Coca-Cola (NYSE:KO) recently launched Orange Vanilla Coke, an offshoot of the hugely successful Cherry Coke and Vanilla Coke products. It is the first new variant of Coca-Cola in more than 10 years. However, before you go out and buy Coca-Cola stock, you might want to consider both sides of the argument.
While there’s no question that Coke is an iconic brand worldwide, it’s hard to get behind a stock that’s generated an annualized total return of 8.4% over the past three years, 7.9% over the last five years, and 11.5% over the past 10 years.
By comparison, the S&P 500 has managed annualized total returns of 16.3%, 10.5%, and 14.9% over the past three, five and 10 years respectively. That’s an average beat by the index of 463 basis points. It hasn’t even been close.
To some, the launch of a third variety is a sign the company has run out of ideas. To others, it’s an indication the Atlanta-based beverage maker is prepared to innovate its way to growth.
For me, I’ve never been a big fan of Coca-Cola stock. However, I can quickly come up with seven reasons to own KO. Here they are in no particular order of importance.
Warren Buffett Owns Coca-Cola Stock
Once upon a time, Coca-Cola would have been the Oracle of Omaha’s largest equity holding. That distinction falls to Tim Cook and Apple (NASDAQ:AAPL) these days. According to the Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) Portfolio Tracker, Apple stock is number one at $43 billion, $23 billion higher than Coca-Cola, which is the fourth-largest.
Last May, Buffett did admit that Coca-Cola’s not looking as attractive as it did a decade ago due to changing diets and less royalty from consumers. Despite that admission, Berkshire Hathaway remains the company’s largest stockholder holding 9.4% of its outstanding shares.
As long as Warren Buffett is the largest shareholder of Coke, I think it’s safe to say your investment’s in good hands.
KO Stock Has a Good Dividend
KO stock currently pays a quarterly dividend of 39 cents, which works out to $1.56 on an annual basis, and yields 3.1%. In Coke’s third quarter, it earned 58 cents a share on a non-GAAP basis, making its payout ratio a reasonable 67% of net income, leaving plenty to reinvest in its business.
Through the first nine months of fiscal 2018, Coca-Cola paid out $3.3 billion in dividends, $156 million more than in the same period a year ago. By comparison, it repurchased $1.6 billion in the first nine months, almost half what it did ($3.1 billion) a year earlier.
Oh, and if you’re concerned about it raising its dividend in 2019 and beyond, don’t be because Coca-Cola has increased the dividend for 56 consecutive years. There are Dividend Aristocrats. And there’s Coke.
It’s not glamorous, but it gets the job done.
It’s a Contrarian Play
If there’s one thing I know about Coca-Cola stock, it’s this: It’s not unanimously loved by analysts. According to the Wall Street Journal, of the 25 analysts covering its stock, 12 consider it a buy, two have it overweight and the 11 remaining analysts give it a hold rating. The good news is that no analysts rate it underweight or sell.
The overall consensus of the 25 analysts is overweight KO stock. However, the average 12-month target price is $52.13, an upside of just under 5%.
In 2018, while most stocks were falling, Coca-Cola managed to eke out a small gain of 2.9% while PepsiCo (NASDAQ:PEP) lost 8%. Investors were looking for yield and safety, and Coke provided both. Already a month-and-a-half into 2019, the reality is that many investors don’t view Coca-Cola stock as nearly the safe bet it once was — thanks to the changing food habits noted by Buffett and many others — and are moving on.
As a result, I consider Coca-Cola stock the ideal contrarian play.
2018 Was Good to Coca-Cola Stock
As I mentioned in the previous slide, investors’ flight to safety in 2018, helped KO stock stay out of the way of a falling stock market. However, if you look at the company’s financials, I think it’s fair to say that it didn’t do too badly on the only scorecard that counts: the income statement.
On the top line, the company’s revenues through the first nine months of fiscal 2019, fell 11% to $24.8 billion. However, Coca-Cola is in the process of going asset-light, selling its bottling operations to new franchisees like Toronto Maple Leafs part-owner Larry Tanenbaum, who acquired the Canadian bottling operations in 2018 with partner Junior Bridgeman, for approximately $800 million.
While this process takes money from the top line, it solidifies the balance sheet and cash flow, allowing KO to ratchet up growth without a massive capital infusion. Organically, however, it has been a different story so far in 2018, with revenues growing 6% year over year in Q3 2018 and 5% through the first nine months of the year.
On the bottom line, on an adjusted basis, Coke increased its operating income by 20% in the third quarter and 12% through the first nine months of the fiscal year. Add in lower income taxes and Coca-Cola’s net income increased by 48% in the first nine months of the year.
Less revenue. More profits. Not a bad tradeoff.
The Coffee Business
On Jan. 3, 2019, Coca-Cola completed its $4.9 billion acquisition of Costa Coffee, a deal it first announced at the end of August. The coffee segment of the beverage industry is growing at 6% annually on a global basis. By acquiring the UK coffee business, Coke can capture a big slice of a growing industry, at 16 times Costa’s latest 12-month EBITDA.
In the short term, investors might view this as expensive. However, long term, I believe Warren Buffett could look back at 2019 as the year Coca-Cola turned the tide and started growing again.
If KO was to become a truly a hot and cold beverages company, the acquisition of Costa was a no-brainer for CEO James Quincey — and Coca-Cola shareholders.
KO’s Free Cash Flow
In the first nine months of 2018, Coca-Cola’s free cash flow decreased by 2% to $4.6 billion. Over the trailing 12 months through September, the company’s free cash flow was $5.5 billion, close to the lowest level it’s seen in over a decade.
However, as it moves to an asset-light business model, I could see Coke generating $6 billion-$7 billion in free cash flow, the amount it has historically thrown off on an annual basis, within the next 2-3 years. And as you may or may not know, dividends tend to get paid out of free cash flow along with all the other things a company can allocate capital to after it’s covered what needs to be paid to keep the business running.
Without free cash flow, it’s challenging for a business to grow. Coca-Cola is no exception.
Potentially Game-Changing Acquisitions
There aren’t too many acquisitions that are game-changers. Costa Coffee could be the one for Coca-Cola. However, it’s just as likely that a lot of gains in the future come from smaller tuck-in acquisitions that nobody pays attention to that strengthen the company’s business.
Consider its partnership with Monster Beverage (NASDAQ:MNST). Coke paid $2.15 billion in 2014 for a 16.7% stake in the energy drink leader. Coke got Monster’s non-energy drink business and became Monster’s most important distributor while Monster got Coke’s energy business.
Four years later, Coke owns 18.2% of Monster — it has an option to go as high as 25% — which is worth $6 billion. That’s a nice 180% return on its investment. Most people in 2014 thought the deal was a good one, including myself. However, I’m not sure I ever thought Coke would see such a significant return.
As companies grow, it takes bigger and bigger acquisitions to move the needle. Therefore, it’s safe to assume we won’t see another Costa-sized acquisition over the next 24-36 months. That said, I wouldn’t be surprised if it bought some smaller, up-and-coming brands.
Those are the ones whose value tend to sneak up on you.
As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.