Coca-Cola stock: problem with the bearish thesis (NYSE: KO)

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justin sullivan

Surprisingly or not, the negative sentiment toward consumer staples and Coca-Cola (NYSE: KO) in particular, has increased in recent months. The prevailing narrative is that as we enter a period of higher inflationary pressures, consumer staples will have a more time to deal with rising costs.

Another line of thought is that the largest multinational companies will be the most threatened in a global market by de-globalization. In this simplistic bearish thesis, Coca-Cola’s premium valuation is yet another ‘red flag’.

After all, if you have a company with a poor relative valuation and growth outlook, while facing inflationary pressures, how can you not be bearish?

Coca-Cola Factor Grades

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The set up

About two years ago, I first wrote about my reasons for being optimistic about the future of Coca-Cola. At the time, the pandemic was raging across the world and lockdowns were still in place. The sentiment around KO was similar to today, with many market commentators telling us that Coke’s business model is now well positioned for such an environment.

Ultimately, however, since my first company think piece, KO has outperformed on an absolute (not to mention risk-adjusted) basis its two major peers – PepsiCo (PEP) and KDP (KDP), the sector consumer staples and the broader market as measured by the S&P 500.

Chart
Data by Y-Charts

So what happened?

While many investors were focused on high price-earnings ratios and external risk, Coca-Cola management made a great capital allocation move by acquiring Costa Coffee. Of course, not all the positives of this acquisition were obvious in the short term, especially with all the lockdowns in place.

Coca-Cola Costa Coffee offer

Presentation to Coca-Cola Investors

But for anyone with a longer investment horizon, Coca-Cola’s capital allocation decisions seemed superior to those of its peers.

I go into all of this in detail in the analysis titled “Coca-Cola: Why Business Transformation Will Have Profound Implications for Returns”. If you haven’t read it, I strongly encourage you to do so as it delves deeper into the subject of capital allocation.

Is there really a problem?

Coca-Cola’s premium valuation is largely supported by its industry-leading profitability. This is why, as we see in the chart below, on a historical basis, multiple price moves to knockout sales in unison with the company’s net profit margin.

Valuation and profitability of Coca-Cola

prepared by the author, using data from SEC Filings

In terms of fixed costs, Coke is still well ahead of its peers due to its large international exposure and low business activity. Even compared to PepsiCo, Coca-Cola’s competitive advantage is obvious.

Coca-Cola versus PepsiCo

prepared by the author, using data from SEC Filings

So far, inflation is having a profound impact on margins, however, we must remember that inflationary readings are backward looking and prices of key commodities for KO appear to have already peaked.

corn and sugar prices

Fred

Of course, what the future holds is largely speculative, however, Coca-Cola has already partially offset the inflationary impact on margins through pricing actions.

Our 12% price/mix was mainly driven by strategic pricing actions across all markets, as well as revenue growth management initiatives, further improvement in out-of-home channels in most markets and a positive segment mix. Comparable gross margin for the quarter decreased approximately 250 basis points from a year agomainly due to the impact of 3 elements: one, a significant increase in business costs due to the inflationary environment; of them, currency headwinds driven by the volatile macro context; and three, the mechanical effect of the consolidation of the BODYARMOR finished products activity.

John Murphy – Chief Financial Officer

Source: Coca-Cola Q2 2022 Results Transcript

In fact, the underlying decline in gross profitability due to the unprecedented jump in raw materials was relatively small.

2022 Coca-Cola margins

Coca-Cola Q2 2022 Investor Presentation

Of course, this does not represent the full impact of the current spot price of raw materials, as input costs are covered. Additionally, the truly international nature of KO gives it a significant advantage over its peers that focus on North America or Europe, as the inflationary impact varies widely from country to country.

Additionally, Coca-Cola’s strong brand portfolio also allows management to pass on a significant portion of these higher costs to the consumer.

We expect further cost increases to occur across a wide range of inputs. And we will continue locally in each country because it is very different. We will continue to pass them on.

James Quincey – Chairman and CEO

Source: Coca-Cola Q2 2022 Results Transcript

Therefore, Coke’s profitability and overall valuation are not at significant risk going forward and even if inflationary pressures continue, Coca-Cola’s business will not be as badly affected as Coke’s consumer goods. low added value basis.

The cash flow perspective

On a cash flow basis, Coca-Cola trades at its long-term median free cash flow yield, which does not indicate material overvaluation.

Coca-Cola Free Cash Flow Yield

prepared by the author, using data from SEC Filings and Seeking Alpha

Indeed, bond yields are currently near their 10-year highs, which might make fixed income more attractive at this point, but that’s another topic.

It should also be noted that Coca-Cola has also reduced its overall capital expenditure as a result of the pandemic, however, over the past 12 months, KO is again spending more on capex than its depreciation and amortization expenditure. . This is the case even as the company divested its capital-intensive bottling business.

Capex Coca-Cola

prepared by the author, using data from SEC Filings

Compared to its direct peers, Coca-Cola also trades at more attractive free cash flow and dividend yields. The only exception is Keurig Dr Pepper, which has been another great consumer staples opportunity in my opinion.

Dividend yields from Coca-Cola, PepsiCo, KDP and Nestlé

prepared by the author, using data from Seeking Alpha

Finally, the management of Coca-Cola seems to have made very good decisions in terms of capital allocation. In addition to becoming an asset-light company focused exclusively on beverages and the decision to enter the highly profitable and branded coffee space, Coca-Cola also significantly reduced its share buybacks during this period of transition.

Over the past 12 months, however, that has changed, although the price-to-tangible asset ratio remains high.

Repurchase of Coca-Cola shares

prepared by the author, using data from SEC Filings

Conclusion

Coca-Cola is one of those companies that probably won’t make anyone rich quick, however, KO is in a great position to continue beating the market as it has for the past two years. Coke’s share price is by no means a bargain at this level, however, a company of such quality that is also exceptionally well managed is unlikely to trade at a discount anytime soon. Inflation fears are also greatly exaggerated, as Coca-Cola is one of the consumer staples companies best positioned to deal with rising commodity costs.

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