KO’s Clock is Ticking

KO’s dividend is very safe (94 Safety Score), and it has slightly below average growth potential (47 Growth Score). The stock’s dividend yield is 3.2%, placing it in the 63^rd percentile of all current yields (i.e. KO’s yield is higher than 63% of other dividend-paying stocks). For investors seeking moderate but safe income with less concern about long-term growth potential, KO could be attractive. To see the 25+ years of dividend data and 10+ years of fundamental data that we use to evaluate KO and its dividend, click here.

 

With that out of the way, let’s look at some of the differences between KO and PEP and better understand the strategic shifts KO is making to stay relevant in the face of falling demand for soda in developed markets.

 

Business Overview

KO is the world’s largest beverage company with $46 billion in sales, accounting for a 5.4% of all drinks consumed by households globally every day. KO has 20 brands with over $1 billion in sales (up from 10 in 2007) compared to PEP’s 22 billion-dollar plus brands. While PEP’s business is balanced between snacks and beverages, KO only sells beverages, with sparkling beverages accounting for 73% of global case volume last year (soda is < 30% of PEP’s business); Coca-Cola beverages were 46% of global case volume. Some of KO’s key brands include diet and regular Coca-Cola, Fanta, Sprite, Minute Maid, Powerade, Dasani, and Schweppes.

 

Stock Performance

KO’s total annualized return from 2012-14 was 9.5%, significantly trailing the market (+20.1%) and PEP (+15.9%). Over the last year, KO has returned about 6%, about in line with other large caps. KO’s outsized exposure to carbonated soft drinks and international markets caused it to experience a greater slowdown in growth in recent years (organic sales growth slowed to 3%, and reported sales growth dipped into negative territory for the first time since the financial crisis).

 

 

 

 

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. KO’s long-term dividend and fundamental data charts can all be seen here.

 

Dividend Safety Score

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.

 

KO scored a very high Safety Score of 94, meaning its dividend is safer than 94% of all other dividend stocks. PEP scored a 94 Safety Score as well – you won’t lose sleep owning either of these stocks for their dividends.

 

As seen below, KO has generally maintained EPS and free cash flow payout ratios between 40-60% over the past decade, suggesting there is reasonable cushion to continue paying and growing the dividend, even in the event of an unexpected decline in the business. While the EPS payout ratio spiked in FY14, KO’s free cash flow payout ratio remained steady in the low 60% range.

 

 

 

Unlike cyclical companies, it’s always nice to see such stability in the payout ratios, even during the financial crisis. In FY09, KO’s sales fell just 3%, and operating margins actually improved by 20 basis points:

 

 

KO is a cash machine in almost every environment and has generated a whopping $29 million per day in operating cash flow over the past three years! The company consistently throws off loads of free cash flow (licensing intellectual property – brand formulas – to bottlers and restaurants doesn’t require much capital):

 

 

Like PEP many other consumer staples businesses, most of KO’s products are in slow-moving industries and benefit from recurring consumer demand. These are some of the most durable businesses a dividend investor will find.

 

While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.

 

KO’s debt to capital ratio has increased over the last decade from under 10% to nearly 50% as of Q2. However, as seen below, KO has a very modest net debt load of about $7.1 billion, less than the free cash flow it generated in FY14. The balance sheet provides a solid foundation to continue paying and growing the dividend.

 

 

Dividend Growth Score

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.

 

KO’s Growth Score is 47, meaning its dividend’s growth potential ranks a little below the average dividend stock’s growth potential (a score of 50 is “average”). PEP’s Growth Score was higher, and the company seems to have better (and clearer) long-term growth potential with its snacks and beverages (soda is < 30% of PEP’s sales).

 

KO’s Growth Score ranked slightly below average primarily because of its slowing sales growth, slightly above-average payout ratios, and large size.

 

As seen below, KO has grown its dividend at a 9% annual clip over the past decade and increased its dividend by 8% most recently, marking its 53^rd consecutive increase and keeping it in the Dividend Aristocrats Index.

 

 

Yield Score

Our Yield Score simply ranks a stock’s current dividend yield against all of the other dividend yields in the market. A score of 50 means the stock’s yield is right in the middle of the pack. A score of 100 means it has the highest yield. The Yield Score helps assess a dividend stock’s relative value.

 

KO’s Yield Score is currently 63 (PEP’s Yield Score is 56), placing it approximately in line with the market’s average dividend yield. Given the similar levels of dividend safety but PEP’s higher Growth Score, PEP seems like the better bet at today’s yields.

