Sunday, January 23, 2011

Rule #1 Analysis Blitz #10: Coca-Cola (KO)


This is the concluding post of the Rule #1 Analysis Blitz Series.  I had intended to write 10 posts in 10 weeks, but due to sickness and various other reasons, I was unable to stick to that goal.  Luckily, I was only behind a week or two.  So, I'll give myself 8 out of 10 for punctuality! :)

This week, I'll end with the company with which everyone is familiar: Coca-Cola (Ticker: KO).  Coca-Cola happens to be one of Warren Buffet's favourite companies and we will explore why that is the case.  Let's see if it meets Rule #1 standards!

Moat
You can download the completed Rule #1 spreadsheet here.

Coca-Cola is the ultimate example of a company with a brand moat.  Time after time, Pepsi has shown through blind taste tests that people generally prefer the taste of Pepsi.  However, most people I know, when ordering fast food, will order a "Coke" and not a "Pepsi".  When it happens that the fast food place only sells Pepsi, I get a little annoyed when I'm asked, "Is Pepsi ok?", when I asked for a Coke.  Heck, I don't even know if there's any difference in the taste, but just the thought that I'm not going to get a Coke frustrates me.  I won't go much further, but I think you understand well the power of Coca-Cola's brand.

Looking at the numbers, they look pretty darn good.  Considering Coca-Cola is a more than 100 years old, the growth is pretty spectacular.  ROIC is very high in the high teens to low 20s for the past 10 years.  EPS growth is at an impressive 14.3% over last 9 years.  BVPS and free cash flow growth are both excellent.  The only yellow flag I have is sales growth.  Sales dropped a bit last year and grew at single digits for the past decade.  As I said, this is a mature company, the sales growth numbers are not bad.  However, this is truly a yellow flag.  This trend cannot continue indefinitely.  If sales growth is slow, EPS growth will eventually slow because gross/operating margins cannot increase indefinitely towards 100%.  And of course, we all know that earnings is pretty key in the valuation of a stock.  So, it can be expected that, unless sales growth accelerates, EPS growth will likely decrease to the levels of sales growth.

Recently, Coca-Cola bought the North American operations of Coca-Cola Enterprises, which is the bottling company for Coca-Cola's products.  This is seen as a move to gain more control of how product move through the pipeline and also to enable better adoption of non-carbonated drinks as demand shift.  So, management sees this as a move to accelerate revenue growth.  At least, Coke knows what requires work in their numbers!

Coca-Cola gets a 10 for the qualitative portion of Moat, but overall, I'm going to give it an 8.

Moat Score: 8 / 10



Figure 1: Rule #1 Analysis of Coca-Cola (KO)

Margin of Safety
Unfortunately, Coca-Cola is overpriced right now.  At $63 right now, the stock has a P/E ratio of 19.4.  It's fairly high for a company whose EPS growth has been single digits.  For comparison, Apple (Ticker: AAPL) has a P/E of 22 right now and its year-over-year EPS growth was 78%!

Using somewhat conservative numbers of EPS growth of 9.0% and P/E ratio of 16.7, we come up with a sticker price of $33.03 and entry price of $16.52.  So, the share price is almost double that of its current value and almost 4 times that of its entry price!

Payback time is also at 10.9 years, which is way too long for stockpiling of the stock.

Coca-Cola gets a 2 out of 10 for Margin of Safety.

Margin of Safety Score: 2 / 10

Management
Muthar Kent is the CEO and Chairman of Coca-Cola.  He has a long track record with the company, starting his employment there as an entry level employee some 30 years ago.  He worked his way up the ranks, left the company for about 6 years in the late 90s to mid 2000s, and finally returned to Coca-Cola and assumed the CEO position in 2008.

Kent comes from an interesting and noble background.  His father, Necdet Kent, is nicknamed "Turkish Schindler" for helping saved many Jews during the second World War.  Kent was born in New York City, when his father was consul-general there.  He grew up in Turkey, was educated in the UK, and worked in the US (later back in Turkey).  He definitely has led a cosmopolitan career, which is almost a requirement for the CEO of such an international company.

