Description

Coke is it. If you want to join a stock that has an unfair game to the shareholders’ advantage, this company is it.  As I quarantine myself, I see that I am consuming only very few products on a daily basis.  Coke Zero is one of them. My recommendation is to buy Coca-Cola at today’s prices and get a 12.5% annualized IRR in five years.  If you are lucky with your price buy targets, you can buy them over several transactions in the next 18 months at lower prices, and add an incremental 1 to 1.5% annualized IRR. There is no special catalyst, except that if Covid lasts longer than people think, Coca-Cola will only get stronger than its competitors.Its spin-off as a syrups business from the rest of the packaging operations is one of the understated best financial engineering transactions ever. Don’t compete against Michal Jordan in basketball.  Invent a new game and invite him to play with you. Coke is It! 

TABLE OF CONTENTS

1. INTRODUCTION

2. NEAR-TERM OUTLOOK: HEADWINDS FROM CORONA VIRUS

3. LONG-TERM POSITIVES

4. VALUATION

5. CATALYSTS

6. OVERVIEW OF COMPANY

7. CONCLUSION

1. INTRODUCTION

1. My style of investing has evolved from the tiresome practice of finding net-nets to finding strong businesses with advantageous intangible assets. And leverage the returns of the portfolio with leaps or options writing.  

2. NEAR-TERM OUTLOOK: HEADWINDS FROM CORONA VIRUS

1. In the near-term, Coca-Cola unquestionably, for such a large company, will face headwinds from the Corona Virus. However, compared to other consumer staples companies such as those in the packaged goods companies like Campbell’s, Coca-Cola is not suffering from negative product trends as badly as them. Hence, its valuation is not as cheap as Unilever, my other idea.  Coca-cola’s supreme long-term advantages is why I am recommending Coca-Cola even though on paper the valuations are higher than other consumer staple products.

3. COMPETITIVE ADVANTAGE/  LONG TERM POSITIVES

1. More than anything, Coca-Cola has a supreme corporate, business model structural advantage over Pepsi.  

1. Brutally speaking, Coca-Cola did game the competition by financial engineering when it spun-off the syrups company from the bottling company in the 1980s. It obviously worked.  But that spin-off move really put all the good aspects of the soft drinks business on the syrup company as opposed to the bottlers. And since then, historians may marvel at the genius of the CEOs or the genius of the product and marketing team of Coca-Cola, or compare how it is better than Pepsi, but at the end of the day, it has been this  financial engineering move that gave Coca-Cola a structurally advantage and keeps on giving Coca-Cola the tailwind through up and down markets.It reminds me of the quote, “How do you beat Bobby Fischer?” Answer: “You play him any game, but chess.”. In a way, Coke played a different game from Pepsi. But part of life is choosing the right game and game rules. In a way, choosing Coke is choosing to play an unfair game to your advantage versus the game Pepsi and all the other consumer staple companies are playing.

2.  The syrups business is  structurally lower-cost. Coke does not package and distribute its own beverages. Instead, Coke produces the concentrate or syrup for these beverages and ships these mixtures to bottlers for processing (adding carbonated water and various sweeteners), packaging, and distribution. Concentrate operations are less capital-intensive, less labor-intensive and overhead relative to finished-product operations, which require specialized canning and bottling production lines that are typically not interchangeable across products or package sizes. Coke’s syrup business only needs 30 manufacturing facilities, while the finished-product operations need 90 facilities. And yet, the syrup business accounts for 80% of total unit case volume, while the finished product operations account for less than 20% of unit cases.  Coke also wields some control through ownership stakes in its bottlers and distributor network. Coca-Cola’s dominant share attracts hundreds of bottlers to its system. The extensive bottling, distribution network, retailer relationships, collection of data analytics and firm’s market share form a virtuous cycle for Coke to keep its unfair competitive advantage.

2. Oligopoly with Pepsi and Taste Loyalty Ensure Strong Pricing Power

1. Coke and Pepsi, owning 70% of the global volume together, form an oligopoly.  Both enjoy scale, cost advantages and intangible assets. They both use cheap ingredients: water, sugar, some syrup, but they each developed a core loyal customer base. A loyal Coke consumer will not change to Pepsi for price reasons; as a result, both companies do not engage in useless price wars.  In the end, they both garner enough volumes to achieve scale efficiencies. Additionally, both Coca-Cola and Pepsi consistently appear in surveys highlighting the most favored brands among fast-moving consumer packaged goods.

3. More Attractive unit economics than Pepsi

1. Coke’s leading volumes, capacity utilization, efficient procurement of raw materials lead to the most attractive unit economics among peers.  Beverage research firms estimate that Coke’s unit cases per manufacturing facility is triple Pepsi’s, thanks to robust productivity and capacity utilization. Coke enjoys lower per unit costs for raw materials, such as sweetener and juice concentrate, than Pepsi. Coca-Cola’s gross margins, above 60%, is highest among its peers.

4. More focused portfolio, lower G&A means higher operating margins.

1. Coke has a more focused portfolio than Pepsi. Pepsi may have twice the revenue of Coke, but it has 4 times as many employees. Coke’s more focused portfolio and unit economics means lower costs for workforce, leading to also, a more efficient G&A. Pepsi’s higher marketing synergies from a broader portfolio, as a whole, are outweighed by the benefits of operating leverage and lower cost structure of Coke. Coca-Cola’s operating margins, in the high 20s is superior to Pepsi’s margins in the midteens.

5. Strong Brands

1. Taste sensitivity results in big brand differentiation; thus, strong brands are built in beverages. The mind share and happy emotions associated with a brand stand out from private label brands. There is also a trend toward even more premium brands, which favors the brand portfolio of Coke. 