 

Competitive Strengths

To state the obvious, KO has some of the post powerful brands in the world. KO’s portfolio holds leadership positions across its major categories: #1 in sparkling, #1 in juice, #1 in ready-to-drink coffee, #2 in energy (Monster partnership), #2 in sports, #2 in water, and #3 in ready-to-drink tea. Overall, KO is #1 in value share in 25 of the top 32 global markets.

 

Brand strength is reinforced by KO’s advertising spending ($3.5 billion in FY14 and up 22% YTD) and global distribution reach, especially in emerging markets (81% of KO’s volume is outside of the US – Mexico, China, Brazil, and Japan are next four largest markets) that will becoming increasingly important growth drivers going forward.

 

One of the quickest 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, KO has generally maintained a return on invested capital in the teens or higher for the past decade, a durable and consistent business with low capital intensity (licensing brand formulas to restaurants and bottlers). The drop in FY11 was driven by KO’s acquisition of some of its bottlers, which have lower margins and greater capital intensity. Prior to acquiring bottling operations, KO generated very high and stable returns in the 20% range.

 

 

From a growth perspective, KO’s organic sales have decelerated from a 5% growth rate in FY12 to 3% in FY13 and FY14. Growth potential remains the biggest uncertainty surrounding KO’s long-term investment case.

 

 

With declining demand trends for soda in developed markets, KO has taken action to diversify more of its business while capitalizing on core strengths (branding, global distribution; more in “Key Risks” section below). KO has purchased and developed brands in the past (e.g. bought Fuze in 2007 and grew it into a billion-dollar plus brand) but recently took an alternative path, taking stakes in Monster (MNST) and Keurig (GMCR).

 

Many investors seem to be griping about these deals, especially with the walloping GMCR’s stock has taken over the past year (down over 55%). These unrealized losses are awful and demonstrate management’s incompetence, right!?

 

Maybe, but not so fast. By taking stakes in these two businesses, KO gained meaningful exposure to two major growth categories overnight (single-serve, at home and energy drinks). However, KO did not bet the farm, nor did it take on undue operational risk – GMCR and MNST can maintain their independence as they continue with their growth strategies.

 

The MNST deal is appealing because KO is set to generate huge distribution profits by carrying energy drinks on its trucks around the world (MNST was largely US-based prior to the deal). By distributing the energy drinks rather than producing them itself, KO is protected from any negative press that otherwise might have surfaced. More cash, less thrash.

 

Can anyone predict how we will acquire and consume beverages at home in 10 years? Maybe we will continue going to the grocery store for most of our drinks. Maybe we will continue getting drinks at shops and restaurants. What if a meaningful portion of beverage consumption involves final preparation at home? What if Keurig Kold’s selling price comes down meaningfully to drive adoption?

 

No one knows, but for a $2+ billion investment in GMCR, KO is primed to take advantage a new channel to distribute its products with the Keurig brand. Today, approximately 13% of households use Keurig with its ready-to-drink single-serve coffee. It’s hard to know how much, if at all, Keurig Kold will improve that percentage, but it could be meaningful and serve as an unexpected catalyst (based on current negative sentiment surrounding GMCR). Additionally, KO’s global distribution could bring Keurig around the world. Time will tell, but it seems unfair to measure such a long-term initiative over the course of a few quarters. If nothing else, these “insurance” bets have high upside but come with high uncertainty.

 

Key Risks

Warren Buffett claims to drink five Coke’s a day (3 during the day, 2 at night). While I can only hope to have his longevity, I am not sure that I would keep up with him at that pace!

 

Unlike Buffett, the overall US population consumed fewer carbonated soft drinks each year over the past decade, and this shift is only expected to increase going forward. We now have generations of kids that did not grow up with soda being the memorable taste of their childhood like Buffett enjoyed. Coke’s overall brand strength seems likely to gradually decrease as old generations fade and new generations account for a larger share of household spending.

 

As the health-consciousness of developed countries improves, Coke the beverage likely moves from a daily fixture to more of a specialty purchase. In other words, demand fade will probably be very gradual, but KO ultimately needs to reinvent itself to drive longer-term growth.

 

Fortunately, Coke is not down to its last bullet. Far from it, actually. Let’s look at what the company is doing to combat unfavorable healthy drinking trends so it can buy more time to reinvent itself.

 

First, as expected, KO is exercising its pricing power to prop up soda revenues despite sluggish volume trends. While KO is raising prices on its traditional offerings, the company is also doing this in sneakier ways than you might suspect – last quarter, soda price/mix was up 4%. KO is seeing success in selling its soda in smaller packages like mini-cans, which reported double-digit volume growth in Q1 and Q2. Smaller packages are more profitable for KO to sell and might also be reinforcing the earlier point of Coke transitioning from a daily beverage choice to more of a specialty purchase:

 

 

Another factor possibly helping KO realize its price increases is increased advertising spending. Through the first six months of 2015, KO has increased its advertising expenditures by 23% compared to 2014!

