Revenue Compression At Coca Cola - Jump In For Income?

A dividend aristocrat with a high yield is undergoing a massive business transformation.

Persisting currency and structural headwinds limit the company's ability to grow.

What's in store for dividend investors jumping in now?

Stock of The Coca-Cola Company (NYSE:KO) hasn't had a great year so far with its almost flat performance lacking behind that of the broad S&P 500 (SPY; ~+4%). The company is currently undergoing a massive business transformation in terms of refranchising its bottling operations and concentrating on the company's core strengths. Accompanying its latest Q4/2016 earnings release the company, a dividend aristocrat, has raised its dividend by 5.7% and thus extended its 54-years long dividend growth streak. The stock is now yielding about 3.5% and thus generates plenty of income for dividend investors. Shall investors jump in now?

What is going on at Coca Cola?

Source: Coca Cole Website

Coca Cola's financial metrics in terms of revenue, net income and EPS were in line with expectations (revenue actually beat by a fraction). The company reported Q4 adjusted EPS of $0.37 and revenue of $9.41B which is down 5.9% Y/Y. While revenue only showed a 6% decline the company's net income plummeted by more than 50%. Two main drivers, unfavorable currency developments and headwinds from structural changes were negatively weighing on KO's profitability.

Combined these two drivers had a negative impact on revenue of -12% and thus, despite a strong 6% organic growth for Q4, revenues were clearly down compared to Q4/2015. What's more, in Coca Cola's flagship North America market net revenue grew by 8% and by the same amount in Asia Pacific whereas it fell by 4% in Latin America and EMEA.

The sharp drop in income (-56%; -$687M) is primarily driven by incurred losses of $799M related to derecognizing intangible assets within Coca Cola's refranchising activities.

However, for various reasons the fourth quarter is not comparable to Q4/2015 (e.g. the company recorded a big negative in Asia Pacific in 2015 which disappeared in 2016 and thus led to a big positive) and thus not suitable to gauge how we should think about KO's success.

Instead, let's take a look at full-year 2016 to assess how KO is moving on with its transformation and how its future business could look like.

To benefit from global fitness and health trends and also combat the effects of partially imposed and proposed sugary drinks taxes in the US and UK (more countries may follow), the Coca Cola Company is investing a lot of resources to help consumers in reducing consumption of added sugars. At the center of this activity is Coca Cola Zero Sugar which recorded very strong unit sales growth, particularly in Q4, as it expanded into France, Belgium, Netherlands and Ireland with more countries planned to be included in 2017. With this product pushing into more and more markets growth is expected to accelerate in the coming years and thus help limit the impact of soda taxes.

Investors should be eying the performance and progress of Coca Cola Zero Sugar very closely as it gives important clues as to how such products may counter the negative effects of above-mentioned soda taxes. So far the product is very well received and shows consistent and rising double-digit growth rates.

How is Coca Cola transforming its business?

In their recent Q4 earnings presentation, the company included a slide which best summarizes their strategic refranchising efforts.

Put in a nutshell, KO wants to concentrate on what it does best, which is marketing and exploring new products (keyword: driving the consumer-centric portfolio) and not spend resources on bottling operations. This should allow for higher gross and operating margins and more efficient cash flows resulting from a leaner business.

This is a massive business transformation for the company as it means that around 50% of the company's business is in motion. Against that backdrop a clean 4% organic core growth realized in 2016 is already very promising, particularly as the company cannot fully concentrate on its new core business as long as that transformation process has not been completed.

In terms of progress the company expects this business transformation to be completed somewhere in 2018. Already in 2016 KO reached agreement with its bottlers in China and completed the setup of Coca-Cola European partners. In its flagship North America market the company expects finishing the refranchising by the end of this year.

What's in store for dividend investors?

Despite the company's illustrious dividend track record which has earned itself the status of a dividend aristocrat (55 increases in 54 consecutive years) its dividend growth has slowed down markedly over the last years:

  •  2013: +9.8%

  •  2014: +8.9%

  •  2015: +8.2%

  •  2016: +6.1%

  •  2017: +5.7%

So, while the latest dividend raise is significantly smaller than what the company recorded three years ago, it is still beating inflation by a wide margin. However, with declining revenues on the one hand and rising dividends on the other, Coca Cola's financial leeway for future increases has significantly contracted.

Both measured in terms of EPS and free cash flow the company's dividend payout ratio has almost reached full coverage (~92%). Thus, either way we look at it, future dividend growth potential at this stage seems to be limited, at least if the company wants to fund this with its operating business performance.

Still, dividend investors can count on KO to increase its dividend every year, although the magnitude of these increases will likely be limited to a maximum of only $0.01 per share (possibly even less). As the company's long-term prospects start materializing dividend growth for the new Coca Cola company will pick up.

Regarding long-term prospects KO's guidance for 2017 calls for another year of earnings repression as structural and currency headwinds will continue to weigh on the business (-8-10% impact on profit after tax). Another negative driver will be a higher underlying effective tax rate, 24% instead of 22.5%.

This picture is not expected to change in 2018 with the company's initial 2018 considerations showing that further unfavorable developments regarding its tax rate and foreign currency as well as headwinds on revenue from acquisitions, divestitures and structural items will persist.

Take Away

Over the last decades the company has shown its strong commitment to shareholders. In 2016 alone it returned $6B in dividends to shareholders. The company owns one of the world's most valuable brands (#3).

However, investors in Coca Cola need to be patient. Patient for its business transformation to complete. Patient for its revenues to return to growth. And patient for its dividend growth to accelerate again. In the meantime an attractive and reliable dividend income will compensate for the waiting time. Using the Dividend Calendar Tool (check out the link for more information) I can easily extract that KO goes ex-dividend on March 13, 2017. Boasting a current yield of 3.5% it is a great long-term income play.

The journey ahead is not without obstacles but investors believing in the company in the long run and its current business transformation makes the company a strong case for long-term dividend investors.

What do you think? Do you believe in KO's business transformation and its long-term growth prospects? Are you a buyer now?

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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.