Description
KO was written up by tbzeej825 in December 2007. That write up focused on refuting bear points. Here, I'll begin by arguing that KO is worth a 20-25x multiple of earnings and is therefore very undervalued. Then, I'll consider bear points, some of which were not in the previous post.
1) KO's moat will continue to support its 30%+ ROE for decades, yet today the stock trades at only 14x the Street's estimate of current-year EPS ($3.04), and 13x the 2010 estimate ($3.31). It is obvious that a cornerstone of the moat is trademark Coca-Cola. Less commonly acknowledged, however, is the significance of the company's vast economies of scale in distribution and marketing, which will allow it to establish leading positions in increasingly important non-carbonated beverages down the road.
2) This means that KO can be expected to grow faster than the global non-alcoholic beverage industry. The company itself aims for 5-6% long-term revenue growth and 6-8% long-term operating income growth. Let's use lower numbers and assume that over the long haul, KO will grow earnings (= free cash flow) a couple percentage points faster than global GDP, say 5% or 6%.
3) The formula for valuing a growing perpetuity is 1 / (r - g), where "r" is the discount rate and "g" is the growth rate. Plugging in a 10% discount rate, and using g = 5-6%, we get a multiple of 20-25x (not surprisingly, in line with KO's historical trading multiples). Note that if we use a more reasonable 8% discount rate and assume 0% growth, the implied multiple is 12.5x. So, KO is arguably trading quite close to a no-growth valuation.
To be clear, this is not an argument that any company growing at 5-6% is worth 20-25x. In general, I think that high multiples are warranted if growth is either high or enduring. KO represents the latter; it is one of the few companies that can be expected to sustain its competitive advantages over a multi-decade time horizon.
4) If KO were to trade at 20-25x the Street's consensus 2011 EPS estimate of $3.56, the stock would be somewhere between $80 and $100 (including about $10 of value cash generated in the interim, of which about ½ will likely be dividended out and 1/3 will be used in share repurchases). This represents 90-130% upside. The 2-year annualized return would be 40-50%. The dividend yield today is 3.8%.
Below are some concerns and responses to those concerns.
1) Concern: Consumption of carbonated beverages is declining, and KO will be left in the dust by the growing importance of more healthful, non-carbonated beverages. Response: Consumption of carbonated beverages is declining only in North America, which comprises only about 1/5 of the business. Outside NA, per-capita consumption of carbonated beverages is generally relatively low and growing.
KO's economies of scale in distribution and marketing are world-class competitive advantages that should not be overshadowed by iconic status of the brand and the ubiquity of trademark Coca-Cola products. KO has a sustainable edge in attracting customers to current non-carbonated products (such as Vitamin Water) and to future ones (internally developed or acquired).
2) Concern: Where will all the growth come from? Response: The worldwide annual per capita consumption of KO products is 85 (measured in 8 fluid ounces of finished beverage). In North America it is 412, nearly 5 times as great. Consider just China and India, in which KO is competitively dominant. Each has the potential eventually to become a larger market than North America is today:
China India US
Population 1.3 billion 1.2 billion 300 million
Multiple of US population 4.3x 3.8x -
% of world population 19% 17% 4%
Per capita consumption of KO products* 7 28 412
% of US 2% 7% -
* From the 2008 Annual Review; measured in units of 8 fluid ounces of a finished beverage consumed annually
A common misconception is that KO raises prices faster than inflation, whereas prices actually rise with inflation. This is important because it means that the per-ounce price of the product decreases as a percentage of consumers' earnings power over time, which allows for growth in per-capita consumption.
Another property of the product (and of colas in general) that facilitates heavy usage is the lack of taste memory. That is, the 5th Coke of the day tastes the same as the first. This is not true of, say, grape soda, the taste of which accumulates after each serving, deterring multiple servings in a compressed period of time.
3) Concern: KO will destroy value by overpaying for acquisitions. Response: This is a worry for me, but there are at least two mitigating factors. First, KO has demonstrated a pattern of paying out about half of earnings as dividends and, on average, a third of earnings as buybacks. On average, only 15% of earnings are retained each year.
Second, even large acquisitions are small relative to the size of the company and its earnings power. The much-criticized purchase of Glaceau for $4B was less than that year's net income, and equal to about only 4% of the current market cap (and an even smaller proportion of intrinsic value). If KO overpaid for Glaceau by 100%, the value destroyed was only 2% of the market cap and less of intrinsic value.
4) Concern: KO is too big and well-known to be mispriced. Response: The stock was over $60 in early 2008 and now it is in the low $40s. One who argues that KO cannot be mispriced is committed to the conclusion that the intrinsic value decrease by 1/3 in the past year. That seems a tough case to make.
KO could be caught in no-man's land for style-box institutional investors. It is not a "growth stock" because the growth is slow. Many consumer moat stocks are trading at similar or even lower multiples, and the underlying businesses are currently growing faster. At the same time, KO lacks characteristics to which "value" investors are commonly drawn: neglected, misunderstood, out-of-favor, etc. It is not a special situation, and there is no catalyst.
In my view, none of the preceding issues is relevant to the investment case; only price versus value matters. I recommend reading tbeezj825's insightful comments for other reasons that KO might be an orphan stock today
Catalyst