I just wrote a post comparing the stock market to a roller coaster, and you can see that bear out with the way The Coca-Cola Company (KO) and International Business Machines Corp. (IBM) saw their respective stocks react after third quarter results that were, to varying degrees, disappointing.
I’m a shareholder in both companies, so you can bet that I was just as interested in anyone else in these reports. Perhaps even more interesting than the results themselves was the carnage that followed – KO was down just over 6% on Tuesday, while IBM has fallen by more than 10% over the last two days. Those are big numbers when we’re talking about two titans of their respective industries that both sport market caps north of $165 billion.
But what does all of this mean? Without some context, a stock dropping by 5% or 10% means nothing. After all, if a stock is overvalued by 20% and falls by 10% it’s still overvalued, right?
So let’s take a look at these two stocks. I’ll give a brief overview of their respective third quarter results, where the stocks are at now, and reasonable estimates of valuation.
International Business Machines Corp.
This one took me by surprise. IBM has long been suffering through revenue growth issues, which hasn’t really been a major problem for me. After all, you can take in all the revenue you want and still be an unprofitable and unsuccessful enterprise if you’re unable to convert that incoming revenue into some sort of profit. However, I don’t feel totally comfortable with the complete lack of top line growth either. You can only squeeze so much efficiency and margin out of the same top line dollar and there are only so many shares to buy back, so at some point the core business needs to grow.
But this most recent report spoke to profitability issues, which is new for IBM. However, let’s keep things in perspective here.
IBM has grown earnings from $4.94 in fiscal year 2004 to $14.94 in fiscal year 2013 (fiscal year ends December 31). That’s a compound annual growth rate of 13.08% over that time frame. So this is a company that usually generates pretty exceptional results. Now, earnings have grown rather briskly, even while revenue is pretty much flat over this period. And this is partially due to a pretty substantial share buyback policy – they’ve reduced the share count from 1.646 billion to 1.054 billion during this 10-year stretch.
However, if you’re all, “What have you done for me lately?” then IBM disappointed. 3Q EPS came in at $3.46, down 8% YOY. However, not only was profit down, but it was substantially below analysts’ estimates. S&P Capital IQ, for instance, was estimating $4.41. So this was a huge miss. They’re now guiding for $15.97 to $16.30 for FY 2014 earnings, which is well below consensus. Furthermore, IBM abandoned its well-known 2015 roadmap objective of $20 in operating EPS. The company is citing weak software sales, currency headwinds, and unprecedented change in the industry. However, keep in mind that hitting $16.00 in EPS would still be a 7% improvement over last fiscal year’s results.
What’s more, gross operating margin was down 40 basis points year-over-year, and revenue was down down 4% to $22.4 billion. I will discuss for a moment that the revenue drop is not surprising. As was noted by Martin Schroeter, SVP and CFO in the conference call:
In the near term, our revenue will be down, not surprising since the three divestitures this year represent about $7 billion of revenue with pretax losses of about $500 million. So clearly we’ll have improved margin profile.
He then noted:
These actions also free up our spend and capital to be reinvested to areas that will accelerate our transformation and these allow us to continue to provide very strong returns to our shareholders through dividends and share repurchases.
Gotta love that, right?
Perhaps the biggest news of all is that the company unloaded its semiconductor unit and paid a head-scratching $1.5 billion to do so, finding a buyer in Globalfoundries Inc. I’m not quite clear on why they had to pay to unload this business, but it has been losing money for the company. This is further action to increase margin and profits for the company, as it can be tough to move the revenue needle when we’re talking $100 billion per year in revenue. So IBM noted that they’ll get supply (when they need it) at market price, while allowing Global Foundries to run the business in perhaps a more profitable manner. It appears they basically unloaded a loser and moved on. Seems appropriate, though this move was surprising based on the terms.
One other note on this earnings report was that the company’s backlog fell by 7%. However, one fact people might be missing is that the backlog is still $128 billion.
