Coca-Cola (KO): Are the Best Days Behind This Buffett-Owned Dividend King?

When it comes to high-quality dividend growth stocks, investors naturally gravitate to blue chips like dividend aristocrats and dividend kings. After all, no company can increase its dividend for at least 25 or 50 years in a row without a certain combination of highly admirable characteristics.

 

These traits tend to include stable and predictable cash flows, strong competitive advantages, good profitability, modest amounts of debt, and of course a very shareholder-friendly corporate culture.

 

In addition, Warren Buffett, history’s greatest value investor, has made his fortune buying “wonderful companies at a fair price.” So naturally, any company that Berkshire Hathaway (BRK.B) owns a large position in (Coke is 9.5% of Berkshire’s portfolio) is seen as a defacto high-quality blue chip.

 

Investors can review analysis on all of Warren Buffett’s dividend stocks here.

 

While Coca-Cola (KO) does indeed possess many admirable qualities, including 55 consecutive years of rising dividends, that doesn’t necessarily mean that this popular dividend growth stock is a good fit for most income portfolios right now.

 

Let’s take a look at the pros and cons of Coke to see if its best days are behind it, and more importantly if today’s valuations means investors could be better off not adding the company to a diversified dividend portfolio at this time.

 

Business Overview

Founded in 1886 in Atlanta, Georgia, Coca-Cola has grown to become the world’s largest drink purveyor and the fifth most valuable brand in the world. It markets over 3,900 products through over 500 brands in more than 200 countries.

 

In fact, Coca-Cola is so geographically diversified that the US market accounts for less than 20% of its overall sales volumes.

 

 

The vast majority of the company’s sales and profits come from a strong core of $1 billion+ brands that the company produces in about 900 plants around the world and markets through 24 million global retail outlets.

 

 

Business Analysis

Coca-Cola is the epitome of a wide moat company, meaning it has numerous competitive advantages that allow it to command strong pricing power. The two biggest advantages are its leading global scale and unbeatable brand strength.

 

Coke generally spends about 8% of its revenues on advertising around the world, in order to make its products universally known and loved in almost every nation on earth. However, the true power behind Coke’s global beverage empire is owning the largest distribution network on earth.

 

In the consumer food and beverage market, distribution is everything. Having the best product in the world is meaningless if you can’t get it on the shelf and into the hands of consumers. Coke has spent 132 years and an absolute fortune to build the largest distribution and logistics chain in the industry.

 

This, combined with its very strong brand loyalty, means that Coke has dominant shelf positions in over 24 million retail outlets around the world. This giant reach also allows the company to achieve impressive economies of scale, which lead to above average margins and impressive free cash flow to consistently pay higher dividends.

 

Coca-Cola Trailing 12-Month Profitability 

 

Of course, long time Coke shareholders know that the past few years have not been easy for the beverage giant. Sales and earnings have actually been in decline because of several factors, including declining soda volumes, negative currency effects (more on this later), and the company’s major strategic shift.

 

 

Specifically, Coca-Cola plans to become a much more profitable company by refranchising its bottling operations around the world.

 

Coke’s plan is to sell its bottling operations (other than the super high-margin concentrate business) to its current global partners. The logic behind this is that it will make the company much less capital intensive and send margins and returns on capital soaring.

 

Coca-Cola North American Bottling Refranchising Plan

 

Management expects that, starting in 2019 when the global bottling refranchising plan is complete and it finishes its $3.8 billion cost cutting initiative (from 2016 to 2019), the company’s operating margins will rise from 22% to 35%.

 

Of course, cost cutting and financial engineering may boost profitability substantially, but ultimately Coke needs to grow its sales, earnings, and free cash flow if its dividend is to continue growing as it has every year since 1962. Fortunately, Coke also has a plan for how to not only maintain its market share but even grow it, just like it has for many decades.

 

 

The first step is the continued transition from Coke’s namesake soda brands into trendier alternatives, such a: bottled water, juices, milk, energy drinks, and teas. Coke plans to devote about 50% of its resources to growing this side of its business.

