A European Gem: “De-Greeking” Coke

We’ve received a lot of pushback since taking a more constructive stance on European equities, as we discussed in our last letter, available here.  At the time, we cautioned investors that, “The actual risk of permanent impairment is usually lowest when perceived risk is highest and as such, it is likely that the market has already discounted the impact of a prolonged European recession.  The news only needs to be slightly less bad for stocks to rise from today’s extremely depressed valuations and it would seem that ECB President Mario Monti’s recent actions have provided markets with such a catalyst.”

Putting expectations for the European economy aside momentarily, consider that in the past three years through September, the MSCI EAFE has declined almost 1% annually while the S&P has appreciated by over 13% per year.  Over the past five years, the MSCI EAFE has dropped nearly 8% on an annual basis!  US markets have been the primary beneficiary of Europe’s travails, but we question the wisdom of paying such an enormous premium for any market.  A margin of safety is strictly a function of the price you pay.

The result – it has become increasingly difficult to ignore the massive valuation discrepancies across the pond (highlighted above).  On GMO estimates, international and emerging market equities are priced to deliver 4.8% and 6.3% real returns over the next decade while US markets provide investors with next to nothing.  So we’ve naturally begun digging through the cheapest markets on offer and have found a handful of gems amidst the rubble.  We believe Coca-Cola Hellenic (CCH) is one such gem.  We detail our thesis in the embedded report and provide a brief summary below. 

CCH Thesis (Dec-12)

An investment in CCH represents a compelling opportunity to own a high quality business characterized by high customer captivity with significant economies of scale at a substantial discount to intrinsic value.  Shares have been dragged down by the weight of the Greek stock index at the same time that revenues have suffered from volume declines in established markets, further compounded by double-digit cost inflation which has proven to be detrimental to margins. Importantly, each of these factors appears to be transitory.  If we are right, we should get paid in two ways as both the earnings and the multiple improve.

The coming shift in the company’s listing from Athens to London appears to have sparked a change in investor sentiment.  We expect this move to serve as an inflection point for the stock, driving further multiple expansion over time.  While current sales and future growth are largely driven by the world’s emerging market population, investors have been unable to take their eyes off of the slow-motion European train-wreck represented by CCH’s more mature market exposure – at least until now.  We believe the voluntary share exchange and the London listing should do the trick and properly refocus investor attention on fundamentals.

Importantly, our investment thesis does not require an economic recovery in the European periphery to realize the intrinsic value of CCH shares.  We believe that if CCH can stabilize cash flow in established markets, its emerging and developing markets should generate substantial and sustainable earnings growth, driven by rising per capita beverage consumption, expanding market share and increasing margins. 

Furthermore, we believe input costs are more likely to present a tailwind than a headwind over our forecast period. At the same time, CCH has been investing heavily in infrastructure to expand and build scale across emerging markets, while streamlining operations across its geographical footprint. With most of the heavy lifting now complete, and the drag from input costs sets to ease,  margins should improve with volume growth given the embedded operating leverage in the business.

Finally, given the new listing, we think the company has the capacity to further leverage the balance sheet and the opportunity to reward shareholders with a significant return of capital.  Considering the free cash flow expected over the next few years, and assuming a targeted leverage ratio of 2.5x to 3.0x, management would theoretically have enough cash to take the company private at prices well above recent lows, providing investors with a comfortable floor for the shares.