Coca-Cola: Long past its prime? It doesn't hinder "steady happiness."

Coca-Cola: Has Coca-Cola Already Lost Its Appeal? It Doesn't Hinder "Steady Happiness"

In the previous article, we thoroughly analyzed Coca-Cola's business model and delved into the operational "codes" behind its success from the perspective of three factors in consumer goods. In this article, Dolphin will take a different perspective, using the company's solid financial data as a "magnifying glass" to quantitatively address these key questions:

Where does Coca-Cola's high ROE come from?

What are the changes in Coca-Cola's valuation at each stage & what are the driving factors?

Is Coca-Cola still a good investment target currently?

1. Where does Coca-Cola's high ROE come from? $Coca Cola(KO.US)

Warren Buffett once said, "If I had to choose one indicator to measure a company's operating condition, ROE would be the best choice." Therefore, in this article, Dolphin will explore Coca-Cola from the perspectives of finance, valuation, and growth along the line of ROE.

From the chart below, we can see that over the past 40 years since 1980, Coca-Cola's ROE has remained above 20% except for 2017 (in 2017, Coca-Cola globally sold off its bottling business, resulting in significant one-time losses such as employee relocation compensation and asset impairment). During this period, it peaked at 62% in 1997, which can be considered quite outstanding. (Based on data availability, we will analyze from 1980 as the starting point)

We use the DuPont analysis to break down ROE into three main "components": net profit margin, asset turnover, and equity multiplier for individual analysis:

Firstly, in terms of asset turnover, we can see that except for a slight rebound between 1986 and 1995 (in 1986, Coca-Cola merged its previously acquired bottlers and went public, temporarily improving efficiency by transitioning to a light asset model), the rest of the time has almost been a downward trend, dropping from 1.77 to a low of around 0.4, which has definitely dragged down ROE. This reason is actually quite understandable; as mentioned in the previous article, starting in 1980, Coca-Cola has been continuously acquiring and integrating bottling plants globally, and the value of the bottling segment is far lower than that of the concentrate, so the shift from a light asset to a heavy asset model is the key reason for the decline in the company's asset turnover. After 2015, Coca-Cola began to divest its bottling plants globally, and after returning to a light asset model, the company's asset turnover started to gradually recover.

Looking at the equity multiplier, Coca-Cola showed a significant increase during two periods: 1980-1986 and 2006-2017, while remaining stable during other times. These two periods correspond to Coca-Cola's two major rounds of borrowing for the acquisition and integration of bottling plants and global expansion. With the help of multiple rounds of quantitative easing implemented by the Federal Reserve after 2008, Coca-Cola seized the opportunity to issue bonds extensively, with the long-term debt ratio soaring from less than 7% to over 35%. As a result, the release of leverage drove the increase in Coca-Cola's equity multiplier, which in turn boosted ROE.

Net Profit Margin: The Stabilizer of High ROE; excluding extreme years (the Asian financial crisis in 1999 and the large-scale sale of bottling businesses in 2017), it can be observed that Coca-Cola's net profit margin has continuously and steadily increased from 7.5% to 23.4% since 1980. How did such an excellent net profit margin performance come about?

We further dissect the net profit margin into gross margin and expense ratio:

Gross Margin: As seen in the chart below, Coca-Cola's gross margin increased from 43% in 1980 to 68% in 1998, and has maintained a level above 60% for nearly 20 years. We will discuss this in two parts: 1) Why did Coca-Cola's gross margin increase significantly from 1980 to 1998?

On one hand, starting in 1980, against the backdrop of a sharp rise in international sugar prices, the company began using high fructose syrup instead of sucrose. From a cost perspective, high fructose syrup was priced at only 70% of sucrose. By 1985, high fructose syrup had completely replaced sucrose in all Coca-Cola products in North America, significantly reducing raw material costs and opening up profit margins.

On the other hand, in 1986, after integrating the previously acquired bottling plants (mainly in North America and Western Europe) and spinning them off for listing, Coca-Cola transitioned to a light asset operation, focusing on high-value concentrate segments, which naturally led to an increase in gross margin.

2) Why has Coca-Cola's gross margin been able to maintain above 60% since 1998?

Since the 21st century, from a cost perspective, most consumer goods companies, including Coca-Cola, have experienced three global crises that led to inflation due to massive monetary easing (the 2007-2008 financial crisis, the 2010-2011 European debt crisis, and the post-pandemic period in 2020).