 

 

Specifically, Coke has been very good at making bolt-on acquisitions of fast-growing non-soda brands, such as its recent acquisitions of:

• A 16.7% stake in Monster Beverage (MNST), which posted 15.4% revenue growth in Q3 2017
• Fuse
• Vitamin Water
• Honest Tea
• A large stake in Keurig Green Mountain which was later bought out by a private company for $13.9 billion
• At its most recent investor day, management outlined a potential plan to enter the craft beer market

 

Going forward, Coke says it plans to scale back its buybacks in order to focus more on these investments and bolt-on acquisitions. That makes sense since Coke’s marketing and distribution machine are so strong that its number of billion-dollar brands has more than doubled since 2007.

 

Coke is also planning on being more efficient with its advertising and brand marketing campaigns in the future. Specifically, management wants to focus less on traditional 30 and 60-second TV commercials and instead use more online advertising (currently generates 1% of sales) to try more efficient and targeted campaigns.

 

The company also wants to transform itself into a more powerful local market of all major beverages. This means using advanced data analytics (machine learning and AI) to determine which products are most in demand in any given city, state, or region.

 

The end goal, according to management, is to help Coke continue to use its massive financial, marketing, distribution networks to gain market share in the $110 billion global beverage market, which is expected to grow 4% annually through at least 2019.

 

 

In fact, management believes the company can achieve long-term 4% to 6% revenue growth and 6% to 8% earnings growth, thanks to its tried and true model of acquiring up-and-coming brands and then accelerating their growth rates by plugging them into its global distribution system.

 

While Coke is indeed making many smart strategic moves to finally return to sustainable top and bottom line growth, that doesn’t necessarily mean the company’s rosy projections will come to fruition.

 

Key Risks

Coca-Cola is likely to remain a low-risk dividend stock for the foreseeable future, but that doesn’t mean there aren’t several risks to be aware of.

 

First, because Coca-Cola derives the vast majority of its sales and earnings from overseas, the company has a lot of currency risk. For example, in 2017 the company estimates that negative currency effects will be a 3% to 4% headwind. That’s despite the US dollar depreciating against numerous other currencies such as the Euro, British Pound, Japanese Yen and Canadian dollar.

 

This is a challenge for two reasons. First, usually when the dollar weakens it actually helps boost a multi-national’s bottom line because the value of foreign sales and profits ends up translating into more US dollars when it comes to reporting earnings and paying dividends.

 

However, Coca-Cola’s specific currency mix is very complex because they operate in virtually all currency markets. So whereas most global corporations enjoyed a profit boost in 2017, Coke was one of the few to actually suffer.

 

What’s worse is that accelerating economic growth in the US means there is a stronger probability that US interest rates could rise faster than rates around the world. If that happens, the US dollar could reverse course in the coming years and potentially appreciate relative to other currencies, which would result in even greater currency headwinds.

 

That in turn means that Coke’s planned sales and profit growth of about 5% and 7%, respectively, might not be so achievable, creating a problem for dividend investors because the company’s restructuring plan means that Coke will be a much more profitable but smaller business going forward.

 

 

In the short-term Coke is facing growth headwinds thanks to the now international expansion of refranchising of bottling operations. In fact, Coke expects revenues to shrink by 18.5% in 2017, followed by another 16.5% in 2018. While cost cutting is helping to offset most of that decline, the company is still forecasting a 3.5% decline in 2017 EPS and a 1.5% decline in 2018. And that’s assuming that negative currency effects don’t get worse.

 

In other words, dividends aren’t paid out of high margins, but overall free cash flow (FCF), which is currently in decline for Coke. In other words, Coke’s ability to continue rewarding long-term investors with the kind of dividend growth that has served shareholders so well in the past could be in question.

 

This is especially true given that the declining size of its cash flows have raised Coke’s FCF payout ratio to nearly 70% through the first nine months of 2017. Meanwhile buybacks have consumed another 64% of FCF during this period.

