Wide-Moat-Rated Coca-Cola and PepsiCo Taking Inflation in Stride, but Shares Look a Bit Expensive | KO Message Board Posts

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Msg  78 of 79  at  5/16/2022 12:16:49 PM  by


Wide-Moat-Rated Coca-Cola and PepsiCo Taking Inflation in Stride, but Shares Look a Bit Expensive

 Morningstar Investment Research Center  
Wide-Moat-Rated Coca-Cola and PepsiCo Taking Inflation in Stride, but Shares Look a Bit Expensive 

Chris Owen
Equity Analyst
Analyst Note | by Chris Owen Updated May 12, 2022

With leading brands and stout cost advantages, we’ve long believed that Coca-Cola (the dominant player in the carbonated soft drink—CSD—space, with nearly 21% value share per Euromonitor) and PepsiCo (the top operator in global savory snacks, with nearly 22% value share, and the second-largest player in the CSD market with 10% share) have carved out wide economic moats. From our vantage point, this edge has manifest in pricing power and negotiating leverage with suppliers, which we think will persist and prove particularly valuable as inflationary headwinds show no signs of diminishing.

While we think both Coke and Pepsi are poised to navigate the challenging landscape relatively unscathed, we don’t currently see much value in shares, which trade north of our revised intrinsic valuations (by around 5%-10%).

In this context, we’ve lowered our fair value estimate for Coke by $1 per share to $58, to reflect stepped-up cost pressures that we expect will linger the next several quarters, culminating in our forecast for average gross margins through 2025 of 61.2%, versus 62.4% prior. However, we continue to believe that Coke’s data-driven approach to innovation, combined with its vast international footprint and continued brand support, should result in 5.2% average annual sales growth over our 10-year explicit forecast.

Even though Pepsi isn’t immune to these challenges, we’re raising our fair value estimate to $164, from $154, after incorporating a slightly higher average midcycle revenue growth rate (4.3% versus 3.8% prior), as we now expect recent investments in its brands, direct-store delivery, manufacturing capacity, and data analytics to bolster its top line prospects. We forecast this growth will be achieved against 16.9% operating margins by fiscal 2026 (up 250 basis points relative to fiscal 2021), as the firm funds continued investments in its brands with savings extracted from its operations.

Business Strategy and Outlook | by Chris Owen Updated May 12, 2022

We regard Coke’s strategy favorably, as the firm is working to expand its dominant position in carbonated soft drinks, or CSDs, while building a larger presence in emerging high-growth categories. But we also surmise the firm is keen to pivot its mix to align with evolving consumer trends, particularly as it pertains to a growing interest in healthy fare (such as with Coke Zero Sugar), which strikes us as prudent.

We believe the firm’s global category leadership in CSDs confers benefits including pricing power, scale efficiencies in advertising and procurement, as well as real-time data analysis capabilities based on its consumer relationships worldwide. Against the current global inflationary environment, we see Coke’s ability to take price selectively, adjust its value proposition through packaging and quantity, and to optimize its strategy through data analytics (all in real time and by market) as advantageous. We also think Coke’s efforts to enter other attractive enclaves (through its acquisitions of BodyArmor in natural sports drinks, Costa Coffee in ready-to-drink coffee, and its 19% ownership/partnership with Monster in energy drinks) should serve to further entrench its standing with leading retailers while providing other growth avenues. And we don’t think these opportunities are limited to its home turf; we expect Coke to exploit its position in high-growth markets such as Latin America, where the firm’s 40% share in value terms is about double the level it maintains on a global basis (per Euromonitor).

Coke’s business isn’t immune to challenges, in our view. For one, we believe consumer health concerns, as well as governmental regulation, remain Coke’s biggest hurdles but that the firm will surmount these headwinds through the launch of new products, reformulations, and strategic category expansion. Even within CSDs, we believe Coke will expand its low/no sugar offerings. Further, we expect competition is likely to occasionally wreak havoc, particularly as the e-commerce channel (which allows smaller, niche operators to compete on a more level playing field) gains share, necessitating continued investments in research, development, and marketing.

