NEW YORK (TheStreet) -- While Coca-Cola (KO) - Get Report and PepsiCo (PEP) - Get Report have many similarities, their futures could ultimately be fairly different from each other. Both companies pay extremely safe dividends, but Coca-Cola's greater concentration in soda (>70% of volume) creates a greater need for it to reinvent itself over coming decades.
Coca-Cola is pulling numerous levers to diversify its mix, stabilize near-term business trends, and improve its long-term cash flow generation. Together, these actions seem likely to support the stock for at least several years. However, the company cannot magically restore long-term demand growth for soda (at least in developed markets) and will ultimately need to figure out what it will look like from 2020 and beyond, especially as the iconic Coca-Cola brand moves more from "daily staple" to "occasional specialty treat" (i.e. less consumption).
For now, PepsiCo seems like the more likely long-term winner until Coca-Cola's evolution becomes clearer, so we have included PepsiCo in our Top 20 Dividend Stocks list. However, for investors seeking moderate but safe income with less concern about long-term growth potential, Coca-Cola could be attractive.
Coca-Cola trades at about 19 times forward earnings, a premium considering the company's sluggish growth. However, the stock's 3.4% dividend yield is higher than 60% of all other dividend stocks and appears attractive for investors seeking safe, predictable income.
Let's look at some of the differences between Coca-Cola and PepsiCo and better understand the strategic shifts Coca-Cola is making to stay relevant in the face of falling demand for soda in developed markets.
Coca-Cola is the world's largest beverage company with $46 billion in sales, accounting for a 5.4% of all drinks consumed by households globally every day. Coca-Cola has 20 brands with over $1 billion in sales (up from 10 in 2007) compared to PepsiCo's 22 billion-dollar plus brands. While PepsiCo's business is balanced between snacks and beverages, Coca-Cola only sells beverages, with sparkling beverages accounting for 73% of global case volume last year (soda is < 30% of PepsiCo's business); Coca-Cola beverages were 46% of global case volume. Some of Coca-Cola's key brands include diet and regular Coca-Cola, Fanta, Sprite, Minute Maid, Powerade, Dasani, and Schweppes.
To state the obvious, Coca-Cola has some of the post powerful brands in the world. Coca-Cola's portfolio holds leadership positions across its major categories: No. 1 in sparkling, No. 1 in juice, No. 1 in ready-to-drink coffee, No. 2 in energy (Monster partnership), No. 2 in sports, No. 2 in water, and No. 3 in ready-to-drink tea. Overall, Coca-Cola is No. 1 in value share in 25 of the top 32 global markets.
Brand strength is reinforced by Coca-Cola's advertising spending ($3.5 billion in fiscal-year 2014 and up 22% year-to-date) and global distribution reach, especially in emerging markets (81% of Coca-Cola's volume is outside of the U.S. -- Mexico, China, Brazil, and Japan are its next four largest markets) that will becoming increasingly important growth drivers going forward. With a massive distribution network, Coca-Cola can quickly sell new types of beverages around the world as well.
With declining demand trends for soda in developed markets, Coca-Cola has taken action to diversify more of its business while capitalizing on its core strengths. Coca-Cola has purchased and developed brands in the past (e.g. bought Fuze in 2007 and grew it into a billion-dollar-plus brand) but recently took an alternative path, taking stakes in Monster (MNST) - Get Report and Keurig (GMCR) .
Many investors seem to be griping about these deals, especially with the walloping Keurig's stock has taken over the past year (down over 55%). However, by taking stakes in these two businesses, Coca-Cola gained meaningful exposure to two major growth categories overnight (single-serve, at home and energy drinks). However, Coca-Cola did not bet the farm, nor did it take on undue operational risk -- Keurig and Monster can maintain their independence as they continue with their growth strategies.
The Monster deal is appealing because Coca-Cola is set to generate huge distribution profits by carrying energy drinks on its trucks around the world (Monster was largely U.S.-based prior to the deal). By distributing the energy drinks rather than producing them itself, Coca-Cola is protected from any negative press that otherwise might have surfaced.
For a $2 billion-plus investment in Keurig, Coca-Cola is primed to take advantage of a new channel to distribute its products with the Keurig brand. Today, approximately 13% of households use Keurig with its ready-to-drink single-serve coffee. It's hard to know how much, if at all, Keurig will improve that percentage, but it could be meaningful and serve as an unexpected catalyst (based on current negative sentiment surrounding Keurig). Additionally, Coca-Cola's global distribution could bring Keurig around the world. Time will tell, but it seems unfair to measure such a long-term initiative over the course of a few quarters. If nothing else, these "insurance" bets have high upside but come with high uncertainty.
Warren Buffett claims to drink five Cokes a day. Unlike Buffett, the overall U.S. population consumed fewer carbonated soft drinks each year over the past decade, and this shift is only expected to increase going forward. We now have generations of kids that did not grow up with soda being the memorable taste of their childhood like Buffett enjoyed. Coke's overall brand strength seems likely to gradually decrease as old generations fade and new generations account for a larger share of household spending.
As the health-consciousness of developed countries improves, Coke the beverage likely moves from a daily fixture to more of a specialty purchase. In other words, demand fade will probably be very gradual, but Coca-Cola ultimately needs to reinvent itself to drive longer-term growth.
Fortunately, Coke is not down to its last bullet. Far from it, actually. Let's look at what the company is doing to combat unfavorable healthy drinking trends so it can buy more time to reinvent itself.
