Friday, January 24, 2014

Coca-Cola: A wide-moat dividend growth stock to buy and hold

In the past month, I purchased several hours of freedom, by adding to my position in the Coca-Cola Company (KO). I believe that Coca-Cola is a core holding for long-term dividend investors. This one time effort of investing in Coca-Cola will result in a lifetime of dividend payments which increase annually above rate of inflation. I like situations where most of the work is in the initial set-up, after which I receive cash in the mail every 90 days, for many decades to come.

I view buying shares in quality businesses such as Coca-Cola similar to purchasing time. For example, if you are an average person earning $20/hour, and you purchase 100 shares of Coca-Cola that generate $102 in annual dividend income, you essentially purchased 5 hours of time per year. That is five hours per year you will never have to spend working again. It gets even better - your dividend income raises will likely be much better than inflation and salary increases.

Everyone knows about what Coca-Cola does. Not everyone knows that this dividend king has managed to reward shareholders with higher dividends for 51 years in a row. It is one of only 17 companies in the US that has ever done it. Over the past decade the company has managed to raise distributions by 9.80%/year. In comparison, earnings per share have increase by 12.30%/year. The company has managed to reduce the amount of shares outstanding from 4.924 billion in 2003 to 4.498 billion in 2013, through regular share buybacks.

One of the largest investors in Coca-Cola is Warren Buffett’s Berkshire Hathaway (BRK.B). Coca-Cola fit the four filter criterion that Buffett and his partner Charlie Munger look for in a quality businesses, when they initiated their stake between 1988 – 1993. The four filters include:

1) Understandable quality businesses
2) Sustainable Competitive Advantages
3) Able and Trustworthy Managers
4) Margin of Safety in Valuation

Coca-Cola is a business that is not too difficult to understand. The company essentially sells drinks to consumers, and has a distribution network that allows it to reach consumers in as far out places as possible. The company sells several hundred brands of carbonated and non-carbonated drinks, to the tune of 1.8 billion servings/day. Coca-Cola sells high margin syrup concentrate to independent or partially owned bottling plants throughout the world, who then distribute it in their respective areas. Coca-Cola has significant bottling interests in the US, after acquiring operations from Coca Cola Enterprises (CCE) in 2010.

The competitive advantages of Coca-Cola include strong brands, and a distribution network that spans across the globe. For example, consumers who like Coca-Cola the drink, are going to keep drinking Coca-Cola and not drink PepsiCo (PEP) or put a generic brand Cola in their mouths. Coca-Cola also spends a lot of money on advertising, in order to create a positive association with the brand and strengthen the company’s image. The consumer loyalty also results in some pricing power, which should bode well for profits in the long-run. It would take a competitor a lot of money to take away the business of a company like Coca-Cola. In order to create the same type of brand loyalty, and distribution system, one not only needs a lot of money, but also a lot of time to earn customer trust. Therefore, I would say there are high barriers to entry. People would always need refreshments, which is why I think that Coca-Cola products would still be relevant to consumers 20 – 30 years from now.

I believe that Coca-Cola has able and trustworthy managers. It has a history of constantly executing its strategy in an otherwise very competitive food and beverage industry. Management has been able to diversify product line away from carbonated soft drinks and into things like waters, juices, etc. In addition, management is not focused on empire building for the sake of empire building, but seems to be intelligently allocating capital. They have done some diworsification deals in the past, such as the acquisition of Columbia Pictures in 1982, which was promptly sold a few years later, but by and large they have avoided the stupidity that other corporate managers have succumbed to. I like the fact that management is committed to paying and raising dividends to loyal long-term shareholders. I also like the fact that the shareholder friendly management is buying out weak hands, through consistent share buybacks. This makes each share that I own more valuable over time, particularly because net income and revenues are also growing.

In addition, I would think that the firm would sell for more than what it is selling for to a private buyer. In his analysis of Coca-Cola, Charlie Munger estimated a future value of $2 trillion for the company by 2034. When Buffett bought in 1988, he estimated that the value for a private business owner was twice the price he paid. Based on my understanding of global trends, consumption of Coca-Cola products will increase over time, as it is riding the wave of prosperity around the world. There are going to be hundreds of millions of people that will be lifted out of poverty over the next 20 years, and they would all want to engage in the same type of consumerism that most citizens of developed countries enjoy today. The level of consumption in places like China, India and Russia is much lower than that of places like US, which could translate into growth in volumes for a very long time. In fact, my conservative estimate for earnings growth is 7%/year for the next 20 years. If you add in 3% dividend yield, I would say that Coca-Cola can easily generate total returns of 10% for the next 2 decades. This of course is not a slam dunk, but I think this is a very likely scenario. A more bullish scenario would be for earnings per share to grow by 10%/year, using a 7%-8% net income growth, and 2- 3% in growth from share buybacks.

Currently, the stock is at the high end of my buy range, as it trades at 20 times estimated 2013 earnings. I managed to make my latest investment at an effective price of $38.20, because I had sold January 2014 puts at a strike 40 a few months ago. The puts were assigned over the weekend. I also have January 2015 puts with the same strike, which I hope to get exercised as well. I did purchase some stock over the past 5- 6 years when prices and valuations were lower, but I focused more on PepsiCo (PEP). Now I am working my way on building out my Coke position also. Everyone knows Coca-Cola is a quality company, which is why it demands a premium price.