Economic Moat | by Chris Owen Updated May 12, 2022

We believe that Coca-Cola merits a wide moat rating based on the intangible assets and cost advantages in its global beverage businesses (concentrate and finished product). The company’s edge is reflected in our forecast for returns on invested capital (including goodwill) that fall in the mid-30% range by the end of our explicit forecast period, which is well in excess of our 7% cost of capital estimate, and we think it can consistently generate these outsize returns for 20 years or more. In our view, the firm maintains a unique collection of leading global brands, truly unparalleled in the carbonated soft drink space, with trademark Coke holding a roughly 25% retail value share of global carbonated soft drinks per Euromonitor in 2021, as compared with a 9% share for trademark Pepsi, its closest competitor. Based on its ownership of five of the top six global soft drink brands, we believe the company’s dominant position affords pricing power as well as cost advantages in advertising and marketing, in procuring raw materials, and in maintaining a dedicated global bottler network. We contend this leading edge should persist as Coke’s management team remains laser-focused on leveraging Coke’s strong market share position to enhance returns through structural changes and alignment with evolving consumer trends.

Within the soft drink category, we believe that Coca-Cola remains king in share terms, a position that has facilitated both pricing power and bargaining clout. Per Euromonitor, its 2021 market share by value amounted to 20.5% globally (7.5% for Red Coke alone), or more than twice its closest competitor, Pepsi. We believe that Coke has supported its leading market position by expending around 10% of sales toward advertising on average over the last three years ($4.1 billion), above Pepsi’s nearly 7% levels ($5.1 billion) on a consolidated basis. However, we estimate Pepsi directs 6% of beverage sales, which include bottling revenue unlike Coke, or roughly $2.3 billion in absolute terms toward advertising for its beverage mix. When adjusting for the outsize share that it maintains (more than twice the levels of Pepsi), we think Coke’s ability to spend less attests to its brand strength.

From our vantage point, Coke’s brand strength also confers pricing power. Over the past five years, on a consolidated basis, the company has grown by 2.8% on average in price/mix terms, which exceeds nonalcoholic beverage inflation of 2.2% over the same period based on Bureau of Labor Statistics data. We acknowledge that Coke’s large concentrate business suffered during the COVID-19 pandemic, as the away-from-home business declined precipitously, yet the firm’s ability to raise prices has largely remained intact. In its Latin American segment (11% of sales), a geography prone to inflation, Coke has realized a high-single-digit benefit from prices on average over the past five years while volumes remained flat to slightly up. We think this pricing ability transcends geographies and exists throughout its global platform, as we anticipate that Coke will grow its consolidated revenue at the high end of the 4%-5% levels we expect the beverage industry to grow at midcycle, driven by contribution from higher prices and increased volumes.

Due to Coke’s size (with nearly $39 billion in annual sales), along with its data capabilities, we surmise the firm is uniquely positioned to analyze and act upon real-time consumer observations. No beverage company has as many interactions with consumers around the world as Coke, which accounts for 1.9 billion servings daily, out of an estimated 62 billion beverage servings globally, according to the company. With its enormous real-time data advantage relative to peers, the employment of this strategy affords Coke the opportunity to realize premium pricing in less elastic markets or to provide smaller-size packages (at a lower absolute price point) in order to meet reduced consumer budgets in more elastic markets, in our view.

We believe that management has brought a focus, both strategic and operational, that is likely to reinforce Coke’s moat. From a brand perspective, management is in the process of reducing master brands from 400 to 200, allowing the company to allocate its resources more effectively to its highest return opportunities (from a financial and personnel perspective), in our view. As an offshoot of this, the company’s time to develop new products over the last few years has fallen--from six to eight months to three months--in part due to breaking down silos and leveraging the company’s full capabilities--such as a networked versus matrix organization. We surmise the recent successful relaunch of Coke Zero Sugar, a brand that has outgrown the category since its introduction in 2017, is a testament to Coke’s sharpened focus on core brands, its ability to process consumer feedback in real time, and a streamlined approach to marketing and innovation.

