What Does the Future Hold for Coca-Cola?

How will slowing soda demand impact the company's future earnings and dividend growth?

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Aug 10, 2016
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Coca-Cola (KO, Financial) is one of Warren Buffett’s dividend stocks that has paid a consistent dividend since 1920 and increased its payout for the past 54 years.

Coke has grown its dividend at a 9% compound annual growth rate (CAGR) over the last 10 years. Its extraordinary track record and stable business model put Coca-Cola in the rarefied air of a Dividend King.

Presently, the company looks good with a 3.2% yield and the potential for further dividend increases, making the stock a particular favorite for investors living off dividends in retirement.

However, with slowing growth due to health-conscious consumers moving away from Coca-Cola's core products, should investors continue to count on it to deliver higher dividends for them over the next 54 years?

Business overview

Coke is the world’s largest beverage company with over $44 billion in sales and a portfolio of 20 brands (up from 10 in 2007) with over $1 billion in sales. Unlike other global competitors, Coke only sells beverages with sparkling beverages accounting for 73% of global case volume last year; Coca-Cola branded beverages were 46% of global case volume.

Last year we compared the two global beverage behemoths, Coke and Pepsico (PEP, Financial), which readers can find here. Some of Coke’s key brands include diet and regular Coca-Cola, Fanta, Sprite, Minute Maid, Powerade, Dasani, Vitaminwater and Schweppes.

Coke’s portfolio holds leadership positions across its major categories: No. 1 in sparkling, No. 1 in juice, No. 1 in ready-to-drink coffee, No. 2 in energy (Monster partnership), No. 2 in sports, No. 2 in water and No. 2 in ready-to-drink tea. Overall, Coca-Cola is No. 1 in value share in 25 of the top 32 global markets.

Brand strength is reinforced by Coca-Cola’s advertising spending ($4 billion in fiscal year 2015 and up 14% year over year) and global distribution reach, especially in emerging markets (81% of Coca-Cola’s volume is outside the U.S. – Mexico, China, Brazil and Japan are the next four largest markets) that will become increasingly important growth drivers going forward. This cumulates in the company selling 1.9 billion servings per day of beverages to consumers.

Business analysis

One of the most efficient ways to assess the strength of a business model is to evaluate the level and durability of a company’s return on invested capital. As seen below, Coca-Cola has generally maintained a return on invested capital in the teens or higher for the past decade, which indicates a durable and consistent business with low capital intensity (licensing brand formulas to restaurants and bottlers). The drop in fiscal year 2011 was driven by Coca-Cola’s acquisition of some of its bottlers, which have lower margins and greater capital intensity. Before acquiring bottling operations, Coca-Cola generated high and stable returns in the 20% range.

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Source: Simply Safe Dividends

It’s clear the company’s brands are crown jewel assets; however, less obvious is Coca-Cola’s distribution platform. It delivers products to market in more than 200 countries through its network of company-owned or controlled bottling and distribution operations, independent bottling partners, distributors, wholesalers and retailers. This network builds up to be the largest beverage distributor in the world.

Coke’s growth strategy centers around meeting demand for increasing consumption of Coke per capita in key emerging markets, innovative product introductions and growing share in key categories.

In the U.S., the per capita consumption of 8-ounce beverages is over 400 per year. However in key emerging markets, this figure is much, much lower. For instance in China, per capita consumption is only in the 30s and in India it is in the teens. Growing per capita consumption in these enormous markets will allow global per capita consumption of Coca-Cola to rise for a long time to come.

One of the key strategies for Coke in developed markets where consumption per capita is stable to declining is to increase the sales per occasion by finding ways to subtly increase the price points of its products.

It can do this through different packaging sizes, bottle types and ingredients. Mini cans, aluminum bottles, different size glass bottles and natural ingredients are just a sampling of ways the company is increasing the spend per occasion. For many of these products, the spend per occasion is multiples of what Coke earns from its traditional 12-ounce can and 2-liter bottle sales.

Other key categories including juice, sport, ready-to-drink tea/coffee, energy and water are all growing. These are categories in which Coke holds a No. 1 or No. 2 market share and has the opportunity to continue to acquire and partner with innovative brands.

