed regions through strong brand recognition and well-funded advertising.

Dividend Analysis

Coca-Cola has a current dividend yield of about 2.8%. The company has a payout ratio of just under 60% of EPS. I expect Coca-Cola to grow its dividend payments in line with EPS growth going forward. If Coca-Cola grows at the mid-point of my expectations (8.5%), it will have the following yield on cost over different time frames:

• Yield on cost in 3 years of 3.6%
• Yield on cost in 5 years of 4.2%
• Yield on cost in 10 years of 6.3%

Valuation

Coca-Cola is currently trading at a P/E ratio of about 20.2. For comparison, the S&P 500 has a P/E ratio of about 20 at this time. Coca-Cola is trading about in line with the overall market at this time. Over the past 5 years, Coca-Cola has traded at a premium of about 1.1x to the overall market. This makes sense considering the company’s strong competitive advantage and long-history of growth. At current prices, I believe Coca-Cola to be fairly valued compared to the overall stock market.

With that said, the market is historically overvalued at this time. It could stay overvalued for a decade or longer if interest rates remain at historical lows. If the market were to revert to its historical P/E ratio of about 15, Coca-Cola’s fair P/E ratio would be around 16.5 using the 1.1x multiple it has historically traded at compared to the market.

Recession Performance

Coca-Cola was only minimally affected by the Great Recession of 2007 to 2009. The company saw EPS decline by just 2.6% from 2008 to 2009 during the worst of the recession. Coca-Cola’s low cost beverages are not significantly impacted by recessions as consumers tend to drink just as many beverages during times of economic trouble as during prosperous times. Coca-Cola’s EPS through the Great Recession are shown below to illustrate how the company performs through recessions:

• 2007 EPS of $1.29 (high at the time)
• 2008 EPS of $1.51 (high at the time)
• 2009 EPS of $1.47 (recession low)
• 2010 EPS of $1.75 (new high)

Final Thoughts

Coca-Cola is a high quality stock that has demonstrated its ability to grow profitably for decades. The company is a Top 10 stock based on The 8 Rules of Dividend Investing due to its 9% revenue per share growth rate over the last 10 years, solid dividend yield, and reasonable payout ratio. Additionally, the company has a low price standard deviation of just 18.7% which reflects the company’s earnings stability and strong competitive advantage.