 

While they are serving to stabilize the US soda business today, price increases, more advertising, and “smarter” packaging are unlikely increase long-term demand for soda. They are simply buying KO more time for reinvention.

 

What else is KO doing to extend its fade? Productivity measures.

 

Investors who have been following KO for a long time will remember its acquisition of some North American bottling operations in 2010 for $12 billion. PEP did the same thing around that time, with both companies hoping to cut supply chain costs.

 

The bottling business is more capital-intensive and earns lower margins than selling syrups and concentrates, so the deal predictably lowered KO’s return on invested capital in FY11 (operating margins also fell by 2-3%):

 

 

In mid-2013, KO announced plans to begin refranchising the distribution capabilities of its bottling operations, essentially reversing a key part of its 2010 acquisition. This move will drive improved profitability and cash flow, adding to KO’s financial cushion. As of Q2 2015, KO had transitioned over 5% of US bottle volume and had signed letters of intent for close to another 10% of volume. The refranchising effort is expected to be complete by 2020.

 

Importantly, KO’s business is still better off from the 2010 deal. The company is retaining its bottling production activities and only refranchising distribution back to the bottlers. With advances in production technology, such as in-line blowing and warehouse automation, KO now generates more cash flow from producing the beverage packages rather than just selling syrup and concentrate to the bottlers. These savings all feed into KO’s plan to generate $3 billion in annualized savings by 2019 ($1.4 billion from COGS, $1 billion from operating expenses, $600 million from marketing). If successful, margins should improve ($3 billion in savings out of KO’s $46 billion in FY14 sales represents 600 basis points of margin improvement potential) even in a stagnant sales environment – plenty to support continued dividend growth for the time being.

 

Once again, however, greater efficiency and profitability doesn’t solve the problem of shrinking soda demand in developed markets.

 

What can KO do to reinvent itself, and how risky might these efforts be to long-term shareholders and dividend investors?

 

Given KO’s heavy mix of carbonated soft drinks (73% of its global case volume), the company could become increasingly desperate to accelerate its mix shift into healthier, non-carbonated drinks. One way to do that is acquisitive growth. For a company of KO’s size, larger deals would move the needle faster but also pose the most risk. The market may not respond favorably to this strategy, depending on the premiums paid and the strategic implications. We saw an example of this recently with rumors that KO would acquire a stake Suja Life (competes with Naked Juice) earlier this month at a valuation of $300 million; KO fell slightly on the news. Here is that article.

 

KO is clearly making progress with mix diversification into still beverages – in 2007, the company had 10 billion-dollar plus brands. Only five of these were still beverages. Last year, KO had 20 billion-dollar brands, with 14 of the 20 playing in the still beverages category. However, the sheer size of Coca-Cola, Diet Coke, and Coke Zero suggest the company has a long ways to go down this path, so acquisitions are likely to be appealing.

 

Beyond acquisitions, KO entered into strategic alliances with MNST and GMCR over the past 18 months. As was previously discussed in the “Competitive Strengths” section, these deals are a prudent way for KO to gain exposure to a potentially lucrative and viable long-term distribution system (GMCR’s new Keurig Kold machines) and a growing energy drink market (but without the negative press that could come with owning the actual brands).

 

Altogether, the biggest risk to KO’s (very) long-term future is that it invests billions but fails to find enough powerhouse brands, beverage categories, and distribution paths to eventually overtake its iconic Coca-Cola beverages in developed markets, which see an increased rate of decline in soda demand. For the next 5-10 years, KO will remain a powerhouse and should continue looking for ways to remain relevant in an increasingly healthy world. With soft drinks making up about half of non-alcoholic beverages sold in the US and growing demand in developing countries, fade seems likely to remain moderate. The global non-alcoholic beverage industry is also expected to grow at a 5% annual rate to reach $300 billion in value by 2020, providing room for KO to try and find its next big hit.

 

Conclusion

While KO and PEP have many similarities, their futures could ultimately be fairly different from each other. Both company pay safe dividends, but KO’s greater concentration in soda (>70% of volume) creates a greater need for it to reinvent itself. KO is pulling numerous levers to diversify its mix, stabilize near-term business trends, and improve its long-term cash flow generation. Together, these actions seem likely to support the stock for at least several years. However, the company cannot magically restore long-term demand growth for soda (at least in developed markets) and will ultimately need to figure out what it will look like from 2020 and beyond, especially as the iconic Coca-Cola brand moves more from “daily staple” to “occasional specialty treat” (i.e. less consumption). For now, PEP seems like the more likely long-term winner until KO’s evolution becomes clearer.