Coca-Cola: The Decline Of A Dividend King
How much is The Coca-Cola Company (NYSE:KO) worth? Full Discounted Cash Flow valuation
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DISCLAIMER: The publication expresses my own opinions. Information presented is for educational purposes ONLY and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.
Company Overview
The Coca-Cola Company (NYSE:KO) markets, manufactures and sells beverage concentrates, syrups and finished sparkling soft drinks and other nonalcoholic beverages. This includes the world's top five nonalcoholic drink brands, such as Coca-Cola, Diet Coke, Fanta and Sprite.
Coca-Cola was founded in 1886 and, for over 135 years, the company has delivered supreme excess returns to its investors.
Without any doubt, the competitive advantage behind Coca-Cola’s success is the strong brand awareness generated by heavily investing in powerful marketing campaigns all over the globe. As a result, Coca-Cola is now the 6th most valuable brand in the world, according to Statista.
Macro Themes and Key Drivers
Thanks to its strong brand positioning, Coca-Cola has been able to ride two big macro trends: the expansion of the commercial beverages sector and the increased globalisation, which allowed them to expand worldwide.
However, after over a century of positive tailwind, I believe that the key drivers that helped Coca-Cola’s success are rapidly starting to fade.
The new generations, Millenials and Gen-Z, are more and more concerned about health, wellness and nutrition, and Coca-Cola is not really a representative of these values. Its portfolio of brands is mainly made up of carbonated ultra-sweetened drinks.
One clear example of this macro shift has been seen during the latest press conference of Cristiano Ronaldo. The football player removed two Coca-Cola bottles and said, “Water!”. The snub made the company’s share price drop by over 2%.
In addition, the increasing public concern about obesity and other health-related public concerns surrounding the consumption of sugar-sweetened beverages could lead the governments to increase taxes or introduce new regulations on the advertising, packaging and sales of its beverages.
Without its powerful marketing machine, Coca-Cola would quickly lose its competitive advantage and become a normal company earning its normal Return on Invested Capital (ROIC).
On the other side, if Coca-Cola succeeds in improving its brand perception and expanding its products portfolio with healthier beverages, the expansion potential could be significant. In the developing and emerging markets, representing 80% of the world population, only 30% of beverage consumption is commercialized, and Coca-Cola’s share is only 5%.
I believe the company will find it harder than expected to develop and market new healthy products, especially after spending 100 years building its brand awareness around the Coca-Cola name. In addition, when a company is this big, it tends to grow by acquiring smaller business in the market segment they want to penetrate and, as explained by prof. Aswath Damodaran, this is the worst way to increase shareholder’s value.
Coca-Cola Co. Financial Analysis
After 135 years in the business and total revenues declining since 2012, we can clearly state that the company is in its mature stage. Net incomes didn’t fall as much as the total sales, but they will follow as soon as the company moves into the decline stage.
In addition to the revenues, many other financial metrics have been falling since early 2000. The Sales to Invested Capital ratio, which measures how efficiently the company is run, decreased from 1.2 in 2002 to 0.5 in 2020. The Return on Invested Capital also fell from over 30% to just above 15% in the latest 10-k, indicating that it is slowly losing its competitive advantage.
The only metric that didn’t fell and that actually improved is the Operating Margin. However, as shown from the efficiency metrics listed early, Coca-Cola needed to invest an increasing amount of capital to keep its margins this high.
How Much Is Coca-Cola Worth?
Since Coca-Cola is a mature business paying dividends for a long time, I could use the Dividend Discount Model to estimate the fair value. However, to include the expected decrease in operating margin highlighted in the “Macro Themes and Key Drivers” paragraph, I will use the usual Discounted Cash Flow valuation model.
I expect Coca-Cola to come back to the pre-pandemic level of revenues within a year time (11% growth) and, from that moment, to start growing at a perpetual growth rate of 2%. The Operating Margin will linearly decrease from 30% to 20% in the terminal year. The worsening reflects higher regulations on sugar products and changing customers behaviour. Finally, I expect the Sales to Invested Capital ratio to stay stable at 0.55, implying a Reinvestment Rate of 15%.
The cost of capital will increase from 5.38% to 5.81% to reflect a rise in the risk-free rate.
The resulting Free Cash Flow to Firm and Return on Invested Capital for the next 10 years is shown in the next chart.
Summing up the present value of all the future cash flows, taking out debt, minority interest, and adding cash, we get a fair value for the Coca-Cola shares of $ 23.51.
The estimated fair value is well below the current market price of $54. To understand the implicit market expectations that justify this high price, I run a scenario analysis using as variables the growth rate in the next five years and the operating margin in the terminal year.
The market is clearly expecting Coca-Cola to come back to grow while increasing its Operating Margin. I obviously can't entirely agree with the marginal investors,
If you disagree with the markets and with my inputs, you can refer to the table above and get the corresponding fair value.
What could make the price reverting to its fair value?
To close the gap between the fair value and the price, the stock needs a catalyst that forces the investors to reassess their expectations.
For Coca-Cola, I believe the biggest risk ahead is the implementation of new regulations in markets where the company has a big exposure as the US. For example, a sugar tax on soft drinks manufacturers containing more than 5g of sugar per 100ml is already a law in the UK, and it could soon expand to other developed countries.
When the governments start to increase taxes on ultra-sweetened drinks, and Coca-Cola didn’t succeed to expand in any new healthier segment, the price will soon move back to its fair value.
Conclusion
Coca-Cola has been an excellent company and an excellent investment for almost a century. However, I believe that the new ESG and Health macro themes will make the company smaller and smaller.
The tailwind that made Coca-Cola one of the best company in the world has changed, and it’s now blowing straight it.