After all, would you rather buy a business that is likely to deliver 7-10% dividend growth for the next 20 years at 20 times earnings, or would you rather buy a business at 10 -15 times earnings, which has the potential of dividend cuts during one of the next recessions?

Full Disclosure: Long KO, PEP and BRK.B

Relevant Articles:

Coca-Cola (KO): A Core Holding for Dividend Growth Investors
The Dividend Kings List for 2014
Strong Brands Grow Dividends
Capitalize on China’s Growth with these dividend stocks
PepsiCo (PEP): A Better Value than Coca Cola (KO)

8 comments:

  1. Interesting, but I wonder if you could explain (clarify) how the put options were picked up (assigned) over the weekend as KO hasn't been at $40 since Jan. 13 and only then topped at $40.13. Wouldn't it have made more sense for the buyer of the puts to have bought at ~$39 on the open market. Or is there something I am not understanding?

    Thank You

    Terence

    ReplyDelete
  2. Hi,

    I sold the option to a buyer. I was the seller of the option in 2013, and the other person was the one who purchased the option ( buyer)

    The put provides the buyer of the option the right but not obligation to sell his stock at the strike price. In this case strike price was $40. Since the stock was at $39.28 at expiration, he decided to sell his stock at 40 to me.

    So basically, I sold a put with a strike price of 40 in 2013, and received a small premium for this. This obligates me to buy KO at $40 in Jan 2014, if Coca-Cola stock traded at or below $40. If it traded above $40, the option would have expired worthless. Coca-Cola closed at $39.28/share on Jan 17, which was below 40.

    In reality, my broker makes this assignment automatically in my account.

    If the stock traded above 40, say $41, the option buyer would not have exercised the option. It wouldn't have made sense for them to sell the stock at $40 through the option, when they could have received $41 at the open market.

    Hope that makes sense!

    DGI

    ReplyDelete
  3. It's becoming clearer, but I find it confusing to get one's head around put/call options.

    In your case, I take it that you were obliged to purchase the shares on Jan. 17 at $40. This was worth it to you because the premium reduced your purchase price to $38+.

    Have I got it right?

    Thanks,

    Terence

    ReplyDelete
  4. Hi DGI,

    After this article, I plan on buying a few shares in the near future and auto reinvesting my divs. One can only hope the market selloff will last a few more days and a better entry point can be obtained.

    Keep up the fantastic work!

    ReplyDelete
  5. I think it is interesting that you started this post stating that you “purchased several hours of freedom”. I remember reading somewhere that most adults do not have enough passive income to last them one week for retirement. Basically they will be living on what they saved and whatever the retirement plans they have or Social Security they have earned. I for one don’t want to depend on these, which is why I want to grow my dividend income and other passive income streams to a point where I can live without the others.

    Great analysis on Coca-Cola (KO), it is definitely on my watch list, however I would like to see the price a little lower. After the sell-off the last two days Chevron (CVX) is in my sights for my next buy, which was mentioned in your last article.

    ReplyDelete
  6. Hi Terence,

    You got it! Options are a slightly more advanced topic. They can provide some opportunities, but also limit other opportunities also. I am jut dabbling in them, so I would not consider them the bread and butter of what I do.

    Daddio,

    Thanks for stopping by. I think KO could easily go lower from here. I am hoping that in 2014 prices start coming down..

    DGI

    ReplyDelete
  7. Jedsbud,

    Thanks for stopping by. I am like you in that I will try everything within my control in order to be in a situation where I can achieve FI.

    Every stock I buy is providing me with an income stream that will help me cover expenses, and not be reliant on my day job only.

    I agree with you that KO could go lower from here. That might provide better entry prices for investors. Especially if prices start declining..

    ReplyDelete
  8. What I like to do when grappling with numbers like 51 consecutive years of raising dividends, is to put it into perspective, by recalling all the seemingly apocalytic events that transpired over that time frame.

    In the case of KO, John Kennedy was President when this streak began!

    Now, consider all the doomsday events that rattled the stock market over the ensuing 51 years:

    The assassinations of a President, Martin Luther King & Senator Kennedy.

    The Vietnam War, riots on college campuses prompted by draft card burnings.

    Two bear markets in the 1970's, followed by stagflation, then inflation that saw interest rates top 15%.

    The oil embargos in the 1970s, and ensuing energy crisis when we told we would soon run out dry of the black gold.

    The Hunt brothers attempting to corner the silver market in the 1980s, and gold spiking to $850/oz back then.

    Financial crisis in late 1980s, a 1-day drop in the market of 25%!

    Presidential impeachment hearings, two gulf wars, a Presidential election decided by the Supreme Court, coutnless recessions, including the Great One brought on by the housing crisis, and on and on.

    Pundits predicted the end of the world every time, and for brief moments they were on the right side of the trade.

    But through all those apocalyptic events, KO methodically grinded out dividend increase after dividend increase.

    Can't think of a better measurement of a company's financial stregth & durabilty than dividend raises for more than half a century!

    Mike

    ReplyDelete

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