While Coke’s fate is inherently related to the CSD category, the firm has taken strides to expand into other niche, on-trend areas in the broader beverage sphere (sports and energy, coffee, and bottled water to name a few). For one, Coke recently scooped up BodyArmor (a natural, low-sugar option) to build out its position in the sports and energy drink aisle (complementing its Powerade brand). From our vantage point, this acquisition enhances the firm’s competitive position, as this supports its entrenched retail relationships. Further, we think expansion into niche spaces within the beverage aisle stands to bolster Coke’s understanding of evolving consumer dynamics and its ability to respond to consumer trends in real time, aiding its brand intangible assets.

We find the modest re-acceleration of the CSD market, which has resumed growth after several years of declines in volume terms and is likely to continue on this trajectory, in our view, auspicious for Coke’s competitive position, given its dominance. While some debate exists around the proximate cause of CSD growth--including flexible work arrangements inspired by the pandemic, the successful introduction of zero sugar brands, and/or the recent popularity of citrus flavored variants--Euromonitor expects global carbonate off-trade volume to grow an average of 1.8% over the next five years, which seems directionally reasonable to us. We anticipate that the category will realize modest growth, which Coke is well-positioned to drive through the introduction of new derivative products, including reduced/zero sugar offerings that exploit its core franchise.

Coke’s moat does not rest on the power of its intangible assets alone, though, as its beverage industry leadership confers cost advantages related to economies of scale as well, in our view. For one, we believe the company extracts favorable advertising rates based on its high absolute spend, and this advantage positions it well to spend less on a share adjusted basis than peers. Further, in the procurement of key raw materials such as sugar, Coke has the heft and resources to secure favorable pricing, in our view, given the vast quantities it requires. We also contend that because of its scale Coke is poised to replicate competitive products in a timely fashion and at a lower cost to the retailer.

Under the leadership of CEO James Quincey and CFO John Murphy, we surmise Coke has doubled down on extracting the benefits of its dominant position to reinforce its wide moat through reinvestment. Notably, the company has improved free cash flow conversion, a measure of its capital efficiency, from 75% in 2017 to 116% in 2021. This improvement reflects the implementation of the company’s decision to divest its principal bottlers, where capital intensity formerly dragged down margins and increased capital expenditures and working capital requirements. However, improved free cash flow conversion also reflects a focus on optimizing working capital--payables and receivables--that an industry leader can accomplish much more easily than lesser players.

Fair Value and Profit Drivers | by Chris Owen Updated May 12, 2022

We’re lowering Coke’s fair value estimate a touch to $58, from $59 prior, to reflect a slightly slower pace of gross margin expansion (midcycle gross margin of 61.8% versus 62.4% previously) in light of heightened near-term cost pressures, partially offset by a time value of money benefit. Our revised valuation implies an enterprise value/adjusted EBITDA of around 21 times.

In our view, Coke is poised to enjoy a solid 5.2% compound annual growth rate over the next 10 years, driving category growth and underpinned by price. We believe a recovery in away-from-home consumption (about half of Coke’s business on a normalized basis, by our estimate) over the next several years contributes to this growth. While we expect Coke to benefit from higher prices given inflationary headwinds, we also believe, based on its strong consumer data capabilities, it will manage the price/volume trade-off well. Further, we think Coke will continue to bring on-trend innovation to market, which should aid its ability to continue to win with consumers. These factors underpin our expectations for the firm to realize a 3% benefit from pricing and 2% volume growth over our explicit forecast period. Encompassed within this, we anticipate its North America arm will grow 4% organically through fiscal 2031, reflecting a 3% price/mix contribution and 1% volume growth related to innovation (including its low/no sugar products), modest CSD category growth, and further gains in other niche spaces (like sports energy drinks). In our view, the firm will also benefit from price-driven growth internationally. We have modeled 9% growth over a 10-year horizon for Latin America, which accounts for 11% of sales and includes key Coke consumption countries Mexico and Brazil, with price/mix contributing the preponderance of growth.

