Monday December 16, 2002
Coke Being Mauled By Classic Bear
Due out this week are consumer prices (Nov), housing starts (Nov), Industrial production/capacity utilization (Nov), Trade balance (Oct), Leading Indicators (Nov), Philadelphia Fed (Dec), and final 3Q02 GDP. While each of these reports has the potential to ruffle the markets feathers, what will likely decide if stocks can fly into some sort of ‘Santa Clause’ rally is whether or not geopolitical tensions abate and/or whether or not the U.S. dollar ‘bottoms’. The U.S. dollar index closed last week at 103.83, or less than 0.30 points away from its yearly low (July 19, 02). Furthermore, the dollar index has declined in 7 out of the last 8 sessions.
Coke Stops Trying To Please Wall Street
Coke surprised many investors last Friday when the company announced that they will stop providing investors and analysts with quarterly and annual earnings guidance. Coke Chief Executive Douglas Daft said he made the decision after “a series of discussions with our board of directors”. Not surprisingly, Warren Buffett sits on Coke’s board. Buffett runs Berkshire Hathaway and also sits on Gillette’s board, or two company’s that do not provide EPS guidance.
To begin with, companies should have never been allowed to offer EPS guidance alone. Rather, the SEC should have put a stop to the EPS momentum game long ago, by forcing those companies that give EPS guidance to also report useful targets for things like cash flow, capital expenditures, interest expense, etc. Think about how perfect an investment world it would be if that for every EPS estimate First Call tracks there was also a free cash flow estimate?
Incidentally, the terrifically late and weak effort by the SEC to stop ‘pro forma’ reporting has failed miserably. Pro forma abusers have simply moved on to highlighting EBIDTA or ignoring ‘non-cash’, ‘one-time’ charges that seem to reoccur every quarter.
The EPS Game
Some investor’s applaud companies that consistently beat earnings estimates even though the actual estimates they are beating are, debatably, underestimated on purpose. In fact, Wall Street analysts, the media, and after-hours speculators, are often are quick to conclude that a company is failing or succeeding based upon EPS results alone, even though a company’s financial reports are usually filed weeks after their EPS announcement. Point being, should a company really rally by 10% if it beats estimates by a penny and fall by 10% if it misses estimates by a penny?
“After the close, Intel posted third-quarter earnings of 41 cents per share, ahead of the Street estimate of 38 cents. The estimate had been 41 cents until the company's recent earnings warning.” Oct 17, 2000.
As if it is part of their business effectively manage investor reaction to a single line within their financial statement, companies like Intel have been playing the EPS momentum game for years. That Coke has decided to no longer waste their time trying to cater to this momentum and instead focus on the business is good news for KO shareholder, even if the near term impact may be negative. Why? Because shareholders of KO are more likely to become owners of Coke, and not simply trying to buy and sell based upon EPS considerations. In theory, this should help Coke become a lower beta stock that trades more predictably.
Coke Turning Flat
A logical argument would be that Coke is going to stop offering guidance because its outlook is not as promising as it once was. After all, Coke’s stock price has disappointed investors since 1998, and the company has had its operations problems. However, Coke’s businesses continue to generate cash flow, the company continues to post double digit margins, and pay a quarterly dividend (usually raised by a penny or so every year).
Some investors may think: how is this possible? How can one of the most successful companies in the world see zero stock price appreciation over the last 4 years?
The simple answer to this question is that investors expected too much from Coke. For example, in each of the last 5-years Coke’s dividend yield has risen while in each of the last 3-years its P/E has declined. These type of statistical occurrences do not occur unless either the company was extremely overvalued to begin with or its ‘expectations’ have been hacked lower.
By not providing guidance any longer Coke’s historical price-to-earnings average will hopefully be given more attention than inflated Wall Street’s expectations. With this in mind, for the potential investor the hope is that Coke’s recent trend of lower P/E’s and higher Div’s will continue.
A Classic Bear?
Trading near its 2000 ‘bottom’ Coke is challenging to break lower.
A ‘classic’ bear market is one in which valuations retreat to, or below, historical levels, dividend yields near that of bonds, and investor’s give up on stocks. Despite stomach wrenching swings in stocks over the last couple of years, the fact is that such a bear market has not come to pass. Rather, and partially encouraged by the fact that manipulated EPS results have been improving this year, the majority of investors have decided to hold on. As Coke demonstrates, ‘holding on’ can sometimes mean years of losses.
If investor interest in Coke continues to wane, and if the company’s previous bottom is breached (perhaps dampening investor interest even more), there remains the possibility that the company will be valued within reasonable terms. What this means, is that Coke’s next ‘bottom’ could be the ‘real’ bottom…
However, while Coke’s demise continues to replicate a classic bear market trend, the broader stock markets still trade at historical high multiples. Furthermore, and as opposed to Coke who has said they will begin expensing stocks options, broader market multiples do not immediately reflect the cost of stock options and pension related costs.
In sum, timing the markets is hardly an exact science. However, if a company like Coke begins to trade with respectable valuation premiums and/or an attractive dividend yield, this may be a sign that other stocks are about to follow. After all, Coke is currently trading a discount when compared to the trailing S&P 500 P/E average of 32. Coke may be having their problems, but there a plenty of S&P 500 companies that wish they had it so good (KO has generated positive free cash flow in each of the last 4 quarters while its working capital has also improved).
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