Coca-Cola’s Business Model Not Immune To The Virus (NYSE:KO)

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Hammered

Coca-Cola (KO) share price has declined from a high of $60 back in February to $46 as of this writing. That’s a decline of about 23%. The COVID-19 outbreak has significantly changed my opinion regarding the company’s future in the near-to-medium term. The reason for this is its exposure to away-from-home channels, which includes sales to bars, restaurants and events. Approximately 50% of Coca-Cola’s revenues stem from this segment. We got a sneak peek into the effect that the lockdowns and social distancing measures has on the company’s business in the first-quarter earnings release. Spoiler alert: it isn’t pretty. Volumes were down 25%, and most of this was due to a decline in away-from-home sales.

This evidence leads me to believe that Coca-Cola will face significant headwinds in the coming years and, therefore, that the share price will remain flat at best or even experience a further decline from current levels, i.e., sell KO.

Oh, what a difference three months make

I remember it like yesterday. I sat on my friends couch on a Friday night talking about this and that before we eventually started talking about stocks (which I always end up talking about with this particular friend). KO had just hit $60, and I was contemplating exiting my position as the valuation had become sky-high. I believe it was 29x (historical) at some point, a ridiculous multiple to put on a company that grows its main KPI (unit cases) in the low single digits. My friend told me it would probably be a good idea to realize a portion of the position to lock in some gains, but in the end, I decided against it, as I convinced him (and mostly myself) that I’m an investor (as opposed to a trader) and therefore in it for the long haul. The business appeared solid, and I had no sleepless nights with regard to Coca-Cola’s ability to honor its commitment to pay a growing dividend. Besides, had I listened to him, I would already have sold when it hit $50 and lost a paper gain of $10. Fast forward three months and here I am a seller at sub-$50. What happened? Before we dive into the thesis, let’s consider how the company was doing until COVID-19 hit.

Coca-Cola’s management has added shareholder value through strategic repositioning

One of the most prominent companies in the world, The Coca-Cola Company operates in over 200 countries and dominates the non-alcoholic soft drink segment, with 4 of its brands included in the world’s top 5 (Coca-Cola, Diet Coke, Fanta and Sprite). The company’s biggest market is the US, which makes up 18% of total unit case volume sold. Although the company has developed new products in-house (Coca-Cola Energy is a recent example) and acquired new products (e.g., Costa Coffee), it is still dependent on its flagship product Coca-Cola, which contributed 45% of total unit case volumes sold during 2016-2019. More importantly, away-from-home channels make up approximately half of the company’s revenues. This half of the business is highly affected by the crisis, as we will soon see.

Coca-Cola’s management has made a conscious effort to improve the company’s profitability by divesting (refranchising) its bottling operations, which are low-margin compared to producing and selling beverages and concentrates. The strategy has begun to bear fruit, as operating margin have increased from approximately 21% to about 27% during 2015-2019. At the same time, revenues have declined due to the divestments. The net effect of the company’s higher margin and lower revenues were ambiguous for a while, but when Coca-Cola posted a top and bottom line (operating income) YoY growth of about 9-10% in 2019, it seemed to me that the strategy proved successful.

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In the graph below, we can see that Coke’s revenues and operating income were starting to move in the right direction. The company’s guidance in its 2019 annual report for financial year 2020 was for its top line to grow 5% and bottom line 8% (both non-GAAP).

Development of revenues and operating income

(Source: Coca-Cola Annual Reports 2013-2019)

Coca-Cola’s business model is not immune to the virus

In the first-quarter earnings release, Coca-Cola stated that it was on track to achieve its financial year 2020 targets before the impact of the measures to combat the virus started to creep into its financials (the company removed its guidance for the remainder of 2020).

