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Coca-Cola Company (KO)

Founded in 1886 in Atlanta, Georgia, Coca-Cola (KO) 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 more than 500 brands in over 200 countries.

In fact, Coca-Cola is so geographically diversified that the U.S. market accounts for just  20% of its overall sales volumes and 26% of operating income.
Source: Coca-Cola Investor Presentation
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.
Source: Coca-Cola Investor Presentation
Currently, just under 70% of Coca-Cola's sales are still from sodas, but the company has aggressively been diversifying into energy drinks, juices, water, and dairy (which accounted for 25% of volumes in 2010 and 10% in 2001).

With 56 consecutive years of dividend increase, Coca-Cola is a dividend aristocrat.

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. This is why in North America the firm's market share stands at about 30% for beverages and about 50% for sodas. 
Source: Coca-Cola Investor Presentation
Coke generally spends about 9% of its revenues on advertising around the world (nearly $4 billion per year), in order to make its products universally known and loved in almost every nation on earth. The company's strategy has been successful as Coca-Cola owns number one market share positions in sparkling beverages, still beverages, and ready-to-drink juices and coffees. 

However, the true power behind Coke’s global beverage empire is owning the largest distribution network in the world 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 more than 130 years and an absolute fortune to build the largest distribution and logistics chain in the industry. 

That industry (global beverages) is about $150 billion in size and growing 4% per year, according to analyst firm Euromonitor. This large market size, combined with the company's very strong brand equity, means that Coke has dominant shelf positions in over 24 million retail outlets around the world. Such a giant reach also allows the company to achieve impressive economies of scale, which results in above-average margins near 30% and impressive free cash flow.

Of course, longtime 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 low-margin 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.

Management expects that, starting in 2019 when the global bottling re-franchising plan will be complete and the firm will finish its $3.8 billion cost cutting initiative (from 2016 to 2019), Coca-Cola’s operating margin will rise from 23% in 2015 to 34% by the start of 2020. 

Free cash flow margin is also expected to rise to from 18% in 2015 to about 27% thanks to the company's business model becoming less capital intensive following its bottling refranchising.  

In 2015, the company spent about 6% of revenue on capex, but by 2020 that will fall to 4.5% to 5%, significantly boosting free cash flow. By the end of 2018 Coke's refranchising of its bottling operations was complete in North America, Europe, and China. Only Africa remains to be completed in 2019. 

In the short term, management's refranchising plan means lower revenues and cash flow. For example, in the first nine months of 2018 operating cash flow fell 7% due to the restructuring plan. However, free cash flow was down just 2% and margins expanded 600  basis points.

Of course, cost cutting and financial engineering may boost future 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 as 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 acquisitions of:

  • A 16.7% stake in Monster Beverage (MNST)
  • 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
  • Zico Coconut Water
  • Innocent fruit smoothies and juices
  • AdeS plant-based beverages
  • Topo-Chico (Mexican mineral and water brand)
  • De Valle (juices, now a $1+ billion mega brand)
  • Ciel (Latin American water brand)

De Valle is a great example of how Coke's bolt-on acquisition strategy operates. Coke bought the brand in 2007 when it sold only juices in a handful of Latin American countries. Over the past decade, Coke has extended the brand into new product lines (plant drinks, teas, dairy, additional juices), as well as made De Valle a dominant name across all of Central and South America. 

Coke's "start-up incubator" acquisition model has resulted in De Valle's EBITDA growing 17% annually over the past decade, thanks to significant margin expansion resulting from  Coca-Cola's more efficient economies of scale at work. Management now estimates that De Valle, should it be sold, would be worth five times what Coca-Cola paid for it in 2007. 

Similar success has been seen with Innocent juices, which Coke has diversified into smoothies while tripling the brand's revenue since 2009. In 2018 the company also purchased minority stakes in sports drink company BODYARMOR and Australian fruit juice and smoothie maker Made Group.

Continuing its beverage diversification efforts, in August 2018 Coca-Cola announced one of its biggest acquisitions ever, the $5.1 billion purchase of Costa Coffee. The acquisition is expected to close in the first half of 2019. 

This deal will give Coca-Cola a strong coffee platform across parts of Europe, Asia Pacific, the Middle East, and Africa, via over 4,000 retail outlets (with lots of room for expansion). Costa Coffee will allow Coke to break into the $485 billion global hot beverage market (growing 6% per year) and fits well with the company's global diversification. 

Over the past four years, Costa's revenues have grown at 12% annually, which Coca-Cola believes will continue to make this new business line one of the fastest-growing megabrands it owns. Costa is most dominant in the U.K. (that country's #1 coffee brand) but is also growing fast in emerging markets, especially China. Costa also has a large global network of vending machines, which Coke believes is a natural fit with its own beverage vending distribution business. 

Going forward, Coca-Cola says it plans to scale back its buybacks in order to focus more on these sorts of 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.

That ad spending is focused increasingly on promoting healthy brands, such as Smartwater, which are increasingly important for Coca-Cola's long-term growth.

In 2017, the company launched over 500 new product offerings (both existing and new brands) and plans to continue rolling out new offerings that are "on trend" with changing consumer tastes. Reducing overall sugar consumption is a particularly important initiative.