During each cost upturn, the increase in operating costs such as raw materials, packaging, and transportation generally exceeded 20%, with a corresponding impact on gross margin of over 8%. However, we found that during the three cost upturns, Coca-Cola's gross margin did not decline by more than 3%. The answer is actually two words—price increase! **

In the previous article, we mentioned that after the 21st century, Coca-Cola signed a new pricing system with bottlers, where the price of concentrate is set as a percentage of the bottler's ex-factory price, so a price increase by the bottler can be equivalent to a price increase by Coca-Cola.

Similar to beer, we found that during each round of rising costs, Coca-Cola's bottlers would moderately increase prices through direct price hikes and indirect price increases (reducing capacity, launching new packaging, etc.) in different regions, targeting different channels and products based on the extent of cost increases, thereby passing the cost pressure down to distributors and consumers. Since prices generally do not decrease after a price increase, Coca-Cola's profit margins can further improve when costs decline later.

Source: Company reports, Dolphin Research

To summarize, Coca-Cola has achieved an improvement in gross margin through raw material optimization combined with a phased light asset model, while the key to maintaining a high gross margin later lies in Coca-Cola's strong brand influence, which provides significant bargaining power in the supply chain, allowing it to pass on price increases to bottlers and downstream consumers during periods of rising costs.

Expense Ratio: Let's take a look at the expense ratio. From the chart below, we can see that from 1980 to the end of the 1990s, Coca-Cola's expense ratio first experienced a significant increase, rising from 30% to 43%. From 2000 to 2015, the expense ratio remained between 35% and 37% (the accounting standards changed in 2000, and the actual expense ratio remained stable that year). After 2015, the expense ratio significantly decreased from 37% to around 30%.

During the period from 1980 to the end of the 1990s, both Coca-Cola and Pepsi were in the expansion phase in emerging markets (such as Asia and Eastern Europe). At that time, Pepsi attempted to gain market share through price wars when entering emerging regions. In response to Pepsi's competition, Coca-Cola significantly increased its advertising and marketing efforts to narrow the gap with Pepsi. Entering the 21st century, the duopoly structure became solidified, and both companies maintained relatively stable shares among their core territories and main consumers. Pepsi slowed down its price wars and began to focus on building its brand image, so Coca-Cola's expense ratio remained stable during this period.

But the question is, why did Coca-Cola's expense ratio significantly decrease after 2015 while Pepsi's expense ratio remained stable? Dolphin believes there are two reasons:

1. Actively embracing emerging channels to achieve diversified and precise marketing transformation: With the rise of emerging marketing channels such as social media and e-commerce platforms, Coca-Cola's marketing methods have become more diverse and precise. For example, collaborating with various social media influencers to create creative videos and initiate topic interactions, establishing exclusive social accounts, and live-streaming sales. This series of strategies not only allows for more precise targeting of consumer groups, improving marketing effectiveness, but also reduces the investment costs associated with traditional advertising channels. In contrast, Pepsi still relies more on traditional marketing channels such as television advertising and offline events.

Source: Company reports, Dolphin Research

1. Streamlining brands and focusing on core products: In 2015, Coca-Cola implemented a "one brand" strategy globally, unifying its products, including Coca-Cola, Diet Coke (sugar-free), Coca-Cola Zero Sugar, and Coca-Cola Life (sparkling water), under the main Coca-Cola brand for marketing. Additionally, after 2017, Coca-Cola continuously streamlined its lower-revenue sub-brands, concentrating company operations, marketing, and channel resources on major products. To date, it has eliminated over 400 weak brands, and the integration and focus on branding have effectively improved Coca-Cola's operational efficiency and reduced operating costs.

Returning to our initial question, where does Coca-Cola's high ROE come from? The answer is clear: on one hand, it comes from Coca-Cola's expansion through leverage during low-interest periods; more importantly, it comes from Coca-Cola's continuously improving net profit margin. The increase in net profit margin is partly due to Coca-Cola's strong brand influence, which provides high bargaining power within the industry, thus maintaining a high gross margin level. On the other hand, it also relies on the company's continuous improvement in operational efficiency, leading to optimized expense ratios.

2. What are the valuation changes and driving factors for Coca-Cola at each stage?

In the previous section, we analyzed the secrets behind Coca-Cola's high ROE from a financial perspective. Now, let's review the valuation changes and driving factors for Coca-Cola at each stage from an investor's perspective:

From the chart below, it is clear that the valuation changes of Coca-Cola from 1980 to the present can be divided into three stages:

1981-1998: High overseas growth, accelerated expansion, and Davis double play. During this stage, Coca-Cola's market value rapidly increased from $4 billion to $160 billion, a growth of 40 times, with the valuation rising from 9 times to 46 times, and net profit increasing from $500 million to $4.1 billion. The valuation and net profit increased by 5 times and 8 times, respectively, a standard Davis double play! During this period, Coca-Cola accelerated its expansion into overseas markets, seizing opportunities to enter emerging markets in Asia, Africa, and Eastern Europe, while also expanding its market share in already entered regions such as Western Europe, Oceania, and South America, consolidating its leading position. The proportion of Coca-Cola's overseas business rapidly increased from less than 40% to 70%. The rapid overseas expansion is the core driver of valuation increase during this stage.