For Coca-Cola, I usually follow revenues, operating income, unit case volume and free cash flow to the firm (FCFF), as they are a relatively quick read on its underlying business performance. First-quarter revenues, operating income and unit case volume were essentially flat YoY. You shouldn’t be fooled by a strong EPS figure, as it was mostly due to 1) a revaluation of fairlife (Coca-Cola acquired the remaining stake in the company and its existing position was marked up), which naturally has no impact on cash flow, and 2) a significantly lower effective tax rate. As a matter of fact, the figure that matters more than EPS, FCFF was down about $170 million (from $400 million to $229 million) mostly due to working capital effects. So, with these data points in mind, I wouldn’t call the first quarter spectacular. Actually, I would classify it as rather disappointing. It’s hard to say how much the pandemic affected the results, but even without it, the KPIs wouldn’t have been stellar.

Now, how has the pandemic affected Coca-Cola’s away-from-home business? Well, we can get an initial feel of the impact from the company’s first-quarter report:

For context, since the beginning of April, the company has experienced a volume decline globally of approximately 25%, with nearly all of that decline coming in away-from-home channels.

The ultimate impact on the second quarter and full year 2020 is unknown at this time, as it will depend heavily on the duration of social distancing and shelter-in-place mandates, as well as the substance and pace of macroeconomic recovery. However, the impact to the second quarter will be material.

Source: Coca-Cola 2020/Q1 Earnings Release

So, as the second quarter was roughly 3 weeks in, volumes had fallen an unprecedented 25%. Management realizes that the second quarter is lost. However, management has taken a half-glass-full approach and assumes that the impact is temporary and that the company returns to growth in the second half of the year. To wit:

The company believes the pressure on the business is temporary and remains optimistic on seeing sequential improvement in the back half of 2020. The company, along with its bottling partners, is continuing to adapt quickly to the current environment, with a focus on mitigating the near-term impact while positioning for success coming out of the crisis.

Source: Coca-Cola 2020/Q1 Earnings Release (available here)

And here’s where my view (naturally backed by evidence) of the future differs from company management. Consider the following:

  • Even if the economy opens up in the second half of Q2, the restrictions will be lifted gradually, which means that consumption in restaurants, bars and, especially, crowed-filled events won’t return to normal anytime soon. Not to mention the psychological impact on people, who may not feel comfortable ordering a Whiskey Coke (or something else with Coke) in their local joint as long as there is a risk of catching the virus.
  • It’s not clear that there won’t be a second or even a third wave of infections, which would effectively extend the lockdowns (although they may not be as restrictive) and social distancing measures. Perhaps the expert in the field, Dr. Fauci, states that a second wave is inevitable.
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So, extrapolating those two points to their logical conclusion would mean that half of Coca-Cola’s business may be impaired for a considerable time, possibly all the way beyond the first half of 2021. Consider the back-of-the-envelope estimates of the company’s revenues and operating income for FY2020 I took the liberty to scribble down. I have extrapolated the first 3 weeks of April as an indicator of how the whole year will turn out for Coca-Cola, although instead of 25% reduction, I have conservatively (or aggressively?) assumed “only” a 20% reduction in revenues and approximately 17% to operating income due to the fact that company management felt they could increase margins slightly in 2020 (from 27% to 28% in this estimate).

FY2020 estimate of revenues and operating income

(Source: Coca-Cola Annual Report 2019 and author’s analysis)

If the reduced sales prove temporary (i.e., volume in the second half of 2020 is back to pre-coronavirus levels), I’ll be the first one to admit I was wrong. However, assuming the impairment will be of a more long-lasting nature (due to the two points I introduced earlier), the demand will not rebound to pre-coronavirus levels in away-from-home channels in the near to medium term. What would happen to Coca-Cola in this scenario? Well, let’s look at the company’s financial position, i.e., the balance sheet.

The balance sheet wasn’t healthy before the crisis hit

I have pounded the table for a long time that Coca-Cola has propped up its returns by increasing leverage. As can be seen in the table below, financial leverage (“leverage”) has increased steadily from 2.9x to 4.9x during the period 2014-2020/Q1. Interest-bearing debt reached a peak of $36.7 billion in the most recent quarter. After the quarter ended, Coca-Cola issued $6.5 billion in new long-term interest-bearing debt at the end of April, bringing the total to $43.2 billion. The company may have retired some of the old debt with this issue, making the net increase somewhat smaller, which is why I use the reported figure at the end of the quarter, as it’s most reliable.

