It's just one of the realities of investment writing that nobody's ever going to thank you for writing anything negative about well-loved stocks like Coca-Cola (NYSE:KO), Nike (NYSE:NKE) and PepsiCo (NYSE:PEP). But as these stocks have shown over the past year, valuation always matters; all three remain high-quality companies with incredible brands, but all were expensive a year ago and they have underperformed in the market. Although I see nothing fundamentally disturbing about Coca-Cola from a long-term perspective, I wouldn't be in a rush to pay the going rate for its shares.
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On Target, but not of the Highest Quality
Coca-Cola delivered essentially in-line performance this quarter, but how the company got there may trouble more fundamentally-inclined investors.
Revenue rose about 1% this quarter, with unit volume growth of about 4% and essentially flat pricing. North America, Europe and Latin America were pretty solid volume-wise relative to expectations, while Africa and the Pacific were softer than expected. With price and mix up about 3% in North America, however, it was a pretty encouraging result for not only Coca-Cola, but also PepsiCo and Dr Pepper Snapple (NYSE:DPS).
Core profitability was not as impressive. Pro-forma gross margin declined about 70 basis points, and adjusted operating income fell almost 6%. North American profits were up more than 2%, however, and it looks like a lot of the underperformance was tied to ongoing investments in the European and Pacific markets (which should even out over time). Unfortunately, Coca-Cola met its earnings target with a larger contribution from "below the line" items, so earnings quality wasn't very high this quarter.
SEE: Understanding The Income Statement
2013 Should be Better
Even a company like Coca-Cola is going to have the occasional year where global demand, cost trends and FX combine to create tougher conditions and disappointing performance. Looking on into the next year, however, some of the cost and currency headwinds should ease. Likewise, I would think that China ought to start getting better and contributing more to the company's volume growth.
Even so, it's likely going to take some time for the company to get back to the high teens/low 20s free cash flow margins. Acquiring bottlers and investing in growth markets such as India, China and developing Europe has altered the company's free cash flow profile and not in a positive way. These moves will likely improve the company's long-term growth and margin ceilings, but they represent "pay now, prosper later" decisions.
SEE: Free Cash Flow: Free, But Not Always Easy
More Water a Mixed Blessing
It's also worth noting that Coca-Cola's business mix continues to evolve over time and this too has consequences when it comes to margins and cash flow. Nielsen data suggests that Coca-Cola is gaining share in the water business, particularly with its Dasani brand. That's a mixed blessing, for while Nestle (OTC:NSRGY) (the category leader in bottled water) has certainly seen growth from this segment, water (particularly the Dasani brand) seems to offer lower margins.
Coca-Cola may be able to offset some of that with better sports drink sales, but it's not as though PepsiCo is going to just cede that share willingly. Along similar lines, the need to improve mix and margins may help keep rumors alive that Coca-Cola will eventually make a bid for Monster (Nasdaq:MNST).
The Bottom Line
I find myself in a familiar place with Coca-Cola's stock. Warren Buffett may still love this stock and it has delivered better than 5,400% performance over the past 30 years, but past performance doesn't guarantee future results. I do believe there is significant growth potential in developing Asia, Latin America and Africa, but a lot of that already seems baked into the shares.
If you estimate that Coca-Cola will grow free cash flow at a rate of 8-10% over the next decade (better than the trailing decade's growth of roughly 6%), you have to drop the discount rate to roughly 7% to generate a fair value close to $50. I'm just not willing to go that low with an equity discount rate, so I continue to maintain that although Coca-Cola is an incredibly well-run company with above-average growth prospects, the current valuation is just too rich for me to think it's going to be a long-term market-beater.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.