1999-2009: The "lost" decade, where "internal troubles and external challenges" resonated to cause a valuation decline. During this stage, Coca-Cola's market value shrank from $160 billion to $100 billion, with its valuation dropping from 46x to 20x, and net profit increasing from $4.1 billion to $6.8 billion. The valuation was halved, and the net profit CAGR slowed from 13% to 5%.

Externally, the company faced the 1998 Asian financial crisis and the burst of the internet bubble in 2000, leading to an economic recession that significantly reduced consumer spending willingness.

In terms of industry space, after the 21st century, the penetration rate of carbonated beverages in mature markets represented by North America gradually saturated, with a noticeable decline in growth rate; internally, Coca-Cola replaced its CEO in 2000, and the new management team implemented significant layoffs. Coupled with Coca-Cola's heavy asset model operation during this period, the continuous acquisition of underperforming bottling plants globally also lowered ROE. In summary, the main reasons for the valuation decline were the external economic recession combined with the company's own slowing growth and heavy asset model.

2009 to present: Light asset operation + high dividend drives valuation recovery. During this stage, Coca-Cola's market value rose from $100 billion to $260 billion, an increase of 160%, with valuation recovering from 20x to 30x and net profit increasing from $6.8 billion to $10.7 billion, with valuation and net profit increasing by 50% and 57%, respectively.

From a growth perspective, during this period, Coca-Cola's net profit CAGR further slowed from 5% to 3%, indicating that growth was not the reason for the valuation increase during this stage.

From the perspective of shareholder returns, it can be observed that Coca-Cola significantly increased its dividend payout ratio from less than 35% in 2009 to over 100% in 2017. Thus, the answer becomes clear: after experiencing accelerated globalization and diversified product development, Coca-Cola's growth rate stabilized, gradually transforming into a high-dividend stock. Coupled with the company's return to light asset operation after 2015, focusing on core business, in summary, high dividends + return to light asset operation are the core reasons for the valuation recovery.

III. How to view the current investment value of Coca-Cola?

In the previous text, we used a "magnifying glass" to dissect the reasons behind Coca-Cola's high ROE from an operational perspective and explored the changes in Coca-Cola's valuation and core driving factors at each stage from a valuation perspective. Now, from a telescopic view, how should we assess the investment value of Coca-Cola? 1. How is the growth potential?

Revenue Side: First, according to the disclosure from Coca-Cola, the company's nominal revenue growth (impacted by volume, price, exchange rates, etc.) can be broken down into six major departments: Europe, the Middle East & Africa (EMEA), Latin America, North America, Asia-Pacific, Global Venture Capital, and Bottling Investments. Each department's revenue growth can further be divided into three parts: organic revenue growth, structural impacts (mergers and acquisitions), and foreign exchange impacts.

Here, we focus on the company's organic growth, which we break down into volume and price forecasts: in terms of volume, considering that Coca-Cola has already passed the rapid penetration phase of globalization, future sales growth will vary by country and development stage.

Overall, sales growth in developing countries and emerging economies is expected to outpace that of developed countries. However, due to numerous variables, especially at the specific country level, performance fluctuations will be greater. Therefore, for sales, we use the average sales growth rate over the past five years in different regions as the future growth center;

In terms of price, although inflation in developed countries has eased, some emerging economies still maintain high inflation rates. Thus, we assume that future price growth will gradually slow year-on-year, but the growth rate will still be higher than that of sales (due to factors such as product shifts to higher-value combinations, new packaging, and new products).

Additionally, regarding structural impacts, we assume that after Coca-Cola divests its bottling business in India in 2024, it will remain stable, and the impacts of acquiring new brands and divesting non-core brands will offset each other, so the structural impact will remain unchanged after 2025; we also assume that the negative impact of foreign exchange will gradually decrease as inflation eases.

Based on the above assumptions, we arrive at a set of data indicating that in the next five years, Coca-Cola's sales and price compound growth rates will reach 2% and 7%, respectively, corresponding to an organic compound growth rate of 9%. Considering structural and foreign exchange impacts, the apparent revenue compound growth rate is around 5%. Dolphin believes that if we do not consider structural and foreign exchange impacts, purely from the perspective of organic growth, maintaining a revenue growth rate close to double digits for a century-old company entering maturity is quite impressive.

