Is Barron's Wrong About Coca-Cola?

Last weekend's edition of Barron's ran a bullish article on Coca-Cola (NYSE: KO  ) . The gist of the article is that poor weather caused Coca-Cola and PepsiCo (NYSE: PEP  ) to ramp up advertising and discounts in 2013, but a return to rational pricing and a rising global middle class will boost earnings in the years ahead. Moreover, Coca-Cola trades at 18 times next year's estimated earnings and therefore makes a good investment.

I find little to squabble with as far as Barron's analysis of Coca-Cola's business prospects go: Although carbonated-soft-drink volumes continue to decline in the United States, there is enormous untapped growth in international markets where per capita consumption of Coke is much lower than it is in North America. Emerging markets will drive growth for decades. However, there is reason to doubt that Coca-Cola is a good investment at this price; one of its close peers may be a better investment instead.

Relative valuation
There are two ways in which a stock can be cheap: relative and absolute. A good investment is cheap relative to other opportunities and cheap enough to provide an adequate return for the risk taken.

First, let's determine the attractiveness of Coca-Cola relative to PepsiCo, Dr Pepper Snapple Group (NYSE: DPS  ) , and the S&P 500 index based on three measures: price to earnings, price to free cash flow, and price to sales. Coca-Cola trades at a premium to its peers and the S&P 500 in all three categories. (Note: S&P 500 free cash flow is not readily calculable and has been left out.)

Data from Morningstar.

That Coca-Cola trades at a premium does not automatically disqualify it as a good investment. Coca-Cola is a better company than most in the S&P 500; most companies do not have the scale, market dominance, and growth opportunities available to Coca-Cola, so it deserves to trade at a premium to the market.

Coca-Cola is also a better company than Dr Pepper Snapple. Dr Pepper Snapple has the third-largest share of the carbonated-soft-drink market and owns many brands that are No. 1 or No. 2 in their respective categories. However, it is inferior to Coca-Cola in two important ways.

First, the vast majority of Dr Pepper Snapple's revenue comes from within the United States. Although the company sells some healthier brands like ReaLemon lemon juice and Deja Blue bottled water, the bulk of its profit comes from sugary beverages like Dr Pepper, 7UP, and Sunkist. Sales of sugary beverages are declining in the U.S. and may be subject to excise taxes in the near future. This makes the U.S. a relatively unattractive market for nonalcoholic beverage companies.

Secondly, Dr Pepper Snapple lacks the scale and distribution capability to expand internationally at a meaningful pace. The company is expanding at an excruciatingly slow pace as it builds its distribution network in the Caribbean, which makes up 7.6% of sales. Coca-Cola, on the other hand, already has worldwide distribution capabilities and can easily take advantage of increases in per-capita consumption in international markets.

Coca-Cola's edge over PepsiCo, however, is not obvious. Like Coca-Cola, PepsiCo owns a portfolio of leading beverage brands that it can distribute worldwide through its system of bottlers and distributors. It has a 26% share of the U.S. liquid-refreshment beverages market, second only to Coca-Cola's 34% share. But PepsiCo has something that Coca-Cola does not have: diversification from the beverage market.

Although there remains a tremendous growth opportunity in beverages, PepsiCo's ownership of Frito Lay -- which commands a 40% share of the global salty-snacks market -- gives it a wide-moat business that does not (yet) draw the ire of governments and citizens in developed countries like soft drinks do.

Given that PepsiCo has as much exposure to the carbonated-soft-drink market as Coca-Cola and owns a wide-moat snacks business, it is difficult to fathom why it trades at a discount to its larger rival. Coca-Cola and PepsiCo are both wide-moat businesses that generate similar returns on equity and returns on invested capital. Therefore, they should trade in line with each other. That PepsiCo trades at a discount indicates that there is a better alternative to an investment in Coca-Cola.

Absolute valuation
Even if PepsiCo were not available to buy at a relative discount, Coca-Cola does not seem particularly attractive based on its historical financial performance. In the last 10 years, Coca-Cola turned $100 of sales into $19.65 in free cash flow -- on average -- although that number has been declining.

Data from Morningstar.

If you apply Coca-Cola's historical free cash flow margin -- 19.6% -- to its current sales level -- $47 billion -- you get an initial "normal" free cash flow estimate of $9.3 billion. This is $1.3 billion more free cash flow than Coca-Cola has ever generated in its history.

Even working off this record estimate of free cash flow, Coca-Cola trades at just a 5% free cash flow yield. That is, $9.3 billion in free cash flow divided by $184 billion (the company's market price) equals 5%. If you just take the last four quarters of free cash flow -- $8 billion -- you get a 4.3% free cash flow yield. In order for an investor to get a double-digit return on an investment in Coca-Cola, the company would need to grow free cash flow at 5% to 6% per year. In other words, investors have to pay up for growth.

Bottom line
Barron's and I agree that Coca-Cola is a wonderful business with good prospects despite heated anti-soda rhetoric in the United States. We also agree that it trades at something close to 20 times its normal earning power. Where we disagree is the wisdom of paying for growth, especially when PepsiCo can be had for less. Why pay up for Coca-Cola when you can buy PepsiCo -- a company with similar, if not better, prospects -- at a cheaper price?

Warren Buffett hasn't bought more Coca-Cola in years. What is he buying?
Warren Buffett has made billions through his investing and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.


Read/Post Comments (0) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2778894, ~/Articles/ArticleHandler.aspx, 11/24/2014 3:27:39 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 2 days ago Sponsored by:
DOW 17,810.06 91.06 0.51%
S&P 500 2,063.50 10.75 0.52%
NASD 4,712.97 11.10 0.24%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

11/21/2014 4:03 PM
KO $44.50 Up +0.25 +0.56%
Coca-Cola CAPS Rating: ****
DPS $71.98 Up +0.22 +0.31%
Dr Pepper Snapple… CAPS Rating: ****
PEP $98.89 Up +0.83 +0.85%
PepsiCo CAPS Rating: ****

Advertisement