Coca-Cola (NYSE:KO) late last week gave investors further validation that its strategy to navigate the backlash against sugary sodas is working. For the third quarter, revenue increased by 5% year over year on a non-GAAP (adjusted) basis, primarily due to an increase in pricing. Innovation and marketing led to 3% volume growth of trademark Coca-Cola products in North America, where the company has struggled lately to get people to drink more Coke products.
The bottom line didn't perform as well, with adjusted earnings down 2% year over year. For that, management blamed currency headwinds, shaving six points of growth off earnings. On the flip side, it is very encouraging to see free cash flow up 41% year to date to $6.6 billion.
Overall, investors were pleased with Coke's performance, especially as management issued an upbeat outlook and reaffirmed plans to keep the top-line momentum going in the short term with the launch of a Coke energy drink in the U.S. next year.
Solid performance with room for improvement
Coke seems to be successfully adapting to a challenging consumer environment. Consumers are turning away not only from sugary beverages but also from plastic bottles, which pressured sales of Coke's Dasani water business in the quarter. This prompted the company to announce it is aiming to cut 1 billion virgin PET plastic bottles out of the supply chain over the next five years.
Meanwhile, Coke is seeing a positive response from consumers for its smaller can sizes and for Coca-Cola Zero Sugar. Products with smaller packaging are growing at a double-digit rate, and Coke Zero saw sales climb by 14% year to date, which contributed to volume growth.
Additionally, Coca-Cola has launched Coke Energy in more than 25 markets and will launch the product in the U.S. in 2020. An analyst with Guggenheim believes Coke Energy could generate $200 million in sales. While that's tiny compared to Coke's $34 billion in total revenue, it could go a long way toward winning over younger consumers, whom Coke needs to drive long-term growth.
Coke seems to be making progress connecting with millennials with recent marketing efforts. There is still a lot of work to do to reach a new generation of consumers, but CEO James Quincey said that there has been "some reconsideration of the category" by millennials in the sparkling beverage category.
Cash generation should support further dividend increases
All in all, management likes the momentum in the business and is calling for full-year organic revenue growth of at least 5%. More importantly, strong underlying performance is fueling a significant increase in free cash flow, up 41% year to date, which is important for future dividend increases.
Consumer staples stocks are great for those who like income. Coke's dividend yield currently sits at 2.94%, but it's important to note that Coke's payout as a percentage of free cash flow has been hovering around 100% over the last year. (Anything above 100% is unsustainable since a business cannot afford to distribute more than it brings in.)
Coke currently pays out 83.5% of its trailing-12-month free cash flow as dividends, but for CFO John Murphy that's a little too high for comfort: "Free cash flow, look, we've been pretty clear as we've gone around, which is we have a dividend coverage which is not where we want it to be. We've set ourselves a target of expanding that, but also made the clear point that it would clearly be our intent to see the dividends continue to grow."
It's encouraging that free cash flow has improved this year, which is partly due to lower restructuring costs and productivity investments. Management wants to grow earnings per share faster than the dividend and to grow free cash flow faster than earnings. Earlier this year, Coke announced its 57th consecutive annual increase in the dividend (continuing its status as a Dividend King). With sales improving and free cash flow rising, that streak should continue in 2020.