Coca-Cola reported messy first-quarter 2018 results, making an assessment of its underlying free-cash-flow generation paramount. Coverage of cash dividends with free cash flow generation has become rather tight in recent years, and the company’s net debt position isn’t exactly encouraging. Very few companies have the competitive advantages and dividend growth track record of this tried-and-true beverage giant, however.
By Brian Nelson, CFA
On April 24, beverage giant Coca-Cola (KO) reported non-GAAP organic revenue growth of 5% in its first-quarter 2018 results. The headline number of a 16% decline in net revenue may be disturbing at first glance, but most of the decline came from refranchising/divesting its bottling operations. At the core, concentrate sales growth came in at 4% while price/mix growth came in at 1% during the period. It was good to see both volume and price moving in the right direction at Coca-Cola. A byproduct of refranchising/divesting its lower-margin bottling operations is higher levels of profitability, and that’s precisely what we saw during the period, with non-GAAP operating margins expanding 600 basis points. Operating cash flow dipped 20% in the quarter reflecting the benign divestitures of its bottling operations, but free cash flow improved modestly, advancing 5% on a year-over-year basis thanks entirely to its more capital-light operations (reduced spending).
Coca-Cola’s competitive advantages rest on two distinct considerations: its strong brand name and its sprawling distribution network. The company’s One Brand Strategy, for example, helped drive 3% growth in brand Coca-Cola volume and an incredible double-digit pace of volume expansion in Coca-Cola Zero Sugar during the period. The company continues to innovate, too. Volume growth of Diet Coke, for example, is now increasing in North America again thanks to the company’s launch of four new flavors that came with a sleek design and innovative marketing. When you talk about Coca-Cola’s distribution network, the company’s products are almost everywhere. The quarter, for example, saw strong performance in Turkey and South Africa and weakness in Nigeria and Western Europe. It achieved mid-single-digit growth in Brazil, Argentina, and Mexico, along with strong performance in China and India during the period. Volume in its ‘tea and coffee’ segment advanced 5% during the first quarter of 2018.
Looking ahead, reported performance at Coca-Cola will continue to messy as it works through refranchising/divesting initiatives and as new tax laws are implemented. However, the company is guiding for ~4% growth in organic revenue on a non-GAAP basis, and 8%-9% expansion in comparable currency-neutral operating income. As its accounting statements digest a number of dynamics during 2018, we think close attention to the cash flow statement may be most informative. Operating cash flow is targeted at $8.5 billion, while capital expenditures are expected to come in at $1.9 billion. We’ll be watching free cash flow performance very closely this year, and we’d view any shortfall as a disappointment. In recent years, Coca-Cola’s free cash flow has fallen to $5.3 billion in 2017 from ~$8 billion in 2015, as the company’s endeavors to become less capital-intensive haven’t helped free-cash-flow generating capacity at all.
The company’s target for free-cash-flow generation during 2018 is $6.6 billion, barely north of the $6.3 billion it paid out in dividends last year. Total debt at Coca-Cola stood at $34.5 billion while total cash stood at $15.4 billion, as of the end of 2017, revealing a considerable net debt position. Dividend growth investors should be taking a more cautious look at Coca-Cola’s operations, in our view. The company’s Dividend Cushion ratio stands at 1.1, as this tried-and-true beverage giant continues to walk a fine line. Despite our concerns about the tight coverage of cash dividends paid with free cash flow and Coca-Cola’s large net debt position, very few companies come with greater competitive advantages and a better dividend growth track record. We like Coca-Cola a lot, but we’d like to see better free-cash-flow generation and reduced leverage on the balance sheet. Look for more credit downgrades in coming years, in our view. Shares yield ~3.5% at the time of this writing.
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Brian Nelson 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.