Coca-Cola stock: Thirsty for a 3.5% dividend yield?

Whether you like sugary drinks or not, as a serious dividend investor you can hardly escape the Coca-Cola stock. The soft drink has many loyal fans. One prominent example is Warren Buffett, who has been enthusiastic about Coca-Cola as a beverage and as an investment for decades. I also know people drinking more Cola than water. The Coca-Cola Company has positioned itself at the top of the beverage industry over the years. Thanks to its protected brands and secret recipes, the business model is essentially untouchable, as the brand recognition cannot be copied by competitors. Whether you can also benefit from this as a shareholder, you will find out in this analysis.

In the following, I will use the terms “Coca-Cola” and “Coca-Cola Company” as synonyms for the company.

Coca-Cola Stock
Logo
Country	USA
Industry	Beverage
Isin	US1912161007
Market Cap.	203.2 billion $
Dividend Yield	3,5%
Dividend Stability	1.0 (max. 1.0)
Earnings Stability	0.84 (max. 1.0)

The business model: How Coca-Cola earns money

The Coca-Cola Company is mainly associated with its soft drink with the same name. However, the product range adds a variety of other beverages. These include several heavyweights, such as Sprite and Fanta. The company also owns brands for water & sports drinks, juices, as well as coffee & tea. The Coca-Cola Company is therefore much more than just a seller of a dark-colored soft drink. You shouldn’t underestimate these other business segments, because Coca-Cola plays a vital role in these as well. In the following chart you can see that Coca-Cola has the largest value market share in 4 beverage categories.

Market position of Coca-Cola Source: Company presentation

Although comparable products have been around for a long time, such as Pepsi’s Cola, many customers stick to their favorite brand. This gives Coca-Cola an extremely deep moat, as Warren Buffett would call it. This means that the Coca-Cola business model is very difficult for other companies to replicate. On the one hand, the recipe is secret and on the other, customers have become accustomed to the brand and the taste. A potential competitor would have to develop a “better” product in order to assert itself on the market. It is true that there are competitors who offer similar beverages. But these have not prevailed over Coca-Cola and most of them occupy niches at best. Coca-Cola’s business model is well protected against competitors and will therefore continue to generate profits for a long time to come.

The franchise business model

Coca-Cola is a franchise. This means that it allows other companies and private individuals to sell its products independently in return for a license fee. Coca-Cola supplies the syrup concentrate for the beverages and the franchisee then bottles and sells the beverages. Since the value of the concentrates mainly stems from the value of the brands and recipes, the profit margin of this business model is very high. Coca-Cola generates sales through the ownership of the brands and recipes and is able to keep costs low. By contrast, bottling the beverages is much less profitable. For this reason, Coca-Cola has focused its business model on the sale of concentrates in recent years and has sold some of its own bottling plants. If you read my analysis of McDonald’s last week, this strategy will already look familiar to you.

Why Coca-Cola is so profitable

Similar to McDonalds, Coca-Cola initially lost sales due to the restructuring, since the sales from bottling the beverages were now flowing into the pockets of the franchisees instead of Coca-Cola’s. In return, however, Coca-Cola receives royalties from the franchisees. This business model is much more efficient for Coca-Cola because it eliminates the costs associated with bottling. In addition, bottling is very capital-intensive because it requires machinery and buildings. With the realignment, Coca-Cola is saving these costs and is concentrating more on the sale of syrup concentrates. Their value is measured mainly by the brand and the recipe. Coca-Cola does not have to pay anything for the recipes because they have long been owned by the company. So, if Coca-Cola sells more concentrates, it only has to pay for the production. The knowledge from the recipes can be reproduced indefinitely and there are only minor additional costs for higher production. As a result, Coca-Cola can reduce overall costs, which in turn has a positive effect on profits. In the chart you can see that although the change initially resulted in lost sales, the operating margin increased due to the lower costs.

Development of revenues and the operating margin of Coca-Cola

What are the advantages of the franchise strategy?

You may have noticed that this strategy is basically the same as McDonalds’ strategy and wonder why many companies use such a tactic. This is because this concept has many advantages for the companies. As already mentioned in my McDonald’s stock analysis, the franchisor gives up the less profitable part of the value chain. Sales are lost, but there are also significantly lower costs, so that overall margins increase.  At the same time, the need for investment is reduced. It is true that investment expenditures fluctuate from year to year. But over the last few years you can see that these costs have been falling at Coca-Cola. This has a positive effect on free cash flow, which is an important indicator for investors because it shows the potential for distributions to shareholders. When capital expenditures decrease, free cash flow increases.

