Higher rates mean a double whammy for Coca-Cola

Warren Buffett favorite Coca-Cola has a secret formula for extra income that no other company has replicated. But it may also pose a unique risk for Coke shareholders.

A little-noticed line on the company's income statement reveals something that may surprise some investors: Coke actually makes more money from interest income than it pays out in interest expenses. That's impressive, given that Coke has about $20 billion in net debt, adjusted for its cash holdings.

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The benefit has been noticeable and actually gotten larger over the last few years: Since the start of 2011, Coke has generated $311 million in net interest income, according to public filings through the end of September.

While that's not a huge number in the context of Coke's roughly $9 billion in annual net income, it's helpful for a company in Coke's position. The beverage giant, which is the second-largest holding of Berkshire Hathaway, has seen revenue growth stagnate in recent years and faces criticism from some shareholders like Wintergreen Advisers. Coke declined to comment to CNBC.

How did Coke pull it off? Half the answer relates to the company's incredibly low cost of debt. In particular, Coke has tapped a specific part of the short-term debt market that many other companies are less willing or able to use.

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After the financial crisis, many companies abandoned commercial paper, a type of short-term funding that generates income for money market funds and other investors. The concern was that if the commercial paper market dried up in another crisis, companies could be left with no source of funding. Commercial paper outstanding has fallen by 50 percent—from $2 trillion at the end of 2006 to $1 trillion at the end of 2014, according to the Securities Industry and Financial Markets Association.

Coke, meanwhile, did just the opposite. At the end of 2006, Coke had $2 billion in commercial paper outstanding. But at the end of 2013, that amount had swelled to nearly $17 billion and the company has continued to issue short-term debt since then.

In some ways, the appeal of commercial paper is obvious for Coke. At the end of 2013, the weighted-average interest rate on Coke's commercial paper was just 0.2 percent. Rates have been even lower recently, according to fixed-income professionals.

"It looks like they've been making a bet that interest rates would stay low," said Brian Reynolds, chief market strategist at Rosenblatt Securities. He pointed out that almost all of Coke's other debt matures before 2023, indicating that the company has made a broad-based bet on cheap, short-term funding.

Coke has probably been comfortable with such a large commercial paper program because it's extremely unlikely to lose access to credit markets. The company has the highest rating for commercial paper by Moody's and Standard & Poor's.

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Unfortunately, heavy exposure to short-term debt means Coke's cost of funding will increase faster than at other companies when interest rates eventually rise. "They'll probably have more interest rate sensitivity," Reynolds said.

How much could it hurt? Assuming Coke had $20 billion in short-term debt and its average rate increased by 2 percentage points, the annual expense would rise by $400 million. For context, average commercial paper rates averaged 3.2 percent in 2005 and 5 percent in 2006 and 2007. While it could take years to get back to such levels, it's worth remembering how unusual the current environment is.

Even without an interest rate hike, it's also unclear how much more commercial paper Coke can issue. Bankers say it's unusual for companies to issue much more than $20 billion in commercial paper, suggesting Coke would need to find other, more expensive sources of financing if it borrows more.

The other half of Coke's interest-income maneuver relates to where it keeps its cash. The company, which is just about as international as any corporation in the world, has kept cash in investments overseas where it generates income.

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One likely motivation is to delay income taxes due to the U.S. government by waiting to bring money home. Another benefit is that interest rates are much higher in markets like Brazil, where Coke has a large presence.

The risk there is clear: If the U.S. dollar continues to rally against other currencies, the value of that income would decline. And some market participants consider that a likely outcome. Just Thursday, the dollar rallied against the euro after the European Central Bank announced a quantitative easing program.

Longer term, Citigroup, for instance, expects the U.S. dollar to gain against "nearly every other major currency over the next few years."

Of course, Coke uses some hedging to mitigate currency risk. But hedges involving currencies with high interest rates can be very expensive—costly enough to wipe out the benefit of higher rates overseas.

But it turns out that hedges don't show up on Coke's income statement, so it's hard for investors to assess their cost. (Currency hedges appear in "other comprehensive income," a cash flow item).

None of this means Coke is in serious trouble. But the stock looks fragile, trading at a very rich valuation of 21 times consensus forward earnings. One reason Coke commands such a premium is that investors enjoy the company's nearly 3 percent dividend yield.

But when rates rise, high-dividend companies won't be as appealing to yield-seeking investors. In Coke's case, higher interest rates are likely to be a double whammy.