Coca-Cola (KO): A Safe Dividend King Trading at Its 52-Week Low

When it comes to long-term blue chip investing, it’s hard to go wrong with dividend aristocrats.

 

Of course, the only thing better than a company that has grown its dividend 25 or more consecutive years is a dividend king, like Coca-Cola (KO), which has one of the best payout growth track records in America with 54 straight years of dividend growth under its belt.

 

Then again, long-term investing is a forward looking endeavor, and many dividend lovers are understandably worried about where Coke’s future payout growth is going to come from.

 

Fortunately, management has a turnaround plan in place that could allow the dividend growth train to keep rolling along nicely for many more years, and possibly even decades, to come.

 

Better yet, with Coke now trading within 1% of its 52-week low, now is a good time to see if it makes sense to open or add to a position in this bluest of blue chips for a conservative dividend portfolio.

 

Business Overview

Founded in 1886 in Atlanta, Georgia, Coca-Cola is one of America’s oldest companies. However, the cornerstone of its investment thesis is the strong brand (17th most valuable in the world), which gives it a strong competitive advantage and pricing power.

 

Coke is by far the world’s largest beverage maker and distributor, selling 500 total brands offered in 3,800 flavors, including Coca-Cola, Diet Coke/Coca-Cola Light, Coca-Cola Zero, Fanta, Sprite, Minute Maid, Georgia, Powerade, Del Valle, Schweppes, Aquarius, Minute Maid Pulpy, Dasani, Simply, Glacéau Vitaminwater, Bonaqua/Bonaqa, Gold Peak, FUZE TEA, Glacéau Smartwater, and Ice Dew, in over 200 countries around the globe.

 

Coke’s strong brand portfolio includes 20 beverages with over $1 billion in sales.

 

Source: Coca-Cola Investor Presentation

 

In addition, with about 60% and 80% of its sales and operating profits, respectively, coming from outside the U.S., Coca-Cola is a solid international diversification investment. That’s thanks to the world’s strongest beverage distribution network and good long-term growth prospects in emerging countries.

 

 

Business Analysis

Coca Cola has had a rough few years, with sales falling thanks to a secular decline in soda sales. In fact, 2015 marked the 11th consecutive year of declining sparkling drink volumes in North America.

 

 

Looking at Coca-Cola specifically, the company’s revenue has declined for three straight years. More recently, Coke’s sales have fallen at a mid-single digit pace for five consecutive quarters.

 

 

Fortunately for dividend growth investors, management has a three-pronged turnaround plan in motion that could result in solid long-term payout growth and market-beating total returns.

 

Step one is to sell off its 39 domestic bottling operations by the end of 2017. The logic behind this move is that bottling operations are very low margin and capital intensive, and Coca-Cola wants to instead become a leaner, higher margin company.

 

In other words, Coke is planning on becoming a purveyor, marketer, and distributor of its core syrups and drink mixes, leaving the actual manufacturing to partners around the globe.

 

 

Management believes that by divesting itself of its bottling operations it can achieve phenomenally better profitability, including 27% free cash flow, or FCF, margins. To put that in context, Apple (AAPL), one of the highest margin, cash rich companies on earth, has FCF margins around 24%.

 

 

Despite the decline in revenue that bottling divestiture will represent, the new, leaner Coca-Cola will still generate plenty of FCF to cover the dividend. More importantly, the completion of step one in the turnaround plan sets up the company for much stronger growth in the coming years.

 

In addition to selling off the low margin, capital intensive bottling plants, management has found what it believes to be an additional $3 billion in cost savings it can achieve by the end of 2018.

 

Those cost savings will go a long way in making up for the decline in revenues that will result from step 1.

 

Finally, step three of Coke’s growth turnaround is management’s increasing focus on still beverages (i.e. non soda’s such as juices, teas, and health drinks). The plan is for Coke to locate fast-growing brands, such as AdeS, a South American soy drink that the company just bought from Unilever (UL) for $575 million, and then boost sales growth even further by putting it through Coke’s world spanning supply and distribution system.

 

 

And thanks to Coke’s still small global market share in still beverages (15%), the company hopes that it can achieve strong organic growth from still beverages, which are expected to grow worldwide sales at around a 5% CAGR in the coming years.

 

 

Combining this greater emphasis on non-soda products with the unbeatable branding and advertising might of Coke, the company could seemingly generate long-term sales growth of around 5% per year. And with continued cost cutting, industry leading pricing power, and ongoing buybacks of around 1% a year, this means that investors can potentially expect around 6% to 8% growth in EPS and FCF per share.

 

Key Risks

While Coke’s dividend remains highly attractive, there are three risks investors need to be aware of.

 

First, for the foreseeable future soda will remain the cornerstone of Coke’s cash flow. Growing worldwide health concerns mean that in addition to the secular decline in soda consumption, Coke may have to deal with additional political risk from governments that attempt to dissuade sugary drinks.

 

For example, on November 8th voters in San Francisco passed a 2 cent per ounce tax on soda, which studies indicate might lead to a 20% decline in consumption. Two other California cities have also passed Soda taxes, which might set a precedent for a wider tax based governmental war on soda that could result in a large growth headwind for Coke.

 

The second risk factor is execution risk, specifically whether or not management can truly extract sufficient cost savings from its turnaround plan and raise the company’s margins sufficiently to offset the decline in sales that are coming in 2017.

 

After all, this isn’t Coke’s first attempt at a growth turnaround. Back in 2012 the company spent $12.3 billion acquiring its North American bottlers in what management believed to be a solid and accretive growth initiative. Now management is admitting it messed up and is selling off its bottlers, probably at a substantial loss.

