Coca-Cola acquisition adds a caffeine buzz

The Coca-Cola Company, which long ago ceased using cocaine in its eponymously-named soft drink, is in decline. It’s now looking to caffeine to put a buzz back into its business by paying $5.1 billion to acquire the United Kingdom’s leading coffee chain, Costa Coffee.

Coca_ColaIf you are of a certain age, the very thought of an American beverage giant seeking to resurrect its business growth with English coffee is mind-bendingly perplexing. But that was then, and this is now and Coca-Cola is is spending $5.1 billion for a ‘cuppa’ English coffee.

The incidence of obesity and diabetes has climbed around the world in recent years. Some believe that this reflects diets laden with sugar and a lack of physical activity. They see traditional soft drinks as part of the problem. As increasingly health-conscious consumers shift away from soft drinks, the world’s largest soft drink company has felt the impact in its results.

Coke’s sales peaked at $48.017 billion in 2012. They’ve fallen ever since. By 2017, the company’s sales had sagged by more than 26 per cent, to $35.410 billion. Its sales are expected to fall by more than 10 per cent in 2018, to $31.750 billion.

But The Coca-Cola Company (NYSE—KO) is adjusting to changing conditions and we’ve upgraded its shares to a buy for long-term share price gains as well as high and growing dividends.

Coke’s old soft drink business is declining

For a while, Coke bought back shares to raise its earnings per share. (Spreading the earnings over fewer shares increases the earnings per share, of course.) In fact, the company has repurchased shares every year since 2007. By 2017, it had reduced its share count by 377 million.

As sales and earnings declined, even share buybacks couldn’t offset the impact on Coke. Its earnings per share peaked at $2.08 a share in 2012. While the company has continued to raise its dividend each year, the payout ratio went up. Rising dividends become less secure as they account for a larger percentage of the declining earnings.

Coke writes: “Coffee is a significant and growing segment of the global beverage business.” Coke president and chief executive officer James Quincey said: “Hot beverages is one of the few segments of the total beverage landscape where Coca-Cola does not have a global brand.”

That’s why Coke has agreed to pay $5.1 billion to buy Costa Coffee from Whitbread PLC. [Mr. Quincey is a British businessman now living in the US. Maybe that helps explain Coca-Cola’s insight into the quality of English coffee in 21st century Britain.]

Costa currently operates nearly 4,000 retail outlets. These are mostly in the UK, where it’s “the leading coffee company”. Coke writes that Costa will give it “a strong coffee platform across parts of Europe, Asia Pacific, the Middle East and Africa, with the opportunity for additional expansion”. For instance, Costa has a “growing footprint in China, among other markets”. But Costa faces many competitors.

Starbucks Coffee and McDonald’s Corp. already have larger international markets. There are also well-entrenched regional players such as Tim Hortons in Canada and Dunkin’ Donuts in the US. Its likely that many of the markets that Costa covets are already served.

Costa is diversifying into other parts of the business. For instance, its retail outlets have “highly-trained baristas”. It also operates a coffee vending operation, a for-home coffee format and Costa’s “state-of-the-art roastery”. Costa Express sells “barista-quality coffee” in locations such as gas stations, movie theaters and travel hubs.

How Costa is doing financially

Coke expects to complete the acquisition of Costa Coffee in the first half of 2019. As a result, the transaction will not add anything to Coke’s results this year. But it will contribute in the year ahead.

Costa Coffee did well in fiscal 2018, which ended on March 1. Costa generated revenue of $1.7 billion. It also produced EBITDA of $312 million. (EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Some investors use it to assess a company’s underlying profitability.)

Coke expected Costa to add to its earnings in the first full year. But only if you exclude one-time impacts for purchase accounting.

To its credit, Coke is responding to market shifts. We’ve upgraded it to a buy for long-term share price gains and growing dividends that yield 3.3 per cent.

This is an edited version of an article that was originally published for subscribers in the October 5, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

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