For the future, the company is expecting to take on the challenges they face through a number of initiatives. First, there’s the aforementioned divestitures so that they can continue to focus on businesses that provide the highest margins. They also continue to aggressively grow their cloud offerings, and this side of the business is seeing big growth. Even though it’s a small part of the overall company, it’s grown by more than 50% year-to-date. They’re improving flexibility in the way customers buy their products and services and increasing automation in their data centers. So they’re basically still reshaping the business to be as competitive, profitable, and effective as possible. It appears to short-term pain for long-term gain.
Where does that leave the valuation? Well, shares are trading hands for a P/E ratio of 10.25 right now. That appears almost obscenely cheap for a blue chip company with 13% compound annual growth in earnings for a decade straight. Furthermore, this is a company with a 19-year streak of consecutive annual dividend raises, and over the last decade has increased the dividend by an annual rate of 19.4%. Moreover, shares yield 2.70% right now, which is the highest this stock has ever offered. And you get that kind of yield with a payout ratio of just 27.6%. These numbers are extremely impressive, in my view.
The third quarter was no doubt painful, but the recent share price reaction lopped about $16 billion off the market cap of the company. Seems a bit much to me. I valued the shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term growth rate. That growth rate seems reasonable to me considering their historical production, and the fact that even through the worst year in a long while they’re still producing 7% annual growth. The DDM analysis gives me a fair value on shares of $237.60. I think it’s reasonable to assume shares are worth at least $200, which means the current share price gives you a ~20% margin of safety even on that.
I’m strongly considering adding to my IBM position here. Although I don’t plan for or want IBM to be a major position in my Freedom Fund, I think there’s value here and I have a little more room for IBM shares (it’s currently about 1% of my portfolio). This is my only tech holding, and that’s because of its long-term history of adapting, growing dividends, reducing the share count, and increasing earnings. However, I would like to see some growth in the core business at some point, as the lack of revenue growth is now apparently starting to spill over into the bottom line by slowing earnings growth.
The Coca-Cola Company (KO)
How much more blue chip does it get than Coke? If you’re a dividend growth investor, you’re already extremely familiar with this company and it stock. After all, they’ve been paying increasing dividends for the last 52 consecutive years. Not too shabby, right?
So what happened? Why is KO down 6%?
Let’s take a look.
I can tell you the company reported EPS of $0.48, which is a disappointment when compared to EPS of $0.54 for 3Q14. Revenue came in at $11.976 billion. Again, below what we saw last year. An 11% drop in earnings isn’t something I get real excited about, although a 6% drop in the company’s value for one off quarter seems to be an overreaction. The company is sticking to its long-term EPS target of annual growth in the high single digits, but does expect to now miss that target for 2014. They continue to cite currency headwinds and a challenging macro environment. It is interesting to note that KO’s third quarter was weaker than IBM’s results in some respects, yet its stock has not been hammered quite as hard.
However, I did find it promising that the company reported 1% volume growth, with still beverage growth particularly strong. Not only did case volume grow, but so did prices (also by 1%) to offset rising input costs.
The company discussed expanding productivity initiatives which should result in $3 billion in savings by 2019. This will supposedly be achieved through a variety of actions, most notably including refranchising the majority of company-owned bottling territories in North America by 2017, with the rest of the territories being complete no later than 2020.
In addition, the company remains committed to innovation like new sweeteners and its marketing platforms.
Overall, it was a rough quarter. But I’m honestly not concerned about Coca-Cola. Look, this is a company with 17 $1 billion brands. We’re talking the iconic Coca-Cola brand in addition to brands like Powerade, Dasani, Minute Maid, Simply, and Sprite. In addition, they made notable and sizable recent investments in Monster Beverage Corp. (MNST) and Keurig Green Mountain Inc. (GMCR). The former transaction gives them a 16.7% equity stake in the company and exposure to a fast-growing energy drink segment. The latter transaction gives them 16% equity and exposure to coffee, in addition to a unique partnership designed to bring Keurig Cold to homes where consumers have the potential convenience of preparing Coca-Cola’s iconic beverages at home.
