The internet has made our life easier in so many ways. It has become a great place for experts to share their views and ideas with the world. Sometimes we come across good investment write-ups on the internet that we’d like to bring to your attention. In this piece, we are going to discuss an investment thesis by a Reddit user on The Coca-Cola Co (NYSE:KO).
Coca-Cola is the popular stock among hedge funds tracked by Insider Monkey. There are 44 funds in our database with bullish positions in the beverage company.
According to the Reddit user, Redcards, Coca-Cola’s share price is depressed and the equity represents “a rare opportunity to invest in a misunderstood mega-cap that is set to expand margins, grow free cash flow, and increase returns on invested capital.”
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The investment thesis suggests that, at 23.4x next twelve months (NTM) earnings, Coca-Cola equity currently does not price in the upside offered by the forthcoming completion of its bottling operation restructuring efforts. Instead, it reflects the typical consensus story of whether volumes will either be LSD or MSD.
“Normalized earnings, through the noise of the restructuring operations, show a business that is set to return capital to shareholders after several years of disappointing returns (~5.0% P.A. excl. dividend 2012 – Present),” according to the thesis.
The Coca-Cola Co (NYSE:KO) produces syrup concentrate used in the production of various carbonated and un-carbonated beverages that are sold to bottler partners on a global basis. The bottler partners make the finished product, sale, and distribute products to retail stores, vending machines, restaurants, and food service distributors.
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The thesis suggests that 60% of the Coca-Cola’s FY16 revenues were generated through the sale of finished products while 40% was derived from the sale of concentrates. The United States was responsible for 48% of the company’s FY16 revenues while 52% came from international sales.
Coca-Cola maintains equity investments in its bottling partners and receives both equity-interest income and dividends. The market value of these investments is around $20 billion, according to the Reddit user.
Over the past three years, The Coca-Cola Co (NYSE:KO) has been restructuring its bottler relationships across Europe, China, Japan, Africa and North America. The company expects to complete bottler restructuring by the end of 2017.
Coca-Cola is divesting its interest in bottling rights to various partners “because their national scale is too large to adequately invest in the local-level relationships necessary to build high-margin bottling operations,” suggests the thesis.
Cash flow from the restructuring has been slow to materialize which is why I suspect these activities are never more than a brief footnote in consensus research. 2014 and 2015 proceeds from re-franchising was $713mn while 2016 proceeds were $2.3bn plus another $2.4bn from the sale of Keurig to JAB Holding Co. Proceeds through the end of 2017 should come in around $4.5mn from the sale of Chinese bottling operations, divestiture of remaining North American operations, plus dividends and income from bottling equity investments.
Management has been quiet about their capital allocation intentions for these proceeds, but suffice to say they have some levers to pull. Before serious returns to shareholders can begin there are a few obligations KO needs to meet first. $3.2bn to Anheuseur-Busch InBev for their interest in CCBA which should be paid 4Q17 (KO intends to immediately sell the CCBA bottling franchise after this, so maybe it is fair to say this transaction nets out). $3.3bn debt matures in 2018, $4.5bn in 2019, and $4.4bn in 2020.
Talking to valuation, the Reddit user said that Coca-Cola will earn $4.9 billion FCF per year based on the assumptions of 0.0% revenue and EBIT growth. With an additional $4.5 billion from 2017 activities, the company will be able to meet all of their upcoming obligations, including scheduled share repurchases and dividend hike, without raising additional debt.
More from Redcards’s investment thesis on The Coca-Cola Co (NYSE:KO):
In fact, at 2.5x net debt, KO has room for an additional full turn of leverage (approx. $10bn debt) that could be returned to shareholders while comfortably maintaining interest coverage.
But how do normalized earnings look? KO earns a 4.3% pre-tax margin on LTM bottling revenues of $15.9bn. Backing out bottling, KO earns $14.2bn normalized LTM EBITDA and $11.4bn LTM FCF (EBITDA – capex – cash interest) (5.1% yield). Company bottlers earn an average 7.5% pre-tax margin on bottling revenues. Assuming 0.0% growth from acquisition of bottling operations, equity income to KO should grow ~41.0% to $1.4bn given a potential ~70.0% growth in bottling pre-tax income to $1.2bn from $0.7bn (calculated as pro-rata KO share of margin uplift plus historical growth of legacy equity income).
On flat revenues and margins, this will result in ~$12-13bn FCF per year for KO. This is also likely understated due to the real volume benefit gained by better performing bottling operations (KO gains revenue uplift from selling more syrup to bottlers as well as a % of income due to equity ownership). Maybe a more likely scenario would be in the range of $15bn FCF (6.7% yield) per year for KO with unheroic, LSD volume growth. After debt repayments and other obligations this leaves at least an extra $3bn FCF per year for shareholders without adding incremental debt.
On top of this, KO ex-bottling operations will have $37.5bn invested capital (down about $5bn pre-restructuring). On normalized LTM EBIT this yields an ROIC of 33.9%. A 6.7% yield seems like a good deal for a $200bn market cap business with entrenched competitive dynamics that sustains a 30.0%+ return on invested capital.
For its third quarter, Coca-Cola reported a 15% decline in revenues to $9.1 billion due to an 18-Point headwind the ongoing refranchising of bottling territories. Its quarterly profit was $1.45 billion, versus $1.05 billion in the prior year’s quarter.
Meanwhile, shares of The Coca-Cola Co (NYSE:KO) are up over 11% so far this year. During the last 12 months, the stock has climbed more than 9%.