 

Or to put it another way, just as investors who overtrade are likely to underperform the market, so too must investors be careful that their companies aren’t buying and selling the same assets over and over in a desperate attempt to “do something” to appease growth hungry investors.

 

The same applies with the still beverage brands that Coke will acquire over the coming years. Any time a company tries to acquire its way to growth there is the risk that it will overpay for the asset, which in this case might mean paying a steep premium for a drink brand that ends up going nowhere and needs to be written off as a loss later.

 

Finally, we can’t forget that with 80% of operating profits coming from overseas and emerging markets, the largest growth runway for the company, currency risk might represent a major headwind for Coke’s growth plans going forward.

 

Specifically the risk of a rising dollar, which is already at historically strong levels, could mean that when Coke converts local currencies into the dollars that pay the dividend, a rising exchange rate will mean that bottom line growth may prove slower than investors hope.

 

That risk will only increase if U.S. interest rates rise, both because of the Federal Reserve normalizing its short-term rate, and because long-term yields on U.S. Treasury bonds are likely to rise if the Trump administration is successful in passing a major stimulus bill (of infrastructure spending and tax cuts), which could boost economic growth but also inflation.

 

Since 10- and 30-year Treasury yields are based mostly on long-term inflation expectations, these could rise significantly and in fact are already up about 0.6% since Trump won on November 8th.

 

Thanks to interest rates around the globe remaining at zero, or even negative rates, foreign investor demand for higher-yielding U.S. treasury bonds is likely to increase demand for the dollar even further, resulting in potentially stronger negative currency effects in the coming years.

 

Dividend Safety Analysis: Coca-Cola

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

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

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Coca-Cola has a Dividend Safety Score of 99, indicating its dividend payment is extremely safe.

 

This is a result of the company’s strong cash flows which provide for manageable payout ratios that have remained near 70% in recent years. While that may seem high, you have to keep in mind that Coke’s strong brands make for a wide moat, meaning little risk that rivals like Pepsi (PEP) and Doctor Pepper Snapple (DPS) will be able to steal its market share.

 

 

Coca-Cola’s strong Dividend Safety Score is further supported by the company’s excellent free cash flow generation and recession-resistant business. As seen below, Coke has generated positive free cash flow each year for more than a decade and managed to grow its free cash flow per share each year during the last recession (sales only fell 3%).

 

 

In addition Coke has a very strong balance sheet with manageable debt levels. The company could cover its entire debt load using cash on hand and just 1.1 years’ worth of earnings before interest and taxes (EBIT).

 

 

While the high absolute debt levels may initially appear dangerous, keep in mind that all companies operate in different industries, with varying levels of capital intensity. This means we need to compare Coke’s leverage metrics to those of its peers.

 

As you can see, Coca-Cola has a very strong balance sheet relative to both the other two soda giants, as well as the industry at large. That explains why it has the strongest credit rating, which translates to very low borrowing costs, lower cost of capital, and stronger margins. All of these factors help to further strengthen the fortress-like dividend.

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
Coca-Cola	4.06	18.53	43%	1.37	AA-
Pepsi	2.94	11.38	60%	1.32	A
Doctor Pepper Snapple	1.98	12.59	54%	1.08	BBB+
Industry Average	3.58	NA	59%	1.30	NA

Source: Morningstar, FastGraphs

 

Dividend Growth Analysis

Our Dividend 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 very good, and 25 or lower is considered weak.

 

Coca-Cola has a Dividend Growth Score of 37, indicating that Coke’s dividend growth prospects are slightly below average.

 

The weak dividend growth score obviously isn’t to do with the company’s payout growth track record, which is fantastic.

 

Rather the issue is the lack of growth in recent years and the steady increase in the company’s payout ratio.

 

However, as explained previously, the three-step turnaround plan could help Coke to achieve long-term EPS and FCF per share growth of 6% to 8% CAGR, which would allow it to continue growing its payout at similar levels.

 

As seen below, Coca-Cola has reliably increased its dividend by 8-9% annually over the last 20 years. The company has raised its dividend for 54 straight years, making it one of the most reliable dividend growth stocks in the market.

 

 

Valuation

Despite Coke’s recent correction, shares are still trading at a trailing P/E of 24.9, in line with the broader market’s frothy level of 25.4. With Coke’s 13-year median P/E a much lower 20.5, the shares are not exactly a screaming deal right now.

 

Coca-Cola’s shares also trade at a forward P/E multiple of 20.7 based on 2017 earnings estimates – hardly cheap given the company’s questionable future growth prospects.

 

For investors primarily concerned with the dividend, and from the perspective of the forward yield, things look a little different.

 

Specifically, over the past 13 years Coke’s dividend yield has ranged from 2.1% to 4.0%, with a median value of 2.8%. So from a historical yield point of view, shares are currently 21% undervalued relative to history.

 

That’s not to say that, with the market once again hitting all-time highs, that a broader correction might not send shares lower. For example, if Coke were to hit its historic high yield range of 4.0%, that would imply a share price of $35, or 15% below the current price.

 

However, given the company’s quality brands, strong competitive advantages, reasonable long-term growth plan, and rock solid dividend security, that risk level could be acceptable for investors with a long time horizon and confidence in Coke’s turnaround plan.

 

Conclusion

Despite its recent growth headwinds, Coca-Cola’s latest long-term growth plan is likely to allow this legendary dividend growth blue chip to continue rewarding dividend investors with many more years of strong payout growth.

 

With shares now just 1% off their 52 week low, and the yield at a historically high level, today could be a reasonable time for conservative income investors living off dividends to give Coca-Cola a closer look for their diversified dividend growth portfolios. Assuming management is able to deliver on its plans, Coke is also likely to remain a solid business for years to come. After all, the company is still a core holding in Warren Buffett’s dividend portfolio for a reason.