Part of the increase in leverage is also due to a decrease in shareholders’ equity from $30.3 billion in 2014 to $18.2 billion in 2020/Q1, which can in part be attributed to the company’s payout policy. More specifically, dividends have exceeded total comprehensive income for all years during the period (thus having a negative effect on equity). Adding insult to injury, the company has been buying back its own shares for approximately $18.2 billion during the same period, which has a further decreasing effect on equity. The increasing dividend and share repurchase program are not sustainable. Basically, the company has paid out more cash than it has generated. Coca-Cola’s management must have realized the same thing, as the company stated in its 2018 Annual Report that it will “… repurchase shares to offset dilution resulting from employee stock-based compensation plan”. Before 2019, it had repurchased shares well in excess of that.

Debt burden

(Source: Coca-Cola Annual Reports 2013-2019)

So, the company didn’t have a healthy balance sheet before the virus hit, as it has increased leverage and paid out more money than it has made (naturally, the two things are interconnected). The virus will only exacerbate these trends and may bring the most sentimental reason for investing in Coca-Cola into jeopardy, namely the dividend.

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It’s all about cash (and dividends)

Coca-Cola has raised its dividend for over 50 consecutive years, which makes it what is commonly referred to as a Dividend King. This is, of course, an impressive feat for any company, although it bears mentioning that the dividend growth rate has been decreasing during the last decade. Coca-Cola declared a 1 cent increase (or 2.5%) in the first quarter of 2020, and as things currently stand, the company will be able to keep it at that level for the remainder of 2020. However, the internally generated cash will not be able to cover the dividend and capital expenditures, which means that part of the dividends will be financed by debt. Coca-Cola already raised $5 billion and $6.5 billion in long-term interest-bearing debt during the first and second quarters of 2020 respectively, which seem to be precautionary measures against declines in sales and maintaining its ability to pay its dividend.

Look, I’m not saying that Coca-Cola won’t be able to increase its dividend for a measly 1 cent per share for the next couple of years, but what I am saying is that it’s probably the most that any investor can expect from the company going forward as things stand right now. More importantly, the dividend increases will not be sustainable, as they have to be financed by debt in a scenario where we have a second and a third wave of virus infections. In addition, Coca-Cola doesn’t have any extra cash for significant share repurchases, and the best case is a scenario where the company is able to offset dilution resulting from the employee stock-based compensation plan (which would also be financed by debt).

To throw more fuel in the fire (when it rains, it pours), consider Coca-Cola’s acquisition of Costa Coffee, which primarily operates retail outlets and most of them in the UK. The UK has been in lockdown for a couple of months already. I can’t imagine a worse situation for a coffee retail chain than a lockdown. Business has been very slow as the company closed all its stores as of 23rd March and could be dramatically altered in a “new normal” where people don’t go to retail coffee shops in the same volume as before (not to mention all the accounting implications, such as goodwill impairment, which would have a significant negative impact on earnings). Since the beginning of May, Costa has gradually started to re-open stores (70 so far), which is still a fraction of its over 2,000 stores in the UK.

Implications from analysis of Coca-Cola’s business immunity to virus

As most readers have interpreted from reading this article, I’m fairly pessimistic regarding Coca-Cola’s future. My thesis is based on assumptions that away-from-home channels won’t rebound nearly as fast as company management thinks or, even more drastically, that it will never reach the same levels as before the crisis. Nobody knows for sure how a post-coronavirus world will look like, and that is exactly the risk in today’s investing environment. The future economic environment has not been this uncertain since the Global Financial Crisis. Due to this known unknown, particularly in away-from-home channels, I decided to sell my KO shares and will stay on the sidelines until we know more about consumption habits in a post-coronavirus world.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.