Can you beat Coca-Cola?

There are good reasons for investors to like consumer staples companies. They sell the type of things that people buy regularly regardless of how the economy is doing. Big global consumer brands are highly profitable and come with the kind of predictable cash flows that many associate with bonds. 

With the combination of higher income than bonds and an ability for that income to grow in a stable and predictable way, investors have made and can make very good returns from the right consumer staple shares without taking on large amounts of business risk.

Not all consumer staples shares have the same attractions. Some are struggling to grow as they face increased competition and fail to bring new and innovative products to consumers. While they can remain highly profitable, without growth they are unlikely to help an investor to grow the value of their portfolio.

Coca-Cola has one of the most powerful consumer staples brands in the world. Here, I take a look at whether its shares are a good place to invest right now.

A soft drinks giant

Coca-Cola has been in business since 1886. Today, it is the world’s biggest soft drinks company with four of the world’s top five non-alcoholic soft drinks brands: Coca-Cola, Diet Coke, Fanta and Sprite – selling in more than 200 countries.

As well as its four power brands, the company also owns some of the best-known soft drinks brands in Schweppes, Aquarius and Dasani waters, Innocent smoothies, Minute Maid juices, Costa Coffee and FUZE tea, as well as many local brands.

The company sold 29bn cases of soft drinks in 2020; 70 per cent of these were sparkling drinks with just under half represented by the Coke brands. Just over a third of its revenues come from its North American home market. The business is seasonal, with more sales generated in the northern hemisphere spring and summer months.

The company makes the bulk of its money in selling concentrates to its network of bottling companies, which add water and sweeteners to it before packaging it and selling it to retailers and wholesalers. It also sells syrups and fountain syrups to restaurants, bars and foodservice companies where water is added and the drinks are used in dispensers. Coca-Cola also sells finished drinks products and has licences to sell other brands, such as Monster Energy drinks.

An enviable portfolio of brands is backed by the world’s biggest soft drinks distribution system. As well as having its own bottling and distribution assets, the vast majority of Coca-Cola’s drinks are produced at independent bottling companies across the world. Five big bottling companies account for 40 per cent of the company’s sales volumes with operations in Mexico, China, Brazil and Japan making up one-third of volumes in 2020.

Coca-Cola retains an equity stake in these companies, but in recent years has been shedding its own investment in bottling and distribution assets to focus on selling highly profitable concentrate instead. 

The company’s bottling partners are backed up by a huge global network of distributors, wholesalers and retailers, which give it a big source of competitive advantage and a means to leverage revenue growth.

Despite its immense clout, Coca-Cola faces strong competition. In most global markets, Pepsico is its biggest competitor, but it also faces competition from the likes of Dr Pepper, while its water brands are arguably inferior to those offered by Nestle and Danone.

The growth of e-commerce has allowed niche brands to increase their competitive threat while private-label brands have also significantly improved their products. Coca-Cola sells to companies with significant buying power. The big supermarkets have negotiating power over price while the rise of discount retailers presents challenges on pricing and sales volumes. That said, the strength of Coca-Cola’s brand portfolio means very few retailers will not stock its products.

Maintaining relationships with big restaurant chains and foodservice companies is key to the future stability and growth of the company’s revenues, especially in a post Covid-19 environment.

Success on the competitive battlefield is determined not only by distribution strength but also the size and quality of the marketing budget, routes to markets, attractive packaging and the launch of innovative new products. Coca-Cola’s recent results suggest that it is doing well on most if not all of these key areas.

Improving quality of revenues and profits

It’s very easy to look at the relatively lacklustre volume growth of Coca-Cola’s drinks shipments over the past decade and come to the conclusion that it is a business that is struggling to make a lot of progress.

Granted, this is not a business that is seeing huge growth, but the quality of what it has been selling is getting better. The company has downsized its investment in bottling, which in turn has seen a shift in sales mix away from lower-margin finished drink products to higher-margin concentrates.

If we ignore last year’s Covid-19-impacted results, we can see that while volume growth in recent years has been modest, there has been a consistently positive price and mix effect. This reflects the inherent pricing power of the company’s brands and the shift in revenue mix towards concentrates.

This shift is also showing up in the company’s financial performance and key financial ratios.

Gross profit margins remain attractive but fell back in 2020 as sales switched from out-of-home locations to in-home consumption where margins are lower. Operating margins increased while the postponement of investment into dispensing products helped to boost free cash flow.

