Coca-Cola's New Cost Savings, Marketing Will Shoot Stock Higher

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Growing up in a communist country I remember the times when Coke (NYSE: KO) drinks were illegal and if you had a smuggled can from abroad you would usually drink it during a holiday and after that make a pencil holder out of the can. Today, Coke is sold freely around the world including the former communist countries in Europe, while its profitability in the United States is lagging due to competitive pressures and the bad publicity associated with flavored carbonated drinks made from corn syrup or sugar. While some states even went as far as to ban the consumption of soda in schools with limited results, I believe that Coke is well positioned to continue rewarding its shareholders.

The stock is trading at around $72 and pays $0.51 per share for a decent annualized yield of 2.8%. During 2011, the company outperformed the S&P 500 returning 6.4% compared to a slight decline of 0.20% for the index and returns of 1.6% for its major competitor Pepsi (NYSE: PEP) and 12.3% for its smaller competitor Dr Pepper Snapple Group (NYSE: DPS). In my opinion, Coke is a well-run company which is the better investment among the three since it is more focused than Pepsi (it does not sell snacks) and more global than Dr. Pepper.

I estimate the company to earn $4.10 in 2012 which is a growth of 11% from the $3.69 earned in 2011. In addition, it will payout about 50% of its earnings ($2.04) in dividends in 2012 which makes the dividend secure given that the company has increased its annual dividend for fifty consecutive years. The company recorded a net cash increase of $4.3 billion in 2011, after spending the same amount on paying dividends. Further, Coke carries an investment on its books of $4.5 billion in certain publicly traded bottlers whose fair value is $10.7 billion or a $6.2 billion difference not accounted for.

Compared to Pepsi, Coca-Cola stock is more expensive since I estimate Pepsi to earn $4.10 in 2012 but its shares are trading at $65 for a 2012 price to earnings ratio of 15.8 while Coca-Cola 2012 price to earnings ratio is 17.6. Also, the five year price to earnings growth ratio of Coke is 2.9 compared to 2.1 for Pepsi also signifying an undervalued Pepsi. The reasons I like Coke more is that it is a more focused company with products that have larger market share and overall the company has better margins than Pepsi. From a profitability standpoint, Coke has a 22% operating margin compared to 15% for Pepsi and 17.3% for Dr. Pepper. Also, with an increase in inflation, I believe that Coke will be able to weather cost increases better as it is focused entirely on drinks while Pepsi depends to a higher extent on food and farm produce prices. Finally, Coke has a long-term debt to capital ratio of about 28% compared to 49% for Pepsi and 45% for Dr. Pepper. Clearly, Coke has more room to borrow and expand as well as more room for meeting its debt obligations.

Coke has great exposure to growing markets and, for example, its sales in China grew by 13% (12% sparkling growth and 1% still beverages growth) in 2011, and the company received 31% of its total 2011 revenue from Mexico, China, Brazil and Japan. While North America contributed 44% of net operating revenues it had the lowest operating margin at 11% stressing the competitiveness of the North American soft-drink market. The top three leading regions in operating margin in 2011 were Europe (64.7%), Latin America (63.9%) and Eurasia and Africa (40.6%) while Europe (30.4%), Latin America (27.7%), North America (22.8%) and Pacific (21.2%) regions contributed the most to operating income in 2011.

With synergies from the recent acquisition of Coca Cola Enterprise North America and a new cost saving initiative named Productivity and Reinvestment program, I estimate Coke to save well in excess of $500 million in 2012 which should more than offset the estimated cost-inflation of about $450 million. Also, I see Coke benefiting from its $11 billion marketing budget in 2012 and its sponsorship involvement in the Summer Olympics in London this year. In North America, we recently experienced the warmest March on record and I believe the recent tendency to reach new high temperature every new year to also help Coke sell more of its soft drinks world-wide.

In conclusion, I believe that Coke is a stable investment which should not offer too many surprises on the upside or the downside. It pays a stable dividend and the company's sales have been growing organically and through acquisition at 14% per year for the past five years, compared to 9.6% for the average company in the S&P 500 index. If anything, I expect a surprise on the upside arising from lower commodity prices, higher synergies and outpacing of the competition. For decades, Coke has been able to do the same thing over and over – build its brand and sell its beverages worldwide. I expect the Coca-Cola success story to continue, hopefully, without reaching a level of demand where Coke cans will have to be smuggled or sold on the black market similar to when I was growing up.

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