Kent has ownership of about 68000 shares of KO, which is worth about $4.3 million.  If you compare this to ownership of, say, Google executives, this is peanuts.  Is this a cause for concern?  Maybe...But do keep this in mind: Kent only rejoined Coca-Cola a few years back and has been CEO for less than 3 years.  Also, he has not sold many KO shares recently.  So, my guess is that he has only started to accumulate his ownership of KO shares.  As much as most of us think executives of big companies are billionaires, they are probably far and few between.  These billionaires are likely produced "overnight", when their creation transformed from a startup to being an industry stalwart within a few years (read Microsoft, Google, Facebook, etc.).  Kent is not one of these billionaires! His net worth, I'm guessing, is probably around $20 to $50 million.  Having $4 million, or 8 to 20% of ones net worth in his own company stock is probably pretty significant.

Looking from all angles, Kent seems to be a trustworthy, reliable, and ethical leader.  There is some degree of uncertainty due to his short tenure as CEO at Coca-Cola, but I believe in the years to come, he will demonstrate his leadership.

Management Score: 8 / 10

Meaning
Who doesn't like Coke in this room?  Didn't think there were many of you!  Unlike some people I know (my cousin), I don't live on Coke.  It takes a couple of parties at my house to clear out the 2 cases of Coke in my basement, but that is exactly the power of the brand.  I consume maybe 1 to 2 Cokes in a month, and yet, I still have 2 cases of it sitting in my basement.  It is the universal beverage!  When someone comes over to your house, what do you offer them as a drink?  It's either a coffee/tea (depending on your ethnic background) or a Coke.  Coca-Cola is universal.  Does it have meaning to me?  You bet!

On the ethical side of things, is the drink itself ethically positive, negative, or neutral?  No one has ever praised Coca-Cola for being a healthy drink.  It has plenty of calories, lots of sugar, some caffeine, etc.  Diet Coke or Coke Zero is no better.  Just the thought of drinking something tasty but has zero calories tells me something is wrong.  However, many products out in the world are not good for you.  You can argue that oysters are not good for health because they have high levels of cholesterol.  But as with all things, Coke needs to be taken in moderation.  Like myself, I can freely enjoy a Coke whenever I have it, because I don't drink it 3 times a day.  So, I don't necessarily buy the argument that because Coke does not contribute positively to your health, then it is an unethical product.  The product itself is neutral at worst.  Having said that, Coca-Cola also produces healthier products like Minute Maid, Dasani, Nestea, Powerade, etc.

Coca-Cola is a company that supports gay/homosexual rights.  I talked a bit about this issue in my Google post.  Although this is not something Catholics would like to see, it is not something that would cause the USCCB to withdraw its investment funds.

There has been some complaints in Coca-Cola's business practices.  One example involves a Coca-Cola bottling plant (which may not even have been owned by Coca-Cola, but rather, Coca-Cola Enterprises, which is a separate company...but, we'll assume Coca-Cola is the culprit) in India where the bottling plant has caused a decrease in groundwater, in an already poor area.  Another example is allegations that union activists were dealt with in a violent manner in Latin America.  Where there's smoke, there is fire...so, I'm sure that these allegations have some merit.  In a corporation as large as Coca-Cola, you can be sure to find some part of the company that has less than desirable business practices, especially in developing countries.  This is not to give Coca-Cola an excuse, but it does not appear that the problem is systemic.  In North America and Europe, Coca-Cola has had a good reputation in its business practices and all-in-all, I don't see too great of a concern over the company's ethics.

Meaning Score: 6 / 10

Summary
Moat Score: 8 / 10
Margin of Safety Score: 2 / 10
Management Score: 8 / 10
Meaning Score: 6 / 10
OVERALL (not an average): 4 / 10

If only the shares were not overpriced, I'd probably invest in Coca-Cola too.  Warren Buffet has about $11 billion in Coca-Cola.  So, there's probably some merit to owning KO.  I'd wait for a dip in price!

And so, this concludes my Rule #1 Analysis Blitz.  If you've enjoyed it and would like to see more, please leave me a comment and also the company you'd like to see.  I'm probably going to continue this kind of post, but it'd be done in a lesser frequency.  I'm also open to constructive criticism!  Thanks for reading!