I am often asked: ‘what comes next?’
The framework below serves to illustrate how I currently think about the businesses I own and how they should perform over the next several quarters as we head towards “the new normal”.
Clearly, some of the businesses benefit from the initial lockdown phase: Amazon has seen a surge in sales normally reserved for holiday shopping, whilst Netflix is experiencing a similar rush of new subscribers as consumers looking for entertainment are homebound. Both these businesses may become somewhat expensive on the ‘stay-at-home’ trade, but our view is that certain consumer behaviours that entrench their respective competitive positions have received a massive boost. As an example, Amazon found it difficult to break into the online grocery market for several years because consumers preferred the convenience of in-store shopping. In April, it has had to create a waitlist for new customers to order groceries online. Our belief is that the lockdown phase will accelerate the shift of grocery buying to online channels, which will be a net win for Amazon over several years as it consolidates more consumer spending onto its platform.
Other businesses will benefit once the most severe measures of the lockdown phase are lifted and we enter what we call the stabilisation phase. If the lockdown has revealed anything, it is that people do not like to be cooped up at home for extended periods. We think outdoor exercise and physical activity will both be beneficiaries of this phase and believe that Nike – which is substantially better positioned than its competitors via its more fully-developed digital sales channels – will take market share. Alphabet will see declines in revenues as advertising budgets are pared back, but we believe as soon as there is some signs of consumer demand stabilising, its ability to target ads will be more vital for businesses looking to convert potential customers to buyers than ever before. Contract research organisation ICON will see patient access to its clinical trial sites slowly normalise as lockdowns are lifted because its pharmaceutical clients do not want to compromise the validity of clinical data from trials-in-progress.
The normalisation phase will benefit our businesses whose services or products are mostly consumed or purchased on-premise: Heineken and Coca Cola are good examples. While both are benefiting from pantry stocking and at-home consumption, it is not enough to offset the foregone on-premise sales of the lockdown period. Given that large scale public gatherings will be some of the last activities to be allowed to continue, we don’t think the recovery will initially rebound to pre-2020 levels, but ultimately believe the growth drivers for both – the demographic tailwind in emerging markets – will remain intact. MasterCard is currently benefiting from increased online shopping but are losing out on high-margin transactions from international travel. While the latter will take a long time to normalise, we believe this crisis accelerates the move to card-based purchasing relative to cash. Once physical stores start re-opening, we think card-based (or card-backed) payments will take a step-change higher in many markets.
Finally, there is the new normal that all businesses will have to contend with. We don’t know exactly what it will look like or precisely when it will arrive, but we think all of our holdings will survive to make it to that point, and will be in a better competitive position, having either taken market share or seen demand for their products or services increase. Microsoft is a great example. Given the work-, educate- and play-from-home era we find ourselves in, the company is already seeing increased demand for its offerings. Its strong incumbent status with enterprise clients and years of experience managing on-premise IT environments leave it in an enviable position to manage the hybrid IT landscape organisation must now navigate. We believe Accenture will benefit from increased demand for its consulting activities to navigate the post-COVID-19 business landscape and will also win more outsourcing work from companies looking to focus on core activities. Factory automation is likely to only gain in prominence as manufacturing capacity is re-shored to developed markets, benefiting Keyence.
There remains a risk of a second wave of infections setting us back along the path to recovery, but we believe the quality of the balance sheets of the businesses we own allow them to remain resilient in this outcome. Conversely, we cannot discount the potential efficacy of one of the many drugs currently undergoing clinical trials to dramatically shorten the path to normalisation, even if very unlikely. This would be a massive positive, both for the global economy and markets.
I currently own a mix of businesses across all these phases; some will perform better once the lockdown ends, while the market will likely sell some ‘lockdown winners’ on this news. Instead of worrying about these near-term trades, my main focus is to ensure all our businesses will be in good shape once we come out the other end.
One currently out of favour business I have increased my investment in is The Coca Cola Company (KO.US).
The Coca Cola Company
The company reported revenues that were down 1% compared to the first quarter of 2020, though a stronger US dollar negatively impacted this number by 2%. Organic revenues in constant currency were essentially flat, as were global volumes.
Coke sells about half of its product through ‘on-premise’ channels, such as restaurants or at sporting events. These sales channels are essentially closed off to the company at present, meaning there will be a significant decrease in sales volumes in the second quarter. (For context, as at the reporting date in April, management saw volumes down roughly 25% year over year). We expect sales declines to start moderating thereafter, but do not think that volumes will fully normalise until large-scale public events and restaurant are allowed again.
Some of these lost sales are being offset by stronger at-home demand through e-commerce channels, and when consumers are not ordering online, they are mostly doing a once-a-week shopping trip to stock up on groceries. The practical implications of stay-at-home orders mean consumers spend less time browsing in-store. In one sense, this benefits Coke, as consumers are displaying a preference for well-known and recognized brands. Conversely, it means the supply chain needs to be operating smoothly to ensure grocers do not experience stock-outs of Coca Cola’s beverages.
The company announced plans to contain costs and paused all capital investment beyond what is essential for maintenance purposes. While its dividend will be maintained, the company ruled out aggressive M&A or further share repurchases for the remainder of 2020.
Our rationale for investing in Coca Cola was twofold. Firstly, after nearly a decade of owning and fixing its capital-intensive bottlers, the business had gotten to the point where most of these operations were either sold or spun off, meaning that the potential for free cash flow growth to meaningfully accelerate was attractive. Secondly, we believe the Coca Cola brand and franchise remains strong and relevant around the world, but particularly in lower GDP per capita emerging markets which generally have strong demographic tailwinds underpinning long-term consumption growth.
There is no doubt that the second calendar quarter will be the toughest period Coca Cola has faced for decades. Normally a staid defensive stock that would prove resilient in a recession, the nature of this downturn – caused by a pandemic – essentially means a meaningful part of their sales channels are simply shut down. We do not believe either of the key arguments underpinning our investment case are substantially impaired at this stage and I have increased our investment in KO into its recent share price weakness.
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