Yesterday, The Coca-Cola Company (NYSE: KO) took off the growth-company mask and reduced its long-term EPS growth target from 15% to a more reasonable 11-12%. Finally. The new estimate isn't exactly a low hurdle, but it's at least somewhat more realistic than the pie-in-the-sky 15% rate that the company has mocked investors with for the past several years. All cynicism aside, I applaud the company for getting real with investors and setting attainable goals.
The revised earnings outlook accompanied Coke's first-quarter earnings, which came in at $0.35 per share and beat Wall Street's consensus estimate by two pennies. (Fool analyst Paul Larson did a nice job covering the earnings news in yesterday's Fool Plate Special.) I imagine CEO Douglas Daft is plenty tired of over-promising and under-delivering, and thus I'm hopeful that the latest estimate-beating performance will begin a new habit for the company. Heck, if Coke can just meet its new growth targets, that'll be an accomplishment. Today, I'm going to take a close look at Coke's new guidance, assess the valuation, and see what might be reasonable to expect from the stock over the next five years.
Despite the reduced long-term earnings guidance, shares of Coke traded up yesterday, closing at $46.75, giving the company a $116.4 billion market capitalization. That's 29 times analysts' 2001 earnings per share estimate of $1.61 -- an estimate that management granted its blessing upon in yesterday's conference call. By way of comparison, the S&P 500 is priced at 22 times First Call's estimate for 2001 earnings. For years, Coke has traded at a steep premium to the market, and the current 32% valuation premium assigns a fairly high value to the company's ownership of the #1 brand in the world, its low capital needs, and its resistance to economic slowdowns. With that kind of premium, Coca-Cola must deliver on its long-term growth targets, or else this multiple will eventually come down.
That means we better kick the tires and take a close look under the hood at this new 11-12% long-term EPS growth estimate. According to Coke management, this level of bottom-line growth is premised upon 5-6% worldwide unit case volume growth and 1-2% annual price increases. Combined, that translates to 6-8% expected revenue growth. From there, management expects to squeeze out about five percentage points of incremental EPS growth annually, coming from cost optimizations, share repurchases, and benefits from equity income.
Let's break this down.
The 6-8% revenue growth estimate appears challenging but achievable. The first component of this estimate is management's call for 5-6% annual unit case volume growth, which looks realistic considering Coke has grown this metric by 6% annually over the past 5 and 10 years. As in the past, Coke continues to find plenty of growth opportunity outside the U.S., where consumers still drink only a small fraction of the carbonated soft drinks that we do here in the States. The second revenue growth component, the 1-2% annual pricing increase, also looks achievable considering it's basically in-line with the rate of inflation and much lower than the company's historical 3-4% annual rate of price increases.
Beyond revenue growth, the road to 11-12% EPS growth will require five percentage points of incremental EPS growth from efficiency gains, stock repurchases, and equity income. Historical trends lend credence to the reasonableness of this happening. From 1990 to 1998, Coke grew revenue by 7.9% annually and diluted EPS by 13.9% annually -- a full six percentage point spread.
You put it all together and 11-12% EPS growth is realistic for this company. With that settled, let's take a stab at figuring out where the stock might reasonably be in five years. As mentioned earlier, Coke's 2001 EPS is expected to come in at $1.61. This amount actually includes an extra $300 million to 400 million in marketing expense that management insists will not be repeated in the future. Therefore, the "trend EPS" level for 2001 is actually closer to $1.71 when you add back the marketing expense on an after-tax basis. From this trend EPS level, management expects 2002 EPS to grow 11-12%, which brings us to $1.90 (assuming 11% growth). Applying the 11% growth rate for the next four years beyond that would bring us to 2006 EPS of $2.88. Here's how the share price might shake out in five years from now based on several possible P/E multiples applied to this 2006 EPS estimate:
Forward P/E 20 25 30 Stock Price $57.60 $72.00 $86.40
As you can see, achieving 2x/5y -- a double in five years -- from the current level will be quite a stretch. The stock would need a multiple of even greater than 30 to achieve that feat -- not too likely. Nevertheless, for a company with such a low-risk business, the risk/reward trade-off here isn't unreasonable. This is all assuming, of course, that Coca-Cola management delivers on its new forecast. If the company doesn't deliver, let it be known right now, we'll probably be inclined to sell our shares. Coke is definitely on the hot seat here at Rule Maker Central, especially with the tax loss that's available to us based on our $69.11 cost basis. Even now, with Johnson & Johnson (NYSE: JNJ) at 24 times 2001 earnings and PepsiCo (NYSE: PEP) at 26 times 2001 earnings, there are other similarly dominant Rule Makers that are more affordable and offer more growth potential than Coke. (Both J&J and Pepsi made our Rule Maker Top 25, while Coke did not.)
Matt Richey is co-manager of the Rule Maker Portfolio. He doesn't own any of the stocks mentioned in this article, but he does own a convertible, which is a lot more fun than a stock on a nice spring day. The Motley Fool is investors writing for investors.