Does one thing really well
The Coca-Cola Company (NYSE:KO) sells carbonated soft drinks. It has done so for its entire existence and likely will continue to do so for decades into the future. More importantly, it is the best company in the world at selling carbonated soft drinks and no other company is likely to match it any time soon.
The Coca-Cola Company (NYSE:KO) earns higher margins than its peers. Although it manages an enormous distribution network that is near impossible to duplicate unless you are PepsiCo, Inc. (NYSE:PEP), the company’s margin advantage comes from selling its products at a higher markup. The company’s superior brand equity allows it to charge more for Coke than PepsiCo, Inc. (NYSE:PEP) can charge for Pepsi. That’s a powerful advantage.
As a result of having the best brand in the business, The Coca-Cola Company (NYSE:KO) owns the top market share — it owns a steady 40% share of the carbonated soft drink market, whereas PepsiCo, Inc. (NYSE:PEP) has less than 30% share and Dr Pepper Snapple Group Inc. (NYSE:DPS) has a 15% share.
The market share of all three companies has remained remarkably stable over the last decade, an indication of each firm’s ability to protect its share from new entrants as well as each other. Perhaps the chief reason each company can protect its share is customer loyalty. A person typically drinks one of Coke, Pepsi, or Dr Pepper Snapple Group Inc. (NYSE:DPS), but rarely drinks all three with any regularity.
The market entrenchment that leads to stable market share enables these companies to earn above-average returns on invested capital (ROIC).
Although Dr. Pepper Snapple’s decade-average ROIC is unremarkable, the metric has significantly improved over the last several years as the company reached scale.
Although PepsiCo and Dr Pepper Snapple Group Inc. (NYSE:DPS) are arguably great companies in their own right, I prefer The Coca-Cola Company (NYSE:KO) because it is focused on only one thing it does better than anyone else: carbonated soft drinks.
Analysts are raving about PepsiCo’s snack division, which is the largest in the world. It is no doubt a valuable asset — and one that Coca-Cola wishes it had — but it does not pose any threat to Coca-Cola in the carbonated soft drink business. In fact, as PepsiCo focuses more attention and investment on its world-leading salty snack position, Coca-Cola will be in better position in the carbonated soft drink market.
Meanwhile, Dr. Pepper Snapple is too small to pose a real threat to The Coca-Cola Company (NYSE:KO) and there are no similar companies that it could combine with to stage a legitimate challenge. Dr. Pepper Snapple lacks the distribution network and brand equity that enables Coca-Cola to sell its products profitably in over 200 countries. As a result, Dr. Pepper Snapple will have to be satisfied with its strong shares of niche markets — like sparkling drinks — and its third-best carbonated soft drink market share.
Free cash flow indicates likely investor return
Coca-Cola’s market position enables it to earn stable and predictable cash flows year after year; this makes valuation a relatively simple task.
The company produces $1.72 per share in free cash flow during 2012. $1.72 divided by its recent market price of $40.49 per share gives an initial free cash flow yield of 4.2%. Think of this like a bond that will pay an annual coupon of $1.72 per share.
However, Coca-Cola’s stock is not a typical bond — it is a bond with growing coupons. The company earned $1.72 per share in free cash flow during 2012, but it earned only $0.94 per share in 2003. The compound annual growth rate from 2003 to 2012 is nearly 7%.
The Coca-Cola Company (NYSE:KO) is like a bond selling at par that pays a 4.2% coupon — and that coupon has grown at an annual rate of 7% over the last decade. However, it will be difficult to maintain the same growth rate in the future, so perhaps a forward estimate of 5% annualized growth going forward will be more accurate.
If you combine the current 4.2% yield with a 5% annual growth rate in free cash flow per share, you get an estimated annual return of 9.2%. This should be much better than the market returns over the next few years, but it is not a screaming cheap stock since you have to pay up for growth.
Coca-Cola is a cheap stock today, but it will not be screaming cheap until that initial yield is closer to 10%.
The article Is Coca-Cola Finally Cheap Enough to Buy? originally appeared on Fool.com and is written by Ted Cooper.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola and PepsiCo. The Motley Fool owns shares of PepsiCo. Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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