Capital expenditures of Coca-Cola

Are Coca-Cola’s dividends safe?

Coca-Cola’s business model has always been very robust since the demand for its products does not fluctuate all that much. This allows Coca-Cola to generate stable profits and cash flows. The expansion of the franchise model contributes to this stability with regular license payments. This is also important because regular income is necessary for dividend payments and increases.

Coca-Cola Dividend History

Coca-Cola has an impressive dividend history. For 58 years in a row, the company has increased its dividend, which earns it its status as a dividend aristocrat. These are companies that have been increasing their dividend annually for 25 years. Like most US companies, Coca-Cola pays its dividend quarterly. Following the recent increase to USD 0.41, shareholders now receive USD 1.64 per year. At the current share price, this represents a dividend yield of 3.5 percent. In the dividend turbo of Dividendstocks.cash you can see that the yield is above the 5-year average of 3.19 percent.

Dividend history of Coca-Cola Stock

Over the long term, Coca-Cola has always financed its dividend increases sustainably from the growth of profits and free cash flow. You can see that in the amortization power shown in the chart below. In the years with the green areas, free cash flow was higher than the dividend payment, meaning there was still money left after the dividend payment. The red area shows a deficit in the respective years. However, this was only the case in 2017 and 2018 and is due to a large, one-time tax payment that Coca-Cola had to pay in 2017. In 2018, one-time charges were also responsible for the deficit.

Amortization power of Coca-Cola

On the Dividendstocks.cash website you can see that the difference in these years was caused by one-time charges. The following chart compares the profit of Coca-Cola with the adjusted profit. In the adjusted profit, one-time charges are deducted. This gives you a better picture of the company’s profitability. Here, the adjusted profit is shown in brown and the profit in green. You can see that the adjusted profit was significantly higher than the actual profit, especially in the years 2017 and 2018. Since one-time charges should not occur again, you do not have to worry about the negative amortization power in these years.

Adjusted earnings per share of Coca-Cola

Are rising debts a threat to dividends?

Like many other companies, Coca-Cola has taken advantage of low interest rates over the last decade and has increased its debt significantly. Part of the new debt was used to buy back its own stock. You can see this in the debt chart from the fact that the total number of bought back shares has risen along with the debt. Many people are concerned about this trend towards higher corporate debt.

Increase of both debt and treasury stocks of Coca-Cola

However, looking at the nominal debt level is not enough. Equally important is the interest expense. This is the amount that a company has to use each year to pay the interest on the debt. If you put this interest expense in relation to the operating profit, you get the coverage ratio. This is the fraction of the operating profit divided by the interest expense, i.e. it indicates how often a company could cover its interest obligations with the operating profit. The rule here is: the higher the better. In the chart you can see that both the interest expense and the coverage ratio of Coca-Cola have barely changed in recent years.

Interest expenses and interest coverages of Coca-Cola

If you look at the debt chart again, you’ll see why. Although the debt increased rapidly at the beginning of the 2010s, in the last 5 years the debt level has barely changed. Moreover, since the coverage ratio is sufficiently high, the debt is not problematic.

Is the Coca-Cola stock fairly valued?

At the Corona-crash’s peak, the Coca-Cola stock seemed to be undervalued. Since then, however, the stock price recovered. Nevertheless, the current price is still below the fair values  as determined using the Dynamic Valuation tool.

Estimating the fair value of Coca-Cola stock

However, if you look at the forecast for 2020, you will notice that a reduction is expected in the fair values for the earnings and cash flows. This is because both earnings and cash flows are likely to be lower this year. The reason for this is the loss of sales in the restaurant industry due to the Corona pandemic. In 2020, some fair values are below, and some are above the current stock price. On average, Coca-Cola therefore appears to be fairly valued. Nevertheless, since a rapid recovery is expected in the following years, I still consider the Coca-Cola stock a decent investment at the moment. However, I wouldn’t call the stock undervalued at this point in time.

Conclusion: The Coca-Cola stock is a suitable long-term investment

Coca-Cola is a quality company with a solid business model and an almost untouchable market position. The company’s history of uninterrupted dividend increases has proven that distributions to shareholders are a priority. The portfolio of leading brands in the beverage industry ensures that Coca-Cola will continue to generate high profits in the future. This makes Coca-Cola a suitable long-term investment, as the business model is future-proof due to its moat. I consider the current stock price to be justified. However, the stock is not extremely cheap. You should put the stock on your wish list by setting a price alarm on Dividendstocks.cash.