Profit Side: First, regarding gross margin, leveraging Coca-Cola's excellent ability to transfer inflation (price increases + optimizing product mix), we assume that Coca-Cola's gross margin will remain around 60%. As for the expense ratio, considering that Coca-Cola is a pioneer in the industry in using AI for decision-making and cost reduction (most regions have fully adopted AI for advertising production, and digital marketing is expected to enhance marketing efficiency and reduce cost inputs), there is still room for further decline in expenses.

Based on the above assumptions, the net profit margin is expected to continue to rise slightly. Specific data can be seen in the chart below, ultimately concluding that the apparent profit CAGR over the next five years is approximately 6.6%, higher than the revenue growth rate

2. What is the current valuation level?

From Coca-Cola's own valuation level, the average PE over the past decade has been 31.6X (normalized PE after excluding one-time events and other anomalies), and the current valuation of Coca-Cola is 29.6x, slightly below the average, which is not considered high.

From a relative valuation perspective, we compare Pepsi & Farmer, which have similar business operations (both are comprehensive giants in the soft drink industry). First, from the perspective of PEG, it can be seen that Coca-Cola & Pepsi are significantly higher than Farmer, indicating that without considering the impact of future company growth on valuation, the market gives Coca-Cola & Pepsi a higher valuation premium.

Dolphin believes the main reason lies in the different business models of the three (Coca-Cola & Pepsi operate with a light asset model, outsourcing production & distribution through franchising, while Farmer adopts a heavy asset operating model with self-built water sources & production bases). If we simply compare the valuations of Coca-Cola and Pepsi, we can see that Coca-Cola's valuation is relatively reasonable.

Is there an upward catalyst for Coca-Cola's valuation in the future? Let's return to the three factors that influence ROE:

First, regarding asset turnover, based on previous analysis, the key catalyst lies in the gradual reduction of heavy asset business by divesting bottling plants. Currently, Coca-Cola has basically completed large-scale integration and divestment of bottling plants globally, with the proportion of bottling investment business decreasing from 47% in 2016 to about 17% currently.

According to the company's public communications, the scope of future divestment of bottling plants will be significantly narrowed (currently only India, Southeast Asia, and Africa in developing countries remain to be divested), therefore the upward space for asset turnover is not large.

Regarding equity multiplier, the key influencing factor is Coca-Cola's debt ratio. Currently, Coca-Cola has passed the phase of rapid global expansion, and on the other hand, current interest rates remain high, with the central rate of U.S. long-term treasury bonds also above 4%, thus the motivation for Coca-Cola to significantly increase debt seems to be unfounded.

Finally, let's look at the dividend ratio. From a cash flow perspective, we use adjusted EBITDA - capital expenditures (mostly from intangible asset investments generated by mergers and acquisitions, here we use the average capital expenditure over the past 5 years) to represent Coca-Cola's dividend capacity. From the chart below, it can be seen that in recent years, it has almost covered the dividend expenditure, therefore, under the premise of not significantly increasing debt, Dolphin believes that the probability of Coca-Cola increasing its dividend ratio in the future seems very slim; Therefore, the potential drivers that can truly bring about an increase in ROE in the long term can only come from the improvement of net profit margins at the operational level.

From the perspective of absolute valuation, due to the high certainty of Coca-Cola's performance and its low sensitivity to economic cycle fluctuations, the β coefficient is relatively low. We estimate the WACC to be 7.9%, and finally, under the assumption of a 3% perpetual growth rate for Coca-Cola, we calculate the stock price to be $81.2, indicating a 30% upside potential compared to the current stock price.

Summary:

Based on the analysis above, it can be seen that although Coca-Cola has passed the phase of rapid globalization and the "sweet spot" of the Davis Double, no longer possessing a high-growth enticing story, its unique business model and the deep moat built by brand value have become the key for Coca-Cola to navigate through cycles. Therefore, Coca-Cola has also become an ideal "safe haven" for many investors during economic downturns.

From the current standpoint, the Dolphin believes that Coca-Cola remains a rare target among many investment options, with highly certain performance and reasonable valuation.

On the other hand, investors also need to consider that Coca-Cola's international business now accounts for over 60%, and the negative impact of exchange rates during a strong dollar cycle should not be underestimated. If the U.S. enters a rate-cutting cycle as expected in the future, the defensive attributes of Coca-Cola may become even more pronounced against the backdrop of a weakening dollar.

Past research:

Coca-Cola: Why is the "happy fat house water" the favorite of the "stock god"?