I’ve discussed Coca-Cola’s ability to adapt to changing consumer tastes and trends as an advantage, due to its size and scale. And these transactions are evidence of that, in my view.
While this quarter was rough, let’s keep their long-term operational history in perspective. EPS grew from $1.00 to $1.90 from fiscal years 2004 to 2013 (FY ends December 31). That’s a compound annual growth rate of 7.39%. Meanwhile, revenue increased from $21.962 billion to $46.854 billion during this period, which is a CAGR of 8.78%. A dying business? I think not.
People have to drink fluids. So you have to like the odds that the world’s largest beverage company will be around and doing well a decade from now and beyond. And in many developing countries, water is scarce. Coca-Cola provides a safe, clean method of water delivery to billions of people. Sure, you could drink tap water for almost free in a developed country like we have here in the US, but I’m one of those crazy people that like drinking orange juice in the morning, a sports drink after a good workout, and the occasional can of Coke on the weekends with a slice of pizza. The simple things in life are the best.
So I touched on their ridiculous dividend growth record. Over the last decade, KO has increased its dividend at an annual rate of 9.8%. The stock now yields 3.0%, which is typically a marker for a good time to buy shares in this beverage giant. The payout ratio is a touch high, at 65.2%. And that’s probably due to the dividend growth exceeding earnings growth over the last 10 years. As such, I expect future dividend raises to be more or less in line with earnings growth, and the company is targeting high single digits for that.
So where does that leave us? Is Coca-Cola a great deal after the 6% drop? Well, KO shares sport a P/E ratio of 21.74 right now, which doesn’t exactly incite enthusiasm or thoughts of extreme value. Keep in mind KO’s five-year average P/E ratio is 18.3. I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. This growth rate is slightly below their historical earnings growth rate, which will drive dividend growth. And it’s more or less in line with Coca-Cola’s own target. This gives me a fair value on shares of $43.51. So shares are reasonably valued here, but no steal. The 6% drop was probably warranted when you factor in fully priced shares and a weak quarter.
I don’t plan on adding to my KO position right now, and that’s probably just as much due to the fact that I already have a fairly sizable position in the company as it is the current valuation. However, I’m not opposed to buying shares here. It’s a world-class business trading at a fair or better price. I’ll have to assess capital availability and other opportunities in the market over the coming days and weeks.
Both of these companies are iconic blue chips and titans of their respective industries. Looking at one quarter of performance and then making long-term investment decisions based on that is, in my opinion, a poor strategy and extremely shortsighted. I tend to take one quarter and try to put it into context in the here and now while also keeping perspective via the overall long-term operational history. Consistently deteriorating fundamentals, on the other hand, where you have quarter after quarter of losses that eventually add up to years of poor performance is quite another beast. But you can see that’s not the case with either company.
IBM is by far the better value here, but also carries more risk. Technology changes fast, but so far IBM has had an ability to adapt for the most part over long periods of time. They’re shedding unprofitable businesses so as to concentrate on those businesses that offer better margins and higher growth potential. This creates some volatility in operational results over the short term, but one does hope that the business benefits over the long term. They sport innumerable patents, and have the platforms, people, and technology to succeed. It’s really up to management and the business to take advantage of their inherent advantages. I do remain concerned about the lack of revenue growth, however.
Coca-Cola shares are more or less fairly valued, with perhaps a slight margin of safety. However, one could do much worse than pay a roughly fair price for an excellent business. The company isn’t going anywhere, and is, in my opinion, a much lower risk stock than IBM. Hence, the higher valuation. They sport multiple billion-dollar brands, and recent investments appear attractive and strategic. Their marketing has always been extremely strong, and their core products are necessary to sustain human life. Furthermore, there’s a quality proposition at play there with strongly recognized brands. Their economic moat relies around brand and pricing power, global distribution, market share, and scale that is second to none.
Full Disclosure: Long IBM and KO.
What do you think? Is IBM a value here? Is KO fairly valued after the 6% drop?
Thanks for reading.
Photo Credit: artur84/FreeDigitalPhotos.net