By Callum Turcan
The Coca-Cola Company (KO) reported third-quarter earnings for fiscal 2019 (period ended September 27) on October 18, which were positively received by the market as the beverage giant showed signs that there’s strong demand worldwide for its offerings. Coca-Cola’s GAAP net revenues jumped 8% year-over-year while its non-GAAP organic revenues increased 5%, supported by higher prices and a favorable product mix that offset the negative impact from reduced concentrate sales. Management noted that Coca-Cola continued to “gain value share” in the ready-to-drink non-alcoholic beverage market. Shares of KO yield 2.9% as of this writing and ended up over 2% during normal trading hours on Friday October 18.
Coca-Cola
As an aside, it’s important to remember that Coca-Cola acquired Costa Limited through a deal valued at $4.9 billion from Whitbread PLC (WTBDY) at the start of this year (the deal was announced in August 2018 and completed by early-January 2019). This is Coca-Cola’s way of bulking up its ready-to-drink coffee beverage offerings, a space with very promising growth prospects. Management thinks quality synergies can be realized by leveraging Coca-Cola’s global marketing prowess with Costa’s coffee platform, with Costa already operating in more than 30 countries before Coca-Cola completed its acquisition.
However, we caution that Coca-Cola’s GAAP gross margins dipped last quarter on a year-over-year basis, falling by almost 150 basis points due primarily to foreign currency headwinds. GAAP gross margin pressures are largely a product of the strong US dollar and Coca-Cola’s international sales footprint. The company’s adjusted (non-GAAP) operating margin also fell materially year-over-year, dropping by 260 basis points, which was due to foreign currency headwinds and the net impact of acquisition and divestment activity (combined, those two factors shaved 260 basis points off Coca-Cola’s adjusted operating margins in the third quarter on a year-over-year basis).
The top end of our fair value estimate range for Coca-Cola sits at $48 per share, significantly below where shares of KO are trading at as of this writing as we think the market has gotten ahead of itself on this one. While Coca-Cola is targeting higher growth areas, like ready-to-drink coffee beverages, that growth trajectory isn’t strong enough to support its current valuation, in our view.
Outlook Changes
Coca-Cola made some modest changes to its fiscal 2019 outlook during its latest earnings report cycle including updating its full-year (non-GAAP) organic revenue growth forecast to at least 5% annual growth, instead of 5% annual growth flat previously. Additionally, Coca-Cola revised up its adjusted (non-GAAP) operating income growth forecast to 12%-13% on an annual basis in fiscal 2019, up from 11%-12% previously, but please note the company is also now forecasting stronger-than-expected headwinds from foreign currency movements. Full-year adjusted (non-GAAP) EPS is still forecasted to be +/- 1% (plus or minus 1%) from the company’s fiscal 2018 performance, or in other words flat this fiscal year.
Most importantly, Coca-Cola now sees itself generating $8.8 billion in cash from operations this fiscal year, up from $8.5 billion previously. Capital expenditures for the full year are expected at $2.2 billion, down from $2.4 billion previously. A combination of stronger than expected operating cash flows and lower-than-expected capital expenditures indicates Coca-Cola’s free cash flows are expected to be higher than previously assumed in fiscal 2019. The company plans to allocate only enough free cash flow to share repurchases to offset the negative impact of stock-based compensation in fiscal 2019; the rest is going towards covering its dividend payouts and other uses.
During the first three quarters of fiscal 2019, Coca-Cola spent $3.4 billion on dividend payouts, equal to an annualized payout of ~$4.5 billion. Share repurchases totaled $0.7 billion during this period, though we note Coca-Cola raised $0.9 billion from stock issuances. Coca-Cola generated $6.6 billion in free cash flows during this period. Not including Coca-Cola’s marketable securities account, which includes its strategic stake in Monster Beverage Corp (MNST), the firm had a net debt load of $32.9 billion at the end of the third quarter. We aren’t fans of Coca-Cola’s enormous net debt load and caution that $11.5 billion in total debt comes due within a year (versus the $9.5 billion in cash and cash equivalents Coca-Cola had on hand at the end of the third quarter).
The company also put out guidance for fiscal 2020 during its latest earnings update. Management is guiding for the firm’s comparable net revenue (non-GAAP) growth to come in at 1%-2% on an annual basis in fiscal 2020, while comparable operating income (non-GAAP) growth of 2%-3% on an annual basis is targeted for fiscal 2020. Foreign currency movements will have an outsized influence on the final figures. What Coca-Cola is attempting to communicate, in our view, to the market is that adjusted operating income growth will outpace adjusted revenue growth next fiscal year, indicating margin improvement is on the way. Furthermore, Coca-Cola sees its core businesses continuing to grow, which speaks favorably to its long-term trajectory.
Concluding Thoughts
While we like Coca-Cola the company, we think shares of KO have gotten ahead of themselves. Coca-Cola has a large net debt load, faces massive foreign currency headwinds, and its margins are coming under fire as a result. We are staying away from Coca-Cola as we see more appealing opportunities out there.
Non-alcoholic 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.