From a margin perspective, we anticipate gross margins will improve from 2021’s 60.3% level to 63.1% by fiscal 2031 and adjusted operating margins will reach 33.8% versus the 2021 level of 28.7%. Despite facing pronounced inflationary headwinds near term, we think by tactically raising prices, extracting inefficiencies, and managing price/packs that the firm should realize profit expansion over time. In addition, we don’t think these cost pressures will prompt Coke to ratchet back essential brand investments; we forecast it will continue to expend 1% of sales on research and development and 10% on advertising and marketing, which strikes us as prudent.

Risk and Uncertainty | by Chris Owen Updated May 12, 2022

We believe Coke’s uncertainty rating is low. While Coke isn’t immune to volatility in commodity costs, we think the most germane risk to the business lies in environmental, social, and governance issues, particularly consumers’ increased favor for better-for-you fare and the potential actions governments around the world take to incite healthier behavior.

From our vantage point, government efforts to limit consumption of sugary beverages could manifest in advertising restrictions and/or higher taxation (and have already done so in select locales). Whether these actions are having the intended impact (that is, lower rates of obesity and diabetes), remains an open question, but we expect such efforts to persist. Thus, we anticipate Coke will need to continue reformulating its products and/or introducing new lower sugar options to negate any lasting hit to volumes. In addition, the firm depends on water for its products. Given water’s scarcity in some regions, Coke could be forced to absorb increased costs and/or shortages may hinder its ability to bring product to market in a timely fashion.

After muted competitive intensity over the past few years, Coke could face more rivalry now, in our view, with consumer routines normalizing as mobility restrictions have generally been rolled back. Further, we think a shift to the online channel could open the door to smaller, niche startups that haven’t been able to garner a foothold in physical outlets (given Coke’s dominance and retailers’ reluctance to allocate shelf space to unproven suppliers).

In addition, Coke remains at odds with the IRS over an outstanding tax matter. Although the timing of a resolution remains uncertain, in an unlikely worst-case scenario, an unfavorable outcome could see Coke shelling out $13 billion, a hefty penalty that could constrain reinvestment in the business and potentially shareholder returns, in our view.

Capital Allocation | by Chris Owen Updated May 12, 2022

We regard Coke’s capital allocation as Exemplary, as we believe that its balance sheet is solid, its investment track record is favorable, and its shareholder distributions are appropriate. Coke’s net debt/EBITDA ratio was 2.6 times at the end of fiscal 2021, which was slightly elevated relative to its 2.3 times 10-year historical average (after a handful of acquisitions). With limited near-term debt maturities, over $8 billion in cash and investments on hand as of the end of the first quarter, and supported by strong recent free cash flow--in the high 20% of sales range--we think Coke maintains ample financial flexibility.

We expect acquisitions will continue to vie for these funds, in line with its past bent to selectively (and prudently) pursue tie ups to expand its product and geographic reach. Most recently, Coke brought BodyArmor (a health-oriented sports drink brand) into the fold. Despite the elevated price tag (at a mid-single-digit level of sales), we see the strategic merits of the deal--a brand with robust growth characteristics (50% annual growth in U.S. retail sales), operating as the second-largest player in the more than $8 billion domestic sports drink market behind wide-moat PepsiCo’s Gatorade brand (which we estimate controls more than 60% of the category). Further, this price tag tends to align with the multiples expended for other high-growth beverage brands (according to Pitchbook). And we don’t believe that Coke is merely chasing growth. In this context, we surmise Coca-Cola has been prudently parting ways with peripheral brands in order to focus its resources (both financial and personnel) on core vectors for growth such as premium beverages and energy drinks.

We further believe that Coca-Cola remains committed to returning excess capital to shareholders. We expect that the firm will raise its dividend at a high-single-digit rate (maintaining a payout ratio of around 70%) over our 10-year forecast horizon. In addition, we anticipate it will repurchase nearly 1% of shares outstanding on an annual basis, which we view as a prudent use of cash when the stock trades below our assessment of its intrinsic value.


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