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Morningstar | Coca-Cola Enhances Coffee Portfolio With Acquisition of Costa; Shares Remain Attractive

Wide-moat Coca-Cola has announced it will buy Costa, a leading coffee company in the U.K., for $5.1 billion, or approximately 16 times fiscal 2018 EBITDA. Costa generated $1.7 billion in sales in its last fiscal year (ending in March), or approximately 5% of Coca-Cola's 2017 sales. We aren't expecting a material change to our $49 fair value estimate and reiterate our longer-term outlook for mid-single-digit sales growth and mid-30s operating margin on average between fiscal 2019 (during which we expect the structural impact from the firm's bottler refranchising to subside) and 2023.

In our view, the deal (which is expected to close in the first half of 2019) should bolster Coca-Cola's presence in the fast-growing coffee category, particularly in the U.K., where Costa holds more than a one third share of coffee houses. We find merit in the strategy underlying the deal, given the robust growth prospects in the global coffee and tea space. At present, management estimates Coca-Cola controls a 15% share of the ready-to-drink tea and coffee category (which represents around 15% of the overall coffee and tea market, versus a nearly two thirds contribution from out of home consumption) and that coffee and tea account for around 7% of the firm's retail value mix (and just 3% in the Europe, Middle East, and Africa segment). However, Costa should materially enhance Coca-Cola's position in this landscape; 72% of its revenue is generated in U.K. stores (2,422 outlets), with an additional 16% of sales from U.K. express locations (serving coffee in on-the-go locations, like gas stations and movie theaters).

We see potential for Coca-Cola to expand Costa's brands into the ready-to-drink market and across a broader range of geographies. Further, we contend that Costa will benefit from Coca-Cola's vast global distribution network, entrenched relationships with retailers and suppliers, and marketing resources (factors that inform our wide moat rating), and that Costa may support Coca-Cola's coffee supply chain. While we're not blind to the added uncertainty resulting from the firm's entry into the hot beverage and retail spaces, we portend its strategy to allow Costa to be "connected but not integrated" will mitigate operational risk.

The deal will be funded with cash on hand, which we view as reasonable given the nearly $8 billion of cash on its balance sheet at the end of the second quarter. We surmise Coca-Cola still has significant financial flexibility, given strengthening cash generation following its U.S. bottler refranchising (which helped it shift to a more asset-light concentrate model). We estimate net debt/EBITDA (expected to increase by 0.3 times after closing) will average around 2.3 times over the next five years, with free cash flows remaining above a quarter of sales over this time frame.

As such, we wouldn't rule out the possibility of further tie-ups involving strong brands in faster-growing beverage categories, though we posit any deals would be on a smaller scale (like the minority stake acquired in the BODYARMOR sports drink earlier this month). While we appreciate the firm's efforts to diversify its portfolio into new beverage categories (and away from carbonated soft drinks, which have experienced secular declines in volume in the U.S. for more than a decade), we contend Coca-Cola will continue to make substantial investments behind its trademark offering (45% of unit case volume in 2017), ensuring an unwavering competitive edge.