Shares of consumer packaged goods giant Coca-Cola (NYSE:KO) surged to all-time highs today after the company reported better than expected second quarter numbers. Revenues came in ahead of expectations, and boasted a very healthy 6% organic sales growth rate. Earnings also topped expectations, boosted by core operating margin expansion. The full-year revenue guide was lifted slightly, and the full-year EPS guide was maintained.
Broadly, it was a very good report. In response, KO stock shot up more than 5%, an unusually big post-earnings move for this normally quiet and subdued stock.
Unfortunately, I’m unconvinced that this rally in KO stock can continue with much gusto in the near term. KO stock now trades at its richest valuation in recent memory. And while the company has found a long-term winning strategy that should power continued stable profit growth, most of that profit upside is priced in for the foreseeable future.
What’s the investment game plan here? Avoid KO stock for the time being. Buy on dips. The stretched valuation implies limited upside near term. But the company’s long-term growth prospects do imply that the Coca-Cola stock price will eventually head higher.
Second-Quarter Numbers Were Really Good
Coca-Cola’s second-quarter earnings report was good on all important fronts.
First, and foremost, Coca-Cola’s top-line momentum remains the best it has been in recent memory. For two consecutive quarters, Coca-Cola has reported 6% organic sales growth, on volume growth of 3% or better. The core Coca-Cola product line-up has rebounded (4% volume growth in the quarter, led by the seventh consecutive quarter of double digit volume growth for Coke Zero), while new product lines are performing very well, too (25% of revenue now comes from new or reformulated beverages).
Second, margins are healthy. Comparable operating margins did slip year-over-year. But, that slippage was entirely due to currency headwinds. Ex those currency headwinds, core operating margins actually expanded more than 100 basis points year-over-year, due to sustained gains in operational efficiency.
Third, the guide was strong. Organic sales are expected to rise 5% this year. That would mark the second year in a row of 5% organic sales growth – a strong mark for a company that is this big and this mature in a very stable market. Margins ex currency headwinds are expected to keep marching higher. Profits are, too.
Broadly, Coca-Cola’s second quarter earnings report was very good, and it’s no surprise that KO stock rallied to all time highs in response.
Coca-Cola Stock May Not Rally Much Further
Although Coca-Cola Q2 results imply that this company is firing on all cylinders, the KO stock price does not project to rally much further from here.
Bulls think that its relative underperformance year to date positions the Coca-Cola stock price for continued gains. Shares are up just 15% since the start of this year. That compares unfavorably to a 20% gain for the S&P 500 and an 19% gain for PepsiCo (NYSE:PEP) stock.
But this underperformance is the result of Coca-Cola’s rich valuation. Heading into the year, KO stock was trading at 22.5 times forward earnings. PEP stock was trading at just 19.5 times forward earnings.
In this sense, PEP stock has been playing catch-up with Coca-Cola all year long. Today, the KO stock price is still more richly valued than PEP stock. Yet, according to Ycharts.com, the two companies have the same projected long-term earnings growth rate around 6%. Indeed, KO stock’s present 25 times forward earnings multiple is the biggest forward earnings multiple this stock has had in the past decade.
As such, Coca-Cola is trading at a premium relative to peers and its historical standard. This rich valuation has limited gains in the KO stock price over the past seven months. It will continue to limit gains for the foreseeable future, too.
Long-Term Strategy Implies Long-Term Success
In the big picture, Coca-Cola has stumbled upon a winning strategy in a stable growth industry. This implies that KO stock will head higher in the long run.
Zooming out, Coca-Cola is one of essentially only three relevant non-alcoholic beverage companies in the world. Of those three, Coca-Cola is the most potent, with the most reach and the most resources. Coca-Cola leverages this advantage to identify next-generation beverage trends, acquire brands within that trend and push those brands through its global distribution network. This strategy ensures that Coca-Cola’s product portfolio is always relevant. Further, it helps ensure that the company maintains and potentially even grows share in the steady growth beverage industry.
The beverage industry is a mid-single digit growth industry. Assuming Coca-Cola maintains market share, then this company projects as a mid-single digit revenue growth business over the next several years. Margin headwinds should be offset by buybacks. And earnings per share growth should net out in the mid-single digit range, too.
Assuming mid-single digit annualized EPS growth from this year’s projected EPS base of $2.10, then 2025 EPS could be about $3. Based on a historically average 21-times forward multiple, that implies a 2024 price target of $63.
Thus, in the long run, the KO stock price has upside to levels above $60.
Bottom Line on KO Stock
There are two good things about the KO stock price here. First, it has healthy upside potential in the long run. Second, the company is firing on all cylinders today.
There’s also one bad thing about Coca-Cola here: shares appear overextended after a big second-quarter earnings rally.
The implication of these three observations is simple. Avoid KO stock for the time being (because it’s overextended). But buy shares on any big dips, because they will march higher over the long haul.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
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