[October.2024] Warren Buffett's 4th top pick: understanding Coca-Cola's earnings

$Coca-Cola (KO.US)$ , a paragon of the American stock market, has been a popular stock for some investors for over a century, with its stock value multiplying significantly since listing.

Its enduring stability has attracted heavyweights like Warren Buffett, who, through Berkshire Hathaway, invested about $1 billion in the late '80s, securing a top holding that remains a significant stake to this day.

On October 23rd, Coca-Cola will release its latest financial report. Each time a company releases its financial report, it may present a potential trading or investment opportunity.

As we assess Coca-Cola's potential to maintain its solid performance, we should focus on three key areas in its financial reports: operational stability, brand strength, and shareholder returns through dividends and buybacks. These elements are important for evaluating Coca-Cola's investment appeal in a constantly evolving market.

1. Operational stability

Buffett praises businesses that maintain high returns with minimal capital investment, signifying operational stability—a hallmark of Coca-Cola.

It's a relatively simple model in large part, selling syrup to bottlers and managing marketing, limits capital needs while leveraging its strong brand for high margins.

Despite its shift from high growth, Coca-Cola's stability has endured over the past few years. There are several key financial indicators to watch.

Firstly, performance. Over the past decade, Coca-Cola's revenue dipped slightly, but its net income edged up. Performance remained largely stable, with minor ups and downs aside from occasional one-time factors such as goodwill impairment.

Secondly, profitability. This can be measured by gross margin, net margin, and return on equity (ROE).

Reviewing the past five years, Coca-Cola's gross margin consistently hovers around 60%, indicating overall stability. Its net margin remains steady between 22-25%. Since 2019, Coca-Cola has sustained an impressive ROE of 40-50%.

Thirdly, operational capability. This may be assessed by examining accounts receivable turnover and inventory turnover ratios. Coca-Cola's accounts receivable turnover has slightly increased over the past five years, reaching approximately 13.3 times in 2023. As for inventory turnover, it has been maintained at a steady 4-5 times during the same period.

Overall, Coca-Cola has shown a robust and stable business performance in recent years, with steady growth, profitability, and operational capability reflected in its financial reports. Therefore, for future reports, we shouldn't expect dramatic breakthroughs in performance but rather focus on the company's ability to maintain its stability.

2. Strong brand

So, what is the secret behind Coca-Cola's century-long robust operation? The answer may be its brand moat.

Coca-Cola owns a multitude of beverage brands, including Sprite, Fanta, and Minute Maid, to name a few. However, the core remains the Coca-Cola brand itself, the largest cola brand globally.

Coca-Cola is sold in over 200 countries worldwide, establishing a profound brand image in consumers' minds. Warren Buffett once said that even if someone gave him $100 billion to dethrone Coca-Cola as the new leader in the global beverage industry, he wouldn't be able to do it.

How, then, can we measure the strength of Coca-Cola's brand moat? One potential metric may be advertising spending as a percentage of sales revenue. The lower this ratio is, the stronger the brand's influence may be. This suggests that the company, leveraging its powerful brand, may need only minimal advertising spend to capture consumers' hearts and wallets, thereby driving sales growth.

Looking at Coca-Cola's advertising spending as a percentage of sales over a longer period, we observe that around 20 years ago, in 2004, this ratio was maintained at about 10%. By 2011, as Coca-Cola's revenue had doubled compared to 2004, this ratio dropped to approximately 7%.

Starting in 2014, as Coca-Cola's revenue saw a decline, potentially signaling a dip in brand power, the company ramped up advertising efforts, driving the advertising-to-sales ratio up to nearly 13% by 2018. In the last few years, with revenues on a stable growth path, the ratio has readjusted to around 10%.

Analyzing the data from around two decades, it appears that a 10% advertising-to-sales ratio may be a neutral indicator for Coca-Cola. Continuously tracking this metric in future earnings reports is essential; a significant rise above 10% could suggest a weakening of Coca-Cola's brand moat.

3. Dividends and share buybacks

Coca-Cola operates with a light-asset model that doesn't require heavy capital expenditures. So, what does the company do with the profits it earns each year? A common practice among U.S. publicly traded companies is to utilize surplus cash for dividends and share buybacks.

Through these share buybacks and dividends, a company rewards its shareholders and enhances return on equity (ROE) and earnings per share (EPS) while injecting additional liquidity into the market, offering multiple benefits with a single action.

Coca-Cola's track record of buybacks and dividends is notably generous. Taking the last decade as an example, Coca-Cola's net income totaled approximately $83.9 billion, while dividends and net share repurchases (the part of share capital reduced minus the part increased) amounted to a staggering $86.3 billion, even exceeding the net income.

While it's unlikely for a company to maintain dividends and buybacks above its net income in the long term, Coca-Cola's level of shareholder remuneration is quite rare in the U.S. stock market, with dividends and buybacks typically exceeding 80% of its net income. This strategy may have contributed to the rise of Coca-Cola's stock price in most years from 2013 to 2023.

Going forward, it will be important to watch Coca-Cola's dividend and buyback ratios against net income to assess whether it can maintain its strong record of shareholder returns.

Having read this far, you may now have a deeper understanding of how to interpret Coca-Cola's financial reports. It's noteworthy that the release of earnings reports from prominent companies may present unique trading opportunities for different types of investors.

For instance, if an investor, after analyzing past reports and considering recent developments, believes a company's latest earnings will send positive signals and boost the short-term stock price, they might consider taking a long position. This could involve buying the underlying stock or purchasing call options.

Conversely, if the investor expects the earnings to be unfavorable and potentially pressure the stock price, they might consider taking a short position, either through short selling or buying put options.

If the report's outcome is unclear but volatility is expected, they might use a straddle strategy, buying both calls and puts.

However, investors should carefully assess their risk tolerance, particularly when considering high-risk trades like short selling or options, before making any trading decisions.

In summary

Coca-Cola has demonstrated stable operational performance historically. Moving forward, it's important to monitor the company's performance fluctuations, profitability, and operational capacity to gauge its ability to maintain robust operations.

The brand moat may be key to Coca-Cola's solid past performance. The advertising spend to sales ratio is a useful metric to assess the stability of its brand influence.

Lastly, given Coca-Cola's history of generous dividends and buybacks, it's worth keeping an eye on whether this shareholder-friendly trend persists.