Image Source: Broderick
By Callum Turcan
Coca-Cola Company (KO) posted a great second quarter report for 2019 on July 23, sending shares up 6% on the day. Management surprised the market by upgrading their forecast for Coca-Cola’s full-year performance with guidance for organic revenue, constant currency operating income, net operating cash flow, and capital expenditures for 2019 all getting a boost. We still think shares of KO are overvalued as the market has gotten ahead of itself. Consumer staples companies trading at premium valuations late in the business cycle are prime examples of how irrational exuberance can seep into every corner of the market.
Furthermore, the IMF just downgraded global GDP growth projections for both 2019 and 2020, and while the US economy continues to chug along, the US Fed is fearful enough of a global synchronized downturn that chances of a series of “insurance” rate cuts are growing. We value shares of Coca-Cola at $48 per share at the top end of our fair value estimate range, well below where shares are trading at as of this writing. Shares of KO yield 3.0%, and please note that Coca-Cola’s second quarter ended on June 28, 2019.
Guidance Upgrades
Let’s dig into Coca-Cola’s guidance upgrades (for reference, these are annual growth figures). Non-GAAP organic revenue growth was revised up to 5% in 2019 (from 4% previously), while non-GAAP constant currency net revenues was revised down to 12% (from 12% -13% previously) due to Coca-Cola increasing its expected foreign currency movement headwind to 4% (from 3% -4% previously) and due to its tailwind from net A&D and other activities shrinking to 7% (previously estimated at 8% – 9%).
While there is a ton of noise and adjustments in these figures, the most important thing Coca-Cola’s management team wanted to communicate to the market was that there is strong underlying demand for its products. Foreign currency headwinds remain a major obstacle in light of the strong US dollar.
When it comes to operating income, Coca-Cola now sees its non-GAAP constant currency operating income for 2019 growing by 11%-12% this year (up from 10%-11%), with net A&D activity providing a “low single-digit tailwind.” The headwinds from foreign currency movements was upgraded to 7%-8% (from 6%-7% previously), meaning that foreign currency movements are expected to consume a large portion of the guidance increase (if not, all of it).
Perhaps the most important part of these guidance revisions was the upward movement in Coca-Cola’s cash from operations forecast for 2019. Now management is targeting $8.5 billion in cash from operations, up from $8.0 billion previously, while capital expenditures are expected to come in at $2.4 billion, up from $2.0 billion previously. That implies forecasted free cash flows are expected to come in slightly stronger than previously expected.
While underlying demand for Coca-Cola’s offerings remains strong, foreign currency headwinds have eaten into most of those gains. The valuations of consumer staples companies are stretched as the market bids up equities in the face of potential US Fed rate cuts and other factors, which we cover in this article here.
Cash Flow and Dividend Commentary
During the first six months of 2019, Coca-Cola generated $4.5 billion in net operating cash flow while allocating $2.9 billion towards capital expenditures, enabling $1.6 billion in free cash flows. Those free cash flows covered the majority, but not all, of its $1.7 billion in dividend payments this period. Share buybacks totaled $0.7 billion, while share issuances totaled $0.6 billion, making that largely a wash as it relates to cash outlays and inlays.
Coca-Cola ended June 28, 2019, with $9.3 billion in cash and cash equivalents on top of $4.1 billion in marketable securities, which includes Coca-Cola’s stake in Monster Beverage Corporation (MNST). Excluding its marketable securities as those are strategic assets, Coca-Cola’s net debt load sits at $26.5 billion as its $35.8 billion in total debt (short-term debt, loans payable, and long-term debt) looms large. Coca-Cola’s Dividend Cushion ratio stands at 1.2x, which is alright but not great due to its hefty net debt burden.
Reviewing Coca-Cola’s Financials
As reported on a GAAP basis, Coca-Cola’s revenue rose 5% to $18.7 billion year-over-year during the first six months of 2019 while its GAAP gross margin contracted by ~160 basis points. Management noted that the expansion into new product categories (such as hot beverages and coffee drinks) would put some downward pressure on gross margins, but was adamant that productivity gains would more than offset that during Coca-Cola’s quarterly conference call (emphasis added):
“Will expansion of new categories cause the compression of the gross profit margin, we had previously said yes, it might be a little, but it will be offset by productivity. What you’ve seen in the first half is it’s a wash. We’ve been able to drive the Coke franchise and the innovation and manage the portfolio such that the net impact on gross margin is a wash, which is a great result.And then obviously, we’re getting some flow-through of our ongoing productivity efforts. Just because we haven’t announced the new program, we are still focused on using resources effectively in the SG&A on the back — in the back office and investing wisely with the marketing such that this operating leverage is flowing through into the margin. So, I think the game plan is intact and we’re continuing to drive against it.”
Coca-Cola’s GAAP operating income climbed by 15% year-over-year to $5.4 billion during the first half of 2019 versus the same period last year as its GAAP operating margin jumped by ~240 basis points. Management is doing their best to manage Coca-Cola’s operating expenses to offset pressure on gross margins, which we appreciate. However, we caution that a large part of this boost came from a precipitous drop in other operating charges, aided by SG&A expenses rising by only 2% year-over-year during the first half of 2019.
The push into new beverages and new markets, seen through its purchase of CHI (which sells iced teas, juices, and dairy-based drinks in West Africa) and Costa (which sells hot beverages and coffee products on a global level), will help support Coca-Cola’s long-term growth trajectory. On the other hand, this strategy does come with risks including pressure on gross margins and potential foreign currency headwinds.
Concluding Thoughts
While the market clearly liked Coca-Cola’s earnings report, we believe investors are getting ahead of themselves. We aren’t interested in shares of KO at these levels, and we caution readers on the stretched valuation of consumer staples companies in general. Coca-Cola’s free cash flows during the first half of 2019 didn’t fully cover its dividend payments, while a large net debt load will make growing that payout much harder in the future.
Nonalcoholic Beverages Industry – KO CCEP KDP MNST FIZZ PEP
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.