Coca-Cola has been reformulating its drinks to reduce sugar content, and in 2017 more than 40% of product launches were in low or no sugar product lines. In addition, the company is marketing new smaller package offerings which not only reduce sugar intake for consumers but represent higher margins for the firm.
Source: Coca-Cola Investor Presentation
The end goal of these various product and marketing initiatives, according to management, is to help Coke continue to use its financial strength, brand development expertise, and extensive distribution network to gain market share in the large and steadily growing global beverage market.
Source: Coca-Cola Investor Presentation
And with Coke commanding about 10% to 15% market share in beverage categories outside of soda, the company's marketing and distribution machine has plenty of growth potential it can pursue in those healthier product segments.

In fact, despite Coca-Cola's concentration in soda, management believes the company can achieve long-term organic revenue growth of 4% to 6% and earnings growth of 7% to 9%. To reach its goals, the firm will depend on 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.
Source: Coca-Cola Investor Presentation
Management's capital allocation plan calls for maintaining a long-term free cash flow payout ratio of 75%. Given the recession-resistant nature of this industry, that's a reasonable target to help ensure a safe dividend while still providing enough retained cash flow for Coca-Cola to continue developing and acquiring more "on trend" beverage brands. 

However, while Coke is indeed making many strategic moves in an effort 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 in the short term. For example, in 2018 the strong U.S. dollar is likely to take about 300 basis points off of the the firm's reported sales and earnings growth rates.

That in turn means that Coke’s targeted sales and profit growth rates of about 5% and 8%, respectively, might not be so easily achievable. Since management's restructuring plan (refranchising its bottling operations) means that Coca-Cola will be a much more profitable but smaller business going forward, the pace of dividend growth could decelerate if currency fluctuations remain unfavorable. 

While Coke's dividend is sustainable (when backing out restructuring costs the firm's free cash flow payout ratio is near 80% for 2018), the fact is that the company will likely have to grow the dividend slower for the next few years in order to hit its 75% long-term payout ratio target. 

Coca-Cola's free cash flow has declined in recent years as the firm refranchised its bottling operations, so management is planning on less buybacks to help earmark more cash for bolt-on acquisitions. Essentially, Coke needs its long-term investments and growth plans to work in order to continue growing its dividend like shareholders have come to expect over the years. 
Source: Simply Safe Dividends
However, while the company’s larger focus on non-sparkling beverages is a logical move to improve its long-term growth potential, 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 a means of raising revenue and fighting obesity rates.
While the company has seen some recent volume growth in sodas (especially in Diet Coke thanks to new flavor launches), the long-term trend in its dominant product line remains the biggest growth detriment Coke faces. 

Management faces some pressure to shift Coca-Cola's product portfolio into  healthier beverages before trends in the soda market potentially worse. As a result of this increasing level of urgency to adapt, some of the firm's moves to potentially enter new markets may not necessarily be wise decisions.

For example, in recent years Coca-Cola was looking at expanding its presence into craft beers. However, the alcohol industry in general, and craft brewers in particular, have seen their valuations 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 bet big on a relatively new industry in which it has minimal experience (not to mention the potential for overpaying at what could be a market top). Similarly, only time will tell if Coke's big purchase of Costa works out. The size of that deal makes it a definite outlier for the company, which normally pursues far smaller bolt-on acquisitions in areas that it already has expertise. 

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 or coffee. 

Furthermore, should Coke struggle to achieve its 4% to 6% long-term organic revenue growth target, management may come under greater pressure to break into new markets with large and expensive acquisitions. 

For example, Coke has been indicating interest in cannabis-infused beverages and might follow Altria's (MO) lead by paying a steep price for an equity stake in a cannabis company. 

In September 2018, a company spokesman told Bloomberg that: 

"Along with many others in the beverage industry, we are closely watching the growth of non-psychoactive CBD as an ingredient in functional wellness beverages around the world...The space is evolving quickly. No decisions have been made at this time." - Kent Landers, Coca-Cola Spokesman 

Such a deal, depending on its size, could substantially increase the company's debt ratio (currently very strong and at management's long-term target leverage). And while cannabis is indeed a fast-growing new market, it's also impossible to determine whether any of the current major players will manage to achieve dominant market share in what might ultimately prove to be a highly commoditized business. 

How big of an investment might Coke potentially make in a cannabis company? 

In August 2018, Constellation Brands (STZ) invested an additional $4 billion into Canopy Growth (CGC) to increase its stake from 10% to 38%, valuing the firm at nearly $15 billion. Altria's investment in Cronos values that business at $4 billion, a seemingly rich price for an unprofitable company with about $10 million in trailing 12-month revenue.  

The point is that right now many consumer staples and beverage companies are itching to make big investments in cannabis, but the valuations they are paying makes such deals very risky. That's especially true if Coke and Pepsi end up in a bidding war for some overpriced cannabis company. 

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

If management can deliver on its 8% long-term EPS growth plans, then the company should be capable of ultimately continuing its historical mid-single-digit dividend growth rate. If not, then Coke will likely become a slower growing dividend king that, while serving as a decent defensive income stock, might disappoint investor expectations. 

Closing Thoughts on Coca-Cola
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 rising payout ratio 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 bottlers to earn much higher margins), its balance sheet remains 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, at least for the next few years. 

Similarly, the large Costa acquisition represents a nice potential growth opportunity for Coke in hot beverages, but it also comes with increased risks in a brand new product category. While Coca-Cola remains a safe, defensive dividend stock, investors need to have realistic expectations about its future growth rates. 

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