 

As a result, Coke is planning on less aggressive buybacks in the future, earmarking that cash for bolt-on acquisitions. This basically means that Coke needs its long-term growth plans to work in order to continue growing its payout like shareholders have come to expect over the years.

 

However, while the company’s larger focus on non-sparkling beverages is a good potential growth driver (one of many), the fact remains that soda margins are very high for the company and more lucrative than growing product lines such as Simply Juices.

 

The issue for Coke is that soda sales in developed nations have been in a steady decline for years, a trend that isn’t expected to reverse anytime soon (if ever). That’s partially due to shifting consumer trends towards healthier products, as well as governments starting to consider instituting soda taxes as means of raising revenue and fighting obesity rates.

 

 

Even more troubling for Coke? The secular decline in soda has also started to spread to developing markets, which have seen falling volumes as well.

 

 

In fact, global soda volumes decreased in 2016 and only emerging markets posted positive volume growth. Only strong price increases and improved product mix allowed the industry to grow its revenues. If current trends hold, the risk is that as fast-growing emerging markets become wealthier, their overall consumption of soda could follow the global trend and reverse.

 

That would likely create a large headwind that could counteract Coke’s efforts to grow into healthier, non-soda beverages. And speaking of product diversification, Coke’s plans to potentially enter the craft beer industry are not necessarily a good thing.

 

This is because the alcohol industry in general, and craft brewers in particular, have seen their prices appreciate at impressive rates in the past few years due to massive industry consolidation and M&A activity. In other words, Coca-Cola is potentially looking to enter an entirely new industry in which it has no experience at a potential market top (and overpay).

 

While Coke’s track record of buying up-and-coming non soda brands, plugging them into its marketing and distribution channels, and turning them into billion-dollar success stories is impressive, there is no guarantee that this could be repeated in alcohol. That’s due to the very different and largely artisanal nature of craft beers, which generally sell in low volumes and are unlikely to become a large growth catalyst for a company of Coke’s size.

 

Coca-Cola has been an amazing dividend growth success in the past, but it’s future looks far less rosy. Yes, management is making smart strategic moves to adapt to long-term global consumer trends. And the current strategy of shifting from a highly capital intensive manufacturer of drinks to mostly a brand manager is likely to generate far higher margins, returns on capital, and free cash flow in the future.

 

However, investors need to be aware that even if the turnaround proves successful, the company’s days of impressive sales, earnings, and dividend growth are almost certainly behind it. In other words, while Coke is likely to remain a decent low-risk dividend growth story, it holds much less appeal compared to many other proven dividend growers.

 

Coca Cola’s Dividend Safety

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 real-time track record has been, and how to use them for your portfolio here.

 

Coca-Cola has a Dividend Safety Score of 88, indicating a very safe and dependable dividend compared to most other companies in the market. That’s not surprising given Coke’s impressive status as a dividend king, with 55 straight years of payout increases.

 

 

Coke’s high safety and consistent dividend growth have historically been driven by several factors. One of these was its modest payout ratios, which remained near 50% throughout most of the past decade to provide strong safety buffers for the payout, even in times when its earnings and cash flow declined.

 

Of course, Coke’s payout ratio has substantially risen in recent years owing to the refranchising of its bottling operations, which resulted in substantial declines in overall earnings and free cash flows.

 

Fortunately, recently passed tax reform will lower Coke’s corporate tax rate from 26% to 21% and result in a double-digit boost to its bottom line. This should help stabilize the company’s payout ratio and ensure the safety of its payout until Coke completes its restructuring and hopefully returns to stronger earnings and free cash flow growth.

 

 

Another important safety factor is the company’s strong balance sheet because company’s will always meet their debt obligations before paying dividends.

