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September 17, 2004

Bulls Beware: Coca-Cola's Stock Price Not Done Being Mauled
by Brady Willett

When New Coke threatened to replace what is now called 'Coca-Cola Classic' people protested, holding up signs saying "Our Children Will Never Know Refreshment". Nearly 20-years later and it is Coke investors that may soon be doing the protesting. Will the signs read "Our Children Will Never Know Profits!"? *

Shares of KO got hit hard following the warning from CCE last week, and they have been hit hard again following KO's warning this week. Given that the statistical EPS downgrades from KO and CCE were roughly the same, the conclusion to be made following this weeks decline is that investor's didn't like hearing bad new twice.

Speaking of bad news, there is plenty of it to go around at Coke these days. During the company's recent conference call new CEO, Neville Isdell, not only warned on the second half of 2004, but he also highlighted operational woes in Europe (Germany), and offered few details of any turnaround plan. In fact, as analysts pried for something, anything, to suggest that Coke was about to turn things around Isdell said "I have ideas in my armory. I will roll those out in the next six months or so." Given that the average Wall Street analyst/manager has an attention span closer to 6 minutes rather than 6 months, it is unsurprising that Coke shares hit 52-week lows in each session following the call. What would also not be unsurprising is if - baring a seasonal explosion in overall stock market interest - Coke's share price was soon testing 8-year lows.

My bearishness on Coke will likely leave a stale taste on the palette of many value investors. Coke shares, after all, are already off 25% from their peak this year, and the company continues to generate solid cash flows and pay an attractive dividend (currently yielding 2.5%). Moreover, the dividend is not likely to be cut: Coca-Cola has increased its annual dividend in each of the last 41 years, and the company has a string of consecutive dividend payments that dates back to 1920 (there has been talk - in the 2002 10K - of the company slowly adjusting its dividend payouts lower (as a percentage of net earnings). But every value seeker knows that companies that have the cash available will rarely enact such a plan when times are rough).

So what is my problem? Why don't I love the free cash generating Coke at today's prices? Three charts will suffice:

Despite a weakening stock price the above charts do not display any hint of undervaluation yet. Rather, if you back out the mania days (1996-onwaards) a legitimate argument could be made that Coke shares are about to collapse, not rebound.

To better understand how the longest bull market in history has severely change the expectations of Coke investors look at it this way: if you had invested $1 in Coca-Cola in 1983 you would have purchased a company with 54 cents/share in net equity and you would have earned 9 cents a year in earnings. For a $1 investment today you get 13 cents in net equity and 4 cents/share in earnings annually.

While it is probably true that, baring catastrophe Coke will never see 1983-type valuations again, it may nonetheless be wise not to adjust your investment expectation so wildly higher during a bull market as compared a bear market. In other words, if you pay bull market prices you had better be sure that a bull market is around the corner and/or the company is going to continue to perform strongly. In recent years many Coke shareholders were probably not prepared...

At What Price Do You Buy Coke?

One of the only ratios that suggest Coke is undervalued today is the 10-Year Treasury Yield/Coke Div Yield -- The current ratio is 1.62, or the lowest reading since 1983's reading of 1.63 (using av. Annual 10-Y yields). If you take into consideration that Coke has grown its dividend by an average of 9.5% annually over the last 20-years, and you believe that this growth can be sustained, this implies that it will take less than 5-years for Coke's dividend yield to be higher than today's 10-Year Treasury yield.

The dividend speculations on Coke are interesting. However, if interest rates happen to spike there is the threat that a 4.22% dividend yield on Coke 5-years from now (using 9.5% div growth) will be woefully inadequate to support today's stock price. Accordingly, the flow chart below may serve as a better barometer of valuations to watch for.

My general speculation is that at 15 times earnings Coke is an excellent stock to look at. At $30/share this would only bring the price to free cash flow ratio on Coke down to 23 times. However, remember that dividends will continue to be dolled out by the company. For those of you that don't take into account dividends and working capital in your free cash flow estimates, Coke would be trading at 13.2 times free cash at $30 a share. Other things being equal, at 13 times free cash (your basic CFO minus capex) Coke is definitely worth owning.

$30 may be a low target. After all, Buffett is unlikely to stand idly by while one of his darlings tumbles. Nevertheless, Coke has some long-term problems to deal with (Germany and market share/margin issues in developing markets), and, after multiple setbacks shares may not rally until a tangible turnaround in growth is underway. Also, for what it is worth, UBS's Caroline S. Levy downgraded her Coke price target from $60/share to $34/share last week. This downgrade was made before the company's call.

* Much of the negativity on Coke comes from shareholders/analysts that are overly concerned with near term EPS growth. While Coke shares have been unprofitable for a long time, the company continues to generate solid business returns. What the protestors may be unwilling to admit is that they were (and are) too anxious to pay the bull market price for Coke shares.

Disclosure: Coca-Cola Classic was consumed while writing this document. However, no one at FallStreet.com has any investment position in KO or CCE.

Brady Willett
FallStreet.com

Copyright © 2004-2008 FallStreet.com

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