Coca-Cola (NYSE: KO), the undisputed King of Cola, has returned a 32% loss since the Rule Maker Portfolio bought the stock in February 1998. Sadly, we paid a lofty 41 times earnings for the company, leaving little margin of safety for any misstep in performance. In the initial buy report, a Rule Maker co-manager wrote, "we believe that the quality of the business far outweighs any temporary valuation issues. If the company does grow at a rate of 17% per year over the next five years, we're comfortable paying 41 times present earnings for the stock."
It was ambitious, but not unthinkable, to assume that Coke could grow earnings 17% annually, considering in the company's glory days profits grew consistently in the high teens. In the previous two years before we purchased the stock profits grew 18% and 17%, for example. But rather than the expected 17% growth, earnings fell 14%, 31%, and 10% between 1998 and 2000 as the company battled antitrust allegations in Europe, product recalls, asset write downs, management shakeups, and onetime charges from its bottling partners.
Coke's results have started to show signs of life in 2001, however. Although revenues showed little growth in the first-half of this year, pro forma operating income grew a hefty 17%. New CEO Doug Daft has boosted the bottom-line by decentralizing Coke's operations -- a concept known as "Think Local, Act Local" -- giving more control to regional executives and bottlers. The strategy is designed to increase consumption through local marketing and management, and could ultimately save the company up to $300 million annually.
In addition, Daft prudently lowered Coke's long-term earnings growth rate from 15% to between 11% and 12%, but cutting costs alone won't be enough: the company will also need to improve revenue and volume growth. However, Daft also revised the long-term expected volume growth rate from 7% to 8% down to 5% and 6%, slightly lower than the 6.5% growth the company averaged between 1976 and 2000. In the first six months of 2001, volume growth of 3% fell short of the 4% target that the company revised at the beginning of the year.
It's a good sign to see management has set some realistic expectations and it should be able to meet those goals with a number of expanding business possibilities. For example, Coke has some strong offerings in the non-carbonated beverage market -- the fastest growing segment of the industry -- with Dasani bottled water and Powerade sports drink, both of which trail PepsiCo's (NYSE: PEP) similar offerings, Aquafina and Gatorade. The company is also the undisputed beverage leader overseas, where markets are growing faster than North America.
With plenty of growth opportunities abroad, one of the best-known brands in the world, and a widespread distribution system that should spur additional volume growth, Coke remains well positioned for at least the next 10 to 20 years. Whether it has enough growth in store to double over the next five years is a much different issue, however. While management's new expectations are indeed more reasonable, we'd expect more growth from a company like Coke that carries a multiple of 30 times trailing 12-month (TTM) free cash flow.
Coke shares have fallen almost 25% over the last 12 months, making the stock more reasonable than it's been in some time, but price remains an issue. I like to begin any valuation study looking at historical ratios. It's a good idea to look how the market has priced a particular stock in the past, and then compare it to the current price. Coke closed yesterday at $46.18 per share, leaving it with a market cap of $114 billion. Here's a look at the company's historical price-to-earnings, price-to-book, price-to-sales, and price-to-free cash flow ratios:
KO TTM '00 '99 '98 '97 5Y Avg P/E 29 39 45 48 46 44 P/B 11 16 15 20 23 19 P/S 6 7 7 9 9 8 P/FCF 30 53 53 64 44 49 *calculated at year-end
Even though Coke trades below all four five-year averages, making the stock look cheap on historical standards, I'd argue the company is still expensive given its growth expectations. Coke trades at a 36% and 38% premium to the S&P 500 based on TTM P/E and P/FCF ratios, respectively, which isn't surprising given its history of consistent above-average returns. However, paying 30 times TTM free cash flow for a company that expects long-term earnings growth of between 11% and 12% doesn't exactly strike me as a great investment opportunity.
Put another way, if we assume the market will still be willing to pay 30 times free cash flow for Coke in five years, well below its five year average, it would need to grow free cash flow 15% annually over the next five years to more than $7.6 billion for 2x5y returns. Over the past five years, free cash flow has grown about 6% annually. But even if we assume a multiple of 35 times, a price I doubt we'd be willing to pay, Coke would still need to grow free cash flow 11% annually, which is probably the best case scenario for the company.
Below are estimated P/FCF ratios and the growth rates required for 2x5y returns:
Projected P/FCF 40 35 30 25 FCF Growth Rate for 2x/5y 8% 11% 15% 19%
Even with the recent weakness in stock price, it's clear Coke would have a tough time posting 2x5y returns. The company's current valuation of 30 times free cash flow looks pricey, despite having plenty of growth opportunities abroad, one of the best-known brands in the world, a widespread distribution system, and a history of above-average returns. Having said that, I think the Rule Maker Portfolio should sell its stake in Coke and look to invest the money elsewhere, perhaps PepsiCo, which others have suggested over the years.
When we bought Coke in February 1998, we paid too much for a solid business, making the possibility of 2x5y returns highly unlikely. Moreover, even at the current price, Coke would need to execute perfectly in order to double over the next five years. With very little margin of safety at the current price, the time has come to sell Coke. While the company has a good possibility of beating the market over the next five years, we only want to own stocks with a good chance of 2x5y returns. There's no point keeping money tied up in this flat soda.