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Why You Might Want to Avoid This Dividend Aristocrat

By Leo Sun - Aug 26, 2017 at 4:07PM

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Weak growth and a high P/E ratio make Coca-Cola stock a poor long-term play.

Income investors often put Dividend Aristocrats -- companies that have raised their dividends annually for at least 25 straight years -- on a pedestal. Many of those companies certainly deserve respect, since they've paid uninterrupted dividends through multiple bear markets.

However, investors shouldn't blindly buy Dividend Aristocrats without examining their core businesses. For example, Coca-Cola (KO 0.62%) -- which has raised its dividend annually for over half a century and whose stock yields 3.25% at the current price -- isn't really a great investment right now, for four simple reasons.

A hand holds a bottle of Coca-Cola backed up by a glacier vista.

Image source: Pixabay.

1. Soda consumption continues to drop

Over the past few decades, Coca-Cola diversified its business beyond carbonated drinks with bottled water, juices, teas, and energy drinks. But its namesake cola and other carbonated drinks still generate a large portion of revenue.

That's troubling, because soda consumption is dropping across many major markets. Soda consumption hit a 31-year low in the U.S. last year, according to industry tracker Beverage Digest, indicating that even low-sugar and sugar-free versions aren't impressing customers.

Certain sugar-free sodas, like Coca-Cola Zero Sugar, gained ground in Europe, the Middle East, Africa, and Latin America, according to Coca-Cola's latest quarterly report, but rising sales across many of those regions were offset by currency headwinds. That's why analysts expect Coca-Cola's reported revenue and earnings to respectively fall 16% and 1% this year.

2. It lacks diversified growth opportunities

Coca-Cola's business model seems poorly diversified compared to PepsiCo's (PEP 0.80%) portfolio of beverages, Quaker packaged foods, and Frito-Lay snacks, which includes 22 billion-dollar brands. PepsiCo has also been pivoting that portfolio toward items deemed healthier, like Naked Juice and Sun Chips, to meet consumers' desires.

A bottle of Pepsi Cola Light.

Source: Pixabay.

Wall Street expects PepsiCo's better diversified business to boost its revenue and earnings by 1% and 6% respectively  this year. PepsiCo expects its organic revenue to rise at least 3%, which could exceed Coca-Cola's expectations for 3% organic growth this year.

3. Coke has uncomfortably high payout ratios

PepsiCo's forward dividend yield of 2.7% is lower than Coca-Cola's yield, but it is also a Dividend Aristocrat that's hiked its payout annually for over four decades. However, PepsiCo spends a more sustainable amount of its earnings and free cash flow on its dividend than Coca-Cola.

Over the past 12 months, Coca-Cola spent 111% of its earnings and 73% of its free cash flow on dividends. It's unlikely that Coca-Cola will slash its dividend (since its FCF still covers those payments), but the high payout ratios shows how badly sluggish soda sales and macro challenges in certain markets have dented its bottom-line growth.

During that same period, PepsiCo spent just 64% of its earnings and 66% of its FCF on its dividend payments. So PepsiCo could offer bigger year-over-year hikes than Coca-Cola.

4. Coke stock is overpriced

Shares of Coca-Cola have rallied 10% this year, narrowly outperforming the S&P 500's 9% gain. But that rally seems fueled by investors pivoting toward defensive income plays instead of Coca-Cola's fundamental growth.

As a result, Coca-Cola now trades at 48 times earnings, which is much higher than the industry P/E of 33 for soft drink makers. PepsiCo trades at just 25 times earnings -- making it the more sensible play for a frothy market.

The bottom line

Coca-Cola isn't a terrible long-term investment, since it grew its net operating revenues from $24 billion to $42 billion between fiscal 2006 and 2016. Its annual net income jumped from $5.1 billion to $6.5 billion during that period, and the stock rallied nearly 70% over the past decade.

But Coca-Cola is an aging company with weak growth, overheated payout ratios, and a high P/E ratio. Plenty of other Dividend Aristocrats, like PepsiCo, offer much better growth at a lower valuation.

 

Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends PepsiCo. The Motley Fool has a disclosure policy.

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Stocks Mentioned

The Coca-Cola Company Stock Quote
The Coca-Cola Company
KO
$63.44 (0.62%) $0.39
Pepsico, Inc. Stock Quote
Pepsico, Inc.
PEP
$175.90 (0.80%) $1.40

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