Can KO Grow? (Drip Port) August 5, 1999

<THE DRIP PORTFOLIO>
Can KO Grow?
From this price, can it beat the S&P?

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (August 5, 1999) -- Will carbonated soda be a declining or static market over the next two decades due to growing competition in the beverage industry and increased concerns about health? Is Coca-Cola (NYSE: KO) now and forever dependent on international sales for strong earnings growth? Will selling bottled water and other healthy drinks help domestic sales? How much pricing power does Coca-Cola possess? Do you buy the soda that is on sale or are you brand loyal?

Those are all questions that I regularly entertain, and yet I have owned Coca-Cola in a DRP since February of 1997. I typically buy more shares whenever the stock is in the low $60s. Therefore, I haven't lost much money, but I also haven't made any. I buy the company because it is Coca-Cola -- the leading beverage brand in the world. Coca-Cola stock is almost my equivalent of buying a 30-year bond without actually doing so. I believe that Coca-Cola, long term, is as stable as a 30-year bond and that it will deliver at least the return of a 30-year bond and most likely much, much more without incredible risk.

I believe that Coca-Cola, through sheer stability, has a good chance to at least match the S&P 500 over the very long term. The stock holds up in down markets and during company-specific bad news. That stability means preservation of capital. That alone means better returns. Next, the stock typically moves up in good markets or at worst it stays level when its business is lagging and the market is good. Although my hopes for market-crushing returns lessen with every lackluster year, I'm not buying Coca-Cola in hopes of America Online-type returns. I'm buying Coca-Cola to own something very stable that I can give away to family, perhaps, decades from now.

I believe that Coca-Cola stock is going to be what I'd call a "magic wealth creator." It will create wealth without any real apparent effort and without hoopla. The stock may stagnate for three or five years, or more, but then you'll look at it again five years after that and you'll discover that you have more than doubled your money in ten years through dividend reinvestments and dollar-cost averaging. That said, I'm not confident that Coca-Cola will match our 15.5% hurdle rate of return over the next two decades. It could. But the Drip Port isn't in a hurry to bet on it at this price.

At $61, Coca-Cola trades at 47 times trailing earnings per share and it yields 1.06%. Following an estimated 3% decline in earnings per share this year, a 15% gain is anticipated in the year 2000. Note, however, that in the past a gain was expected this year, too, and the year before as well, and both years came up snake eyes instead. Long-term, the company is expected to grow earnings per share 13.9% annually. That, as well, is another guess. The prior guess was over 17%.

Let's imagine that the company did grow earnings 14% annually for the next five years from 1999 results. That would mean $2.61 per share in year 2004 earnings (up from $1.36 that is expected this year). The stock trades at 23 times this five-year ahead estimate. If Coca-Cola really could grow earnings at this rate, we might see significant stock appreciation over five years because it's likely that the company would maintain a healthy premium (a stock with a P/E of at least 30).

However, if industry trends and the recent past mean anything, there is a very real possibility that Coca-Cola will not grow earnings 14% each of the next five years. There is also a possibility for Coke to trade at a P/E in the 20s as it used to, and as PepsiCo (NYSE: PEP) does. Demand for Coke's stock has been high enough in the late 1990s to prevent a lower P/E multiple, but we can't assume that this situation will continue indefinitely, even if it is a somewhat logical assumption to some degree.

So, as in 1997, the main concern we have is valuation. Will Coca-Cola's stock outperform from these prices? Will it return 15% annually? But we have new concerns since 1997, too. I now have greater concerns about sales and earnings growth -- or a lack thereof. And I have concerns about management following the recent European fiasco. (I believe that management will be a temporary concern, though, while growth issues may not be.)

As is typically the case, it appears that we'll spend more than three columns on many of our companies in our food and beverage study. I've written two columns on Coca-Cola and I've barely scratched the surface (granted, though, we know the company well by now so needn't repeat ourselves too much). We'll continue with each company until we reach a conclusion to put them on the Finalist List or not. We will be able to do that with Coca-Cola early next week.

You shared many posts regarding Coca-Cola on the Drip Companies board yesterday. Thank you! I'm compiling your thoughts and I will share them here collectively (and some individually) next week. Tomorrow, Brian will share his view on the company. Please share your thoughts and analysis, if you wish, via the link above.

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