2. The Coca-Cola trademark is the apotheosis of all global iconic brands. Red Coke, Diet Coke, Coke Zero Sugar, Fanta, Sprite are in the top 10 of the soft drink category on both volume and value basis. Red Coke, at 18% US share is double that of number-two Pepsi Cola, according to Beverage Digest. Minute Maid and its Latin American Del Valle brand, Glaceau SmartWater, Dasani water are major brands. Overall, Coca-Cola has the highest market share across the nonalcoholic ready-to-drink (roughly 20% share), carbonated soft drink (mid-40%), and noncarbonated soft drink (9%) categories globally, according to GlobalData.

6. Price Leader

1. Coke is and has always been a price-setter and a price leader. In Japan, Coke recently raised prices, and all the competitors followed suit. The brand’s strong industry positioning allows Coke to be a price leader.

7. Retail Relationships

1. Coke is entrenched as a strategic partner in the retail channels.  Beverages account for over 20% of total food and grocery sales in North America, according to GlobalData. Coke’s products bring foot traffic to retailers.  Retailers then exchange insights with the firm on strategies to increase overall category value. This gives Coke even more advantage in this era of data, artificial intelligence and analytics.

8. Bottling and Distribution Infrastructure

1. Coke’s bottling and distribution infrastructure, over 100 bottlers and products in over 200 countries is the broadest in the industry. Its slogan -- More hands, more place, more quickly is not just a catchy phrase.  They literally are in most locations all over the world with more people drinking them and access to Coke nearby than any brand.

2. Coke monetizes its distribution system with its partnership with Monster that yields per-case distribution fees in exchange for global distribution access. These kinds of agreements are almost pure margin revenue streams that are accretive to profits.

9. Management

1. I have a favorable subjective view of the current CEO and chairman James Quincey, who succeeded long-time company stalwart Muhtar Kent in 2017. Quincey  ideated the price/pack architecture projects, was responsible for the highly successful acquisition of the smoothie brand Innocent in Europe, Jugos del Valle in Latin America.  Innocent has progressed from the number-one smoothie brand in the United Kingdom to the leading juice brand across Europe, and Del Valle is a major contributor to the firm’s global pre-eminence in the juice category.

2. Quincey’s recent acquisition of Costa Coffee was a successful integration with the Coke system, bringing Coke to the hot beverages market.

4. VALUATION:

1. Coca-Cola has delivered over a decade of consecutive dividend increases. I expect continued dividend increases of 3%-4% annually over the next decade.

2. I believe Price to FCF is the best way to value Coca-Cola.  At $188/$12.5=15 times Free Cash Flow, the stock is a bargain. 

3. Even at EV/EBITDA Less Mtc Capex of 17.5, Coca-Cola is inexpensive considering its business model of making concentrated syrup for the bottlers and Coca-Cola distributors generates 60% gross margins, 20+% operating margins, negative working capital needs.  The 2nd consumer staples company, Pepsi, is not even close.

4. I estimate Coca-Cola can grow revenues by at least 3.5 to 4% for the next decade.

5. Buffett Backstop.  It has been rumored before that Berkshire Hathaway may buy Coca-Cola someday.  I believe this is always a possibility. As such, there is a “floor” on the stock price of Coca-Cola.

6. After COVID-19 is over, I estimate gross margins reaching close to 63% in 2024 versus 61% in 2019. This is after Costa Coffee is fully integrated and the lapsing of the comparables to the charges coming from Coke Africa. Technological improvements, continuous improvement in cost efficiencies, should also allow operating margins to widen from 27% in 2019 to over 32% in 2024.

7. I use a 20 multiple Price to FCF, 32% operating margins, 3.5% growth in revenues to estimate and stock price of $69.  That is a 12.5% annualized IR if you include dividends.

HISTORICAL VALUATION:

V. CATALYSTS

COVID CRISIS LASTS LONGER THAN PEOPLE THINK I do not have a special catalyst except that if Covid lasts longer than most expected, Coca-cola will come out stronger than most competitors.  

VI. COCA-COLA OVERVIEW:

The Coca-Cola Company is an American Multinational Corporation, and manufacturer, retailer, and marketer of nonalcoholic beverage concentrates and syrups. The company produces Coca-Cola, invented in 1886 by pharmacist John Stith Pemberton in Atlanta, Georgia. In 1889 the formula and brand were sold for $2,300 to Asa Griggs Candler, who incorporated The Coca-Cola Company in Atlanta in 1892. The Coca-Cola Company is the single largest plastic polluter in the world, producing over 3 million tons of plastic packaging each year including 110 billion plastic bottles.

The company—headquartered in Atlanta, Georgia, but incorporated in Delaware—has operated a franchised distribution system since 1889: the Company largely produces syrup concentrate, which is then sold to various bottlers throughout the world who hold exclusive territories. The company owns its anchor bottler in North America, Coca-Cola Refreshments. The company's stock is listed on the NYSE and is part of DJIA and the S&P 500 and S&P 100 indexes.

Brands:

VII. CONCLUSION

Coca-Cola the stock is a buy at these levels. It is a boring stock, but an exciting business. If you want to join a stock that has an unfair game to the shareholders’ advantage, this company is it.  Its spin-off as a syrups business from the rest of the packaging operations is one of the understated best financial engineering transactions ever. Don’t compete against Michal Jordan in basketball.  Invent a new game and invite him to play with you. Coke is It! 

Catalyst

CATALYST:

COVID CRISIS LASTS LONGER THAN PEOPLE THINK I do not have a special catalyst except that if Covid lasts longer than most expected, Coca-cola will come out stronger than most competitors.