In early 2013, I made the controversial argument that Coca-Cola (NYSE:KO) -- one of Warren Buffett's biggest investments at Berkshire Hathaway -- might have become his worst. It's not that he has lost money in Coke stock. In fact, within a decade of Buffett's initial purchases in 1988, Coca-Cola had become a 10-bagger.
Rather, the problem was that Buffett's penchant for holding his favorite stocks forever has come back to bite him over and over again with Coca-Cola. It should have been obvious by the late 1990s that the stock had become overvalued. Sure enough, it slumped in the ensuing years.
By 2013, when I wrote my original article, Coke stock had finally clawed its way back to roughly where it had stood 15 years earlier. At that time, the stock looked significantly overvalued again, making it a good time to cash out. In the ensuing two and a half years, the stock has gone nowhere -- and it will probably continue to underperform in the coming years.
Coke stock flatlines
Since April 2013, shares of Coca-Cola have bounced around in a very tight range, making no progress. The stock does pay a decent dividend -- currently about 3.3% -- but that's not much compensation for missing out on the S&P 500's 25% gain during that time period.
The poor performance of Coke stock shouldn't have come as a big surprise, given that weak global soda consumption trends were already well established by early 2013. As a result, Coca-Cola posted full-year adjusted EPS of $2.01 in 2012 and grew that to just $2.04 by 2014. For 2015, analysts expect adjusted EPS to sink to $2.01 again, brought down by the strong dollar.
Despite this lack of profit growth, Coca-Cola continues to command a premium valuation of nearly 20 times projected 2015 earnings. Analysts expect EPS to grow modestly to $2.13 next year, which puts the stock at a lofty 18.6 times forward earnings.
The good news
Coke stock's high valuation implies that investors have some confidence in Coca-Cola CEO Muhtar Kent's turnaround plan. There are certainly some reasons for optimism. On the product side, the "Share a Coke" marketing program has been a huge success, stemming a series of declines in Coca-Cola soda volume.
On the cost side, the company announced nearly a year ago that it will cut $3 billion of costs by 2019. As the first stage of that program, Coca-Cola announced in January that it would cut up to 1,800 mainly white-collar jobs.
Coca-Cola is also in the midst of a multi-year project to refranchise most of its bottling and distribution businesses, reversing a foolish 2010 decision to buy its biggest U.S. bottler. Just this week, it announced that it will also sell nine production plants to three of its bottlers.
These moves will allow Coca-Cola to focus on selling syrup concentrate to its independent bottlers and marketing its products. They will also get Coca-Cola out of the lowest-margin, most capital-intensive part of its business. That will free up cash that the company can invest in growth and return to shareholders.
Here's the problem
Unfortunately, it's not clear where Coca-Cola can invest money to jump-start growth. Clever marketing campaigns can only do so much when people are increasingly turning away from both regular and diet soda due to health concerns. And with most consumer goods companies trading at relatively high multiples, Coca-Cola won't find many acquisition targets in the bargain bin.
Meanwhile, Coca-Cola has already lost about $1 billion on its $2.4 billion investment in Keurig Green Mountain. This move, along with a product partnership for the Keurig Kold home soda machine was meant to get Coca-Cola into a new growth business. However, Keurig Green Mountain is facing a mountain of problems, including resistance to high-priced coffee pods -- and the Kold system looks like a likely flop.
Coca-Cola could simply buy back stock if it doesn't have good ways to invest the capital being freed up by the sale of its bottling and distribution operations. However, with Coke stock being so expensive, it won't get a great return on that investment.
For example, if Coca-Cola had converted all of its $10.6 billion in operating cash flow from 2014 into free cash flow -- i.e. if it had cut net capex to zero -- it would have had about $5.3 billion in cash to spend on buybacks after funding its dividend. That would only have been enough to buy back 3% of its outstanding shares, which wouldn't make much of an impact.
Too much of Coca-Cola's profit is tied to the stagnant soda business for the company to generate respectable long-term earnings growth, even with the benefit of its cost-cutting efforts. Until Coke stock comes down to earth to reflect this limited growth potential, investors should continue to stay away.