 

 

While Coke has a large absolute amount of debt on its balance sheet, it’s important to keep in mind that until recently it was a highly capital intensive business. In fact, when we compare its debt levels to those of its peers, we see that Coke’s financial position is very strong, thanks to its large cash position, strong free cash flow generation, and high current ratio (short-term assets/short-term liabilities).

 

 

As a result, Coke has very little trouble servicing its debts and other liabilities. This is why the company has such a strong investment grade credit rating and is able to borrow at an incredibly low average interest rate of just 2.5%.

 

Even better, now that Coke is selling off its less profitable and more capital intensive bottling operations, the company should be able to deleverage over time while still investing in growth and maintaining its secure dividend.

 

However, the downside is that, due to the timing of the restructuring, and the large short-term declines in sales, and earnings, Coke’s dividend growth rate is likely to be rather lackluster.

 

Coca-Cola’s Dividend Growth

Due to its struggles with top and bottom line growth in recent years, Coke’s dividend growth rate has slowed substantially. While management seems to have the company on a better track now, Coke’s elevated payout ratio means that investors need to expect the company’s dividend growth to be even slower in the coming years.

 

 

A slower rate of payout growth is to be expected because even if management achieves strong EPS and FCF per share growth of 6% to 8% a year (analysts expect only 5% to 6%), the company’s dividend will need to grow slower than the bottom line for at least several years in order to let the payout ratios return to safer, historical norms.

 

As a result, Coke’s dividend will probably only grow between 3% to 5% a year, which is about three times slower than its 14.5% average annual growth since 1962. While this isn’t necessarily a terrible figure, it does mean that investors interested in Coke need to make sure to buy the stock when shares are especially attractively priced. Unfortunately, that doesn’t appear to be the case today.

 

Valuation

Over the past year, Coke has underperformed the S&P 500 by close to 10%. However, that doesn’t necessarily mean its shares are a bargain.

 

For example, KO’s forward P/E ratio is 22.8, much higher than the S&P 500’s already frothy 18.5 and slightly above the stock’s historical 21.2. However, keep in mind that Coke’s slower growth rate than in the past means that it probably should be trading at a discount, not a premium, to its historical P/E.

 

It is true that Coca-Cola’s dividend yield of 3.2% is higher than the S&P 500’s 1.8% and the stock’s historical norm of 2.9%. In fact, over the past 22 years the yield has only been higher around 10% of the time. This might make it seem like now is a perfect time to consider buying this notable dividend growth stock.

 

But again, it’s worth repeating that Coke’s growth rate is now much slower than it was in the past. This means we might be better off comparing its current yield to a period of slower growth, which is likely to better represent the future, such as the last five years.

 

As seen below, Coke’s current dividend yield is not that much higher than its five-year average yield of 3.1%, indicating that the stock is unlikely to be more than fairly valued at best for income-focused investors.

 

 

Going forward, the stock has potential to generate about 7.2% to 9.2% total returns going forward (3.2% yield + 4% to 6% annual earnings growth). That’s not necessarily a bad return for a low risk, wide moat dividend king. However, it’s less than some other blue chip dividend growth stocks are offering today, thanks to their faster long-term growth prospects and better valuations in some cases.

 

Conclusion

Coca-Cola remains the world’s largest and most dominant beverage company. Coke’s wide moat, courtesy of its global supply chain, huge economies of scale, and substantial marketing spending, means that it is likely to remain a reliable income growth stock for the foreseeable future.

 

Even despite the company’s declining earnings and free cash flow in recent years, Coca-Cola’s dividend health looks solid. The company has plans in place to boost cash flow over the next few years (cost cutting and refranchising to earn much higher margins), its balance sheet is pristine, and continued bolt-on acquisitions should further diversify and strengthen Coke’s long-term profits.

 

That being said, Coke faces numerous short and medium-term headwinds in its turnaround plan and long-term growth strategy. The company’s relatively high payout ratios and need for increased investment in new beverage brands seem likely to force management to grow the payout at a much slower pace, making Coca-Cola look less attractive compared to many of the best high dividend stocks here.