Overall, these three key growth drivers should allow Coca-Cola to offset any weakness induced by flat to declining case volumes in North America and grow revenue in line to, even in excess of, global gross domestic product (GDP). This should translate into free cash flow growth in excess of inflation over the long term.

Dividend analysis: Coca-Cola

Very long-term Coke shareholders have been handsomely rewarded with uninterrupted dividends since 1920 and a five-decade growth streak.

While it’s unlikely many dividend growth investors today have been shareholders since the early 20th century, long-term investors have benefited from a 20-year dividend compound annual growth rate (CAGR) of 9.4% and 10-year CAGR of 9%, which translates into dividends per share increasing from 22 cents in 1995 to $1.32 in 2015.

Coke announced in February that it will raise its dividend by 6% in 2016 to an annualized dividend per share of $1.40.

We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a company’s dividend.

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more.

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios.

Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.

Coke’s dividend is extremely safe as demonstrated by a Dividend Safety Score of 99 but about average for growth with a Dividend Growth Score of 46.

Overall, dividend growth is largely a function of earnings (cash flow) growth, payout ratio and business model stability. We investigate each of these areas to determine what Coke’s normalized dividend growth rate should be over the coming decade.

Simply, earnings growth is tied to improving sales and margins. Adjusting for currencies (over 50% of Coke’s sales are international), Coca-Cola has grown revenue more or less in line with global GDP growth over the last three years.

The drivers of this growth, which we detailed in the Business Analysis section above, appear to be persistent and should continue for the foreseeable future. While it is well known that Americans are consuming less and less soda per capita, these drivers should be able to allow Coke to continue to grow the top line in excess of inflation year over the coming years.

Historically Coke has had extremely stable margins. The main costs in the business are raw materials (sweeteners, metals, juices), advertising and selling, general and administrative (SG&A) expenses. While raw material costs grow in proportion with sales, advertising and SG&A are costs that can be leveraged. This means that these are costs that are somewhat discretionary and can grow slower than sales growth. Therefore, margins are stable and even have the potential to expand over time, adjusted for the bottling refranchising efforts.

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Source: Simply Safe Dividends

Coke’s earnings per share (EPS) payout ratio is 78%, and its free cash flow payout ratio is 71% over the trailing 12 months. The payout ratio should be a function of business model stability and investment opportunities.

The more stable the business model, the more cash the company can routinely pay out from total cash flow without risking dividend cuts during tough times. Furthermore, the fewer investment opportunities the company has, the more cash the company should payout to its shareholders.

We can see this dynamic by comparing the free cash flow payout ratios of a few different consumer staple companies to cyclical businesses and companies with large investment opportunities. The chart below shows illustrates this with the consumer staple companies (Coke, Pepsi, Colgate-Palmolive [CL] and Procter & Gamble [PG]) having much larger payout ratios than cyclical business (Dow [DOW] and Deere [DE]) and growth companies (Visa [V] and Roper [ROP]).

Company Name 2015 EPS Payout Ratio 2015 FCF Payout Ratio
Coca-Cola 78% 71%
Pepsico 73% 51%
Colgate-Palmolive 96% 66%
Procter & Gamble Company 102% 47%
Dow Chemical Company 29% 36%
Deere & Company 42% 20%
Visa 19% 19%
Roper Technologies 14% 11%

The chart above indicates that Coke’s payout ratio is in line with other staples peers and is unlikely to materially increase. Therefore, the majority of the dividend growth will come from increasing earnings.

When one considers the growth drivers and business model, Coke should be counted on for future dividend growth in excess of inflation or around 4% to 6% per year.

Conclusion

Coke is a blue-chip stock that is a great investment to consider for dividend investors looking to add yield to their portfolios with optionality for continued dividend increases well into the future.

The company has paid an uninterrupted dividend since 1920, has an exceptional business model through all economic cycles and generates consistent free cash flow. However, investors looking for double-digit dividend growth well into the future should look elsewhere for opportunities.

While Coke’s best days in terms of rate of growth in intrinsic value and dividend growth are likely behind it, today’s dividend investors can still reap the rewards of this iconic American company through a steadily growing intrinsic value and dividend growth in excess of inflation.

Disclosure: At the time of this writing, the author was long Pepsi and had no position in Coca-Cola.

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