Shares of global beverage giant Coca-Cola (NYSE:KO) have been on fire over the past year, rallying about 20%, while the S&P 500 index has netted less than a 10% gain over that same stretch. This red hot rally in KO stock, however, will be put to the test on Oct. 18, when Coca-Cola reports third quarter numbers.
Heading into the print, everyone is expecting big things. As they should. This company has been red-hot over the past several quarters, firing off multi-year best organic growth rates amid strength in the company’s sparkling drink, coffee, and energy drink segments. All signs point to the fact that Coca-Cola maintained healthy operational momentum this past quarter. As such, Q3 numbers should be pretty good.
But, there’s one catch — the valuation on KO stock. That is, Coca-Cola stock presently trades at just shy of 24-times forward earnings. That’s the stock’s biggest forward earnings multiple this decade.
In other words, KO stock is trading at a decade-high valuation heading into a Q3 earnings report which will be pretty good. That’s a tricky situation. Ultimately, either the numbers will be strong enough to support the stretched valuation and KO stock will rally, or they won’t be strong enough and the shares will drop.
I think the former will happen. The Coca-Cola growth narrative has a lot of positive momentum right now. All that positive momentum will show up in the Q3 print, and will ultimately provide support for KO stock’s presently extended valuation.
Coca-Cola Earnings Will Be Good
When Coca-Cola reports earnings on Friday morning, the numbers should be pretty good.
Here’s the reasoning. Coca-Cola has been on fire over the past several quarters, reporting steady 5-6% organic sales growth in every quarter since the start of 2018, versus an average ~4% organic sales growth rate from 2012 to 2017. This recent multi-year streak of organic sales growth bests can be attributed to Coca-Cola’s global beverage machine firing on all cylinders.
The sparkling drink category, hampered by anti-soda trends for a long time, is rebounding. Trademark Coca-Cola volumes were up 4% last quarter. The alternative sparkling drink category remains red-hot, with Coca-Cola Zero Sugar volumes continuing to power higher at a double-digit pace.
Meanwhile, the company has two sizable, multi-year growth drivers in the form of Costa RTD beverages (which gives Coca-Cola an opportunity to meaningfully expand share in the large retail coffee market) and Coca-Cola Energy drinks (which gives the beverage maker an opportunity to turn into a more dominant player in the rapidly expanding energy drink market).
Net net, the company is firing on all cylinders today and projects to sustain this strong momentum for the foreseeable future fueled by three drivers: A rebound in the core Coca-Cola brand; Expansion of the Costa business; and, Expansion of the Coca-Cola Energy business.
At the same time, the macro backdrop in the third quarter has been favorable. Yes, the economy is slowing, but, the U.S. consumer isn’t. Retail sales are up 3.8% year-over-year over the past three months, including a 4% gain in food and beverage stores, while big Coca-Cola sellers Walmart (NYSE:WMT), Target (NYSE:TGT), and Kroger (NYSE:KR) all reported strong top-line numbers over the past few months.
The implication? Coca-Cola’s third quarter numbers should be pretty good.
Strong Earnings Will Provide Support For Coca-Cola Stock
Importantly, Q3 numbers should be strong enough to support the stretched valuation on Coca-Cola stock.
The logic is pretty simple. This isn’t the 2015 Coca-Cola. It’s the 2019 version. By that, I mean that Coca-Cola today is a much improved business from what it was a few years back. Four years ago, the company was being hit hard by anti-soda trends, there weren’t many new growth drivers in the pipeline, and organic growth rates were running in the 3%-4% range. Today, with the company benefiting from anti-soda trends phasing out, there are new growth drivers in the pipeline with Costa and Coca-Cola Energy, and organic growth rates are running around 6%.
Basically, the Coca-Cola growth narrative today is as good as its been in the past decade. That’s why the valuation deserves to be as extended as it has been in the past decade, too.
The numbers aren’t too hard to digest. Thanks to Costa and Energy drink expansion plus core Coca-Cola business stabilization, this company projects as a mid-single-digit revenue grower over the next several years. Margins should trend higher with favorable pricing dynamics. Buybacks will factor in. Net net, this company should be able to grow EPS at a high-single-digit rate for the foreseeable future, pegging 2025 EPS around $3.50.
Based on a historically average 22-times forward earnings multiple and a 7% discount rate (3 points below 10% to account for the yield), that equates to a 2019 price target for KO stock of ~$55. Thus, today’s extended valuation is supported by long term growth fundamentals.
Bottom Line on KO Stock
Coca-Cola’s business has a lot of momentum today. This momentum will show up in the company’s third quarter earnings report. It will inspire confidence in the investor base, and ultimately support KO stock’s stretched valuation.
The implication? Stick with KO stock. This one is going higher.
As of this writing, Luke Lango was long KR.
