Coke's thirst for emerging market expansion has yet to be quenched.

by Thomas Mullarkey, CFA

Coca-Cola KO and its local bottling partners plan on investing an additional $3 billion in India through 2020. This investment, combined with prior commitments, means that from 2012 to 2020, the Coca-Cola system will invest $5 billion in India. Much of the investment will go toward adding capacity, expanding its distribution network, and rolling out more cold-drink equipment. We believe that success in India is critical for Coca-Cola's desire to achieve its 2020 vision to roughly double its global volumes. While the details of this investment are new, the concept is not. In order to double systemwide sales by 2020, we have long believed that the company would need to significantly invest in emerging and developing countries. Consequently, we are maintaining our $73 fair value estimate on Coke shares.

While India is home to 1.2 billion people (17% of the world's population), its citizens consume far fewer Coca-Cola products than the rest of the world. While the average American consumes on average 400 Coca-Cola products per year, the average Brazilian drinks 230 servings, and the typical Chinese has 38 servings per year; the average Indian drinks only around 12 eight-ounce servings of Coca-Cola products annually. This is well below the global average of roughly 90 servings per person per year. Coca-Cola India has grown case volumes in the country for over 5 years. While the company's Thumbs Up and Sprite brands are India's top-selling soft drinks, the Coca-Cola brand is seeing healthy growth, with volumes up 27% during the most recent quarter. Additionally, Coca-Cola's Maaza brand is India's best-selling juice drink.

Thesis 04/17/12

Coca-Cola's wide economic moat is bolstered by its extensive distribution network, which enables the company to deliver its products to consumers in more than 200 countries, as well as its bevy of powerhouse brands. While declining consumption of carbonated beverages in North America will serve as a near-term headwind for Coke, we believe international markets will provide plenty of growth opportunities over the long term. Absent any strategic missteps, we view Coca-Cola as a safe haven in an uncertain economic environment given that the firm has one of the widest moats in our consumer coverage universe.

Even though Coke's existing distribution network spans the globe, the company continues to invest for international growth. The company and its bottling partners intend to invest billions over the next few years in countries such as China, Russia, and Brazil, where per capita consumption is increasing in light of the burgeoning middle class. For example, annual per capita consumption of Coca-Cola products in China is just 38 servings, versus eight servings in 1998, and versus 403 servings in the U.S. We think that these investments will build out the firm's manufacturing and distribution footprint to such an extent that it would be too costly for a new entrant to duplicate, further solidifying the sustainability of the firm's competitive advantages.

Over the last decade, tastes have changed in mature markets as consumers have shifted from purchasing carbonated soda to still beverages such as juices, ready-to-drink teas and coffees, and enhanced water. To mitigate this falling volume and maintain share, Coca-Cola has been forced to broaden its portfolio deeper into various still beverage categories, which has enabled the beverage giant to leverage its vast distribution system and marketing might to continue to grow its worldwide volumes.

The pressure on bottlers' margins and the demands of the syrup makers for distribution and production flexibility have been sources of conflict for many years. Consequently, Coke followed PepsiCo's PEP lead by acquiring the North American operations of Coca-Cola Enterprises CCE. This acquisition is intended to eliminate these conflicts and to make the firm more responsive to changing customer demands. Although Pepsi was the first to control its North American bottlers, Coke's copycat move less than a year later shows that there is little that one of these beverage juggernauts can do that cannot be duplicated by the other. We think that Coke's strategy will nullify some of the competitive advantage that Pepsi had hoped to achieve in its route to market.

We believe that Coke's extensive distribution network and strong brands in almost every nonalcoholic beverage category should allow the firm to successfully generate excess returns on invested capital for years to come. We recommend buying the stock at about 15 times forward earnings, and thanks to its strong competitive advantages, we think that Coke should trade at a premium to other consumer staples firms.

Valuation

Following the company's healthy first-quarter results and continued solid execution on its 2020 vision, we are increasing our fair value estimate for Coca-Cola to $73 from $69. Our fair value estimate implies fiscal 2012 price/earnings of 18 times, enterprise value/EBITDA of 13 times, a free cash flow yield of 5%, and a dividend yield of 3%. We believe that Coca-Cola's wide economic moat and opportunities for continued growth merit above-average valuation multiples.

Volume and pricing are key drivers of our valuation model. We forecast Coca-Cola's top line to grow roughly 5.5% per year over the next decade, driven by roughly 3%-4% volume growth and 1%-2% pricing growth. Additionally, we believe that the company's operating margins should range between 25% and 27.5%, in line with Coke's average adjusted operating margin during the last five years. From our perspective, EPS growth should outpace top-line growth going forward as the firm utilizes the substantial free cash flow it generates to reduce debt and repurchase shares.

Our estimates for Coke's revenue growth and EPS growth are within the range of the company's long-term targets of 5%-6% CAGR for the top line and 7%-9% CAGR for long-term EPS growth. For 2012, we expect Coca-Cola to generate about $49 billion in revenue and $4.11 per share.

Risk

Coke's sales and profitability could be negatively affected beyond our forecasts by greater than expected increases in commodity prices, particularly for raw materials such as sugar, cocoa, and oranges. Ownership of the company's North American distribution platform will increase Coke's exposure to other commodities such as aluminum and plastic resins; the deal is also not without integration risk. With about 70% of revenue being generated outside the U.S., the firm is subject to currency and geopolitical risks in the overseas markets in which it operates. Sales of Coke's carbonated drinks could be hurt by negative publicity regarding the health concerns associated with drinks with high sugar content, and volumes of Coke's sugary drinks could be constrained should governments look to increase taxes on soda.

Management & Stewardship

Coca-Cola generally has a high standard of management stewardship. We attribute the firm's consistent execution during the difficult operating environment over the past several years to strong leadership from the top and a very deep bench. We are also impressed with management's focus on the company's 2020 vision, which emphasizes making the best decisions to grow the business over the long term, not just the next quarter.

Muhtar Kent is currently Coca-Cola's CEO and chairman. In general, we prefer to see these roles separated. Executive compensation is generous, but incentive-based pay does appear to be aligned with the long-term interests of shareholders. While six of Coca-Cola's 15 board members have sat on the board for more than two decades, the firm has recently added some high-profile new board members, including Howard Buffett (Warren Buffett's son), Evan Greenberg (CEO of ACE Limited ACE), and former Chicago mayor Richard Daley.

We applaud the firm for its adoption of majority voting, allowing shareholders to vote against the election of a director, but we think that allowing cumulative voting would further enhance the rights of the small shareholder.

Overview

Financial Health: 

Coca-Cola is financially healthy. Although the acquisition of CCE's North American bottling business measurably increased the firm's debt, interest expense, and pension expense, we believe that the firm's strong cash flows will enable the company to meet all of its financial obligations, invest for future growth, and grow its dividend. We forecast EBITDA to cover interest expense more than 40 times, on average, over the next decade, and forecast the firm to generate free cash flow of about 19% of revenue over our 10-year explicit forecast period. We currently assign Coke an issuer rating of AA-, implying very low default risk.

Profile: 

Coca-Cola is the world's largest nonalcoholic beverage company. The firm, which sells a variety of sparkling and still beverages, generates 70% of its revenue and about 80% of its operating profit from outside the United States. Coke's core brands include: Coca-Cola, Sprite, Dasani, Powerade, and Minute Maid. Following the asset swap with CCE, Coke now owns about 80% of its distribution in North America.