First, as expected, Coca-Cola is exercising its pricing power to prop up soda revenues despite sluggish volume trends. While Coca-Cola is raising prices on its traditional offerings, the company is also doing this in sneakier ways than you might suspect -- last quarter, soda price/mix was up 4%. Coca-Cola is seeing success in selling its soda in smaller packages like mini-cans, which reported double-digit volume growth in the first and second quarters. Smaller packages are more profitable for Coca-Cola to sell and might also be reinforcing the earlier point of Coke transitioning from a daily beverage choice to more of a specialty purchase.
Another factor possibly helping Coca-Cola realize its price increases is increased advertising spending. Through the first six months of 2015, Coca-Cola has increased its advertising expenditures by 23% compared to 2014.
While they are serving to stabilize the U.S. soda business today, price increases, more advertising, and "smarter" packaging are unlikely increase long-term demand for soda. They are simply buying Coca-Cola more time for reinvention.
What else is Coca-Cola doing to extend its fade? Productivity measures.
Investors who have been following Coca-Cola for a long time will remember its acquisition of some North American bottling operations in 2010 for $12 billion. PepsiCo did the same thing around that time, with both companies hoping to cut supply chain costs.
The bottling business is more capital-intensive and earns lower margins than selling syrups and concentrates, so the deal predictably lowered Coca-Cola's return on invested capital. In mid-2013, Coca-Cola announced plans to begin refranchising the distribution capabilities of its bottling operations, essentially reversing a key part of its 2010 acquisition. This move will drive improved profitability and cash flow, adding to Coca-Cola's financial cushion. As of the second quarter of 2015, Coca-Cola had transitioned over 5% of U.S. bottle volume and had signed letters of intent for close to another 10% of volume. The refranchising effort is expected to be complete by 2020.
Importantly, Coca-Cola's business is still better off from the 2010 deal. The company is retaining its bottling production activities and only refranchising distribution back to the bottlers. With advances in production technology, such as in-line blowing and warehouse automation, Coca-Cola now generates more cash flow from producing the beverage packages rather than just selling syrup and concentrate to the bottlers. These savings all feed into Coca-Cola's plan to generate $3 billion in annualized savings by 2019 ($1.4 billion from COGS, $1 billion from operating expenses, $600 million from marketing).
If successful, margins should improve ($3 billion in savings out of Coca-Cola's $46 billion in fiscal year 2014 sales represents 600 basis points of margin improvement potential) even in a stagnant sales environment -- plenty to support continued dividend growth for the time being.
Once again, however, greater efficiency and profitability doesn't solve the problem of shrinking soda demand in developed markets. What can Coca-Cola do to reinvent itself, and how risky might these efforts be to long-term shareholders and dividend investors?
Given Coca-Cola's heavy mix of carbonated soft drinks (73% of its global case volume), the company could become increasingly desperate to accelerate its mix shift into healthier, non-carbonated drinks. One way to do that is acquisitive growth. For a company of Coca-Cola's size, larger deals would move the needle faster but also pose the most risk. The market may not respond favorably to this strategy, depending on the premiums paid and the strategic implications. We saw an example of this recently with rumors that Coca-Cola would acquire a stake Suja Life (competes with Naked Juice) earlier this month at a valuation of $300 million; Coca-Cola fell slightly on the news.
Coca-Cola is clearly making progress with mix diversification into still beverages -- in 2007, the company had 10 billion-dollar plus brands. Only five of these were still beverages. Last year, Coca-Cola had 20 billion-dollar brands, with 14 of the 20 playing in the still beverages category. However, the sheer size of Coca-Cola, Diet Coke, and Coke Zero suggest the company has a long ways to go down this path, so acquisitions are likely to be appealing.
Altogether, the biggest risk to Coca-Cola's (very) long-term future is that it invests billions but fails to find enough powerhouse brands, beverage categories, and distribution paths to eventually overtake its iconic Coca-Cola beverages in developed markets, which see an increased rate of decline in soda demand. For the next 5-to-10 years, Coca-Cola will remain a powerhouse and should continue looking for ways to remain relevant in an increasingly healthy world. With soft drinks making up about half of non-alcoholic beverages sold in the U.S. and growing demand in developing countries, fade seems likely to remain moderate. The global non-alcoholic beverage industry is also expected to grow at a 5% annual rate to reach $300 billion in value by 2020, providing room for Coca-Cola to try and find its next big hit.
Coca-Cola's dividend is extremely safe. The company's payout ratio over the last year is about 70%, providing reasonable cushion for a business as stable as Coca-Cola's. Coca-Cola's payout ratio has generally remained between 40% and 60% over the past decade, even during the financial crisis. In 2009, Coca-Cola's sales fell just 3%, and its operating margins actually improved slightly. Like PepsiCo and many other consumer staples businesses, most of Coca-Cola's products are in slow-moving industries and benefit from recurring consumer demand. These are some of the most durable businesses a dividend investor will find.
Turning to the balance sheet, Coca-Cola's debt to capital ratio has increased over the last decade from under 10% to nearly 50% as of last quarter. However, Coca-Cola has a very modest net debt load of about $7.1 billion, less than the $8.4 billion free cash flow it generated in 2014. The balance sheet provides a solid foundation to continue paying and growing the dividend.
Coca-Cola has grown its dividend at a 9% annual clip over the past decade and increased its dividend by 8% most recently, marking its 53rd consecutive increase and keeping it in the Dividend Aristocrats Index.
This article is commentary by an independent contributor. At the time of publication, the author held a long position in PepsiCo (PEP).