The company’s operating and free cash flow margins as well as its return on operating capital employed bear the hallmarks of a high-quality business.

If we scrutinise the recent trend in its operating margins by looking at gross profit and key costs as a percentage of revenues we can get some insight as to why they have improved.

Gross profit margins have come down since 2017, but the big margin improvements have come from selling and distribution and other costs as the business has chased efficiency gains.

2020 saw a big reduction in advertising costs due to Covid-19 and this should increase going forward. That said, the company is looking at being smarter with its advertising budget and getting a bigger bang for its buck by making concentrated and targeted bets on its key products. This suggests that advertising costs as a percentage of sales may not return to its previous levels and some margin gains will be preserved from this source.

Coca-Cola’s free cash flow generation has allowed it to increase its annual dividend per share for many decades. That said, dividend growth has been decidedly lacklustre as dividends have eaten up a bigger slice of profits and cash flow. A dividend cut is unlikely in my view and if the company’s growth strategy pays off, an acceleration in dividend growth is possible.

Can Coca-Cola accelerate its growth rate?

There are definitely grounds for thinking that it can. The bear case against the company is simple: People are cutting back on sugar-laden soft drinks because they are seen as unhealthy, which leaves Coca-Cola looking like a mature, ex growth business.

This concern is not without foundation, but the company’s response to it has been good in my view. Coke Zero Sugar has been a resounding success and continues to grow. It also deflects from the lacklustre Diet Coke brand, which looks decidedly tired nowadays.

Coca-Cola now has big ambitions to replicate its success with Coke Zero with Sprite Zero, which in comparison is largely untapped in what it could achieve.

With the company’s core brands seeing robust demand and increased growth from emerging markets the carbonated portfolio looks to be in good health. 

The company has also slimmed down its brand portfolio from 400 to 200 without shedding much in terms of revenue and profit. The more focused portfolio will be subject to more targeted digital marketing to drive growth. Coca-Cola is pursuing a “Beverages for Life” strategy to capture soft drink spending at different times of the day through sparkling drinks, juices, water, tea, coffee and alcoholic seltzers. 

Costa Coffee was an expensive acquisition, but the big benefit of this business as was shown under Whitbread’s ownership, was how scalable it was, with vending machines in high-footfall areas. A move into the US foodservice accounts can also drive growth.

Followers of the UK flavours business Treatt (LSE:TET) will know that hard seltzers are a major source of growth for it right now. Coca-Cola is rolling out its Topo Chico product across Europe in 2021 and while it’s not going to transform the company, when combined with its distribution and branding strength there are grounds for thinking that there’s a decent growth opportunity here.

Finally, the eventually opening up of economies again should see a recovery in out-of-home consumption and an improvement in revenues and margins from this source.

Management is bullish about the company’s medium-term growth prospects and is targeting organic sales growth of 4-6 per cent with operating profit growth of 6-8 per cent and EPS growth of 7-9 per cent. Free cash flow conversion of net profits is expected to be in the 90-95 per cent range.

Decent outlook and reasonable valuation

2021 should be a decent year for Coca-Cola, which should see it making more money than it did in 2019. As long as further lockdowns are avoided and economies open up, the company is guiding investors to expect high-single-digit percentage organic revenue growth, which will be helped by a weaker US dollar and low double-digit percentage EPS growth.

While there are commodity cost pressures, these are largely hedged. Free cash flow should be at least $8.5bn. At $53.20, the shares trade on a 2021F PE of 24.8 times and offer a prospective dividend yield of 3.1 per cent. 

In a low-interest-rate environment, I think that’s reasonable for the quality and stability of earnings on offer and definitely better than what the bond market currently offers. For UK investors looking for a defensive source of quality income the shares look worthy of consideration.

A source of risk comes from the company’s ongoing dispute with the US tax authorities. It has ruled against Coca-Cola’s transfer pricing arrangements for the use of its brand and trademarks to its bottling customers. The company has set aside $483m to pay a fine, but is challenging the ruling and expects to win. If it does not, then it could be facing a bill of up to $12bn and a 3.5 per cent hike in its underlying tax rate.

At the moment, Coca-Cola’s share price seems to be factoring in a favourable outcome. The company has the financial strength to cope with losing its case but a rise in its tax rate would lower the attraction of its shares.