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Monday, November 2, 1998

An Investment Opinion
by Warren Gump

Another Way to Play Coca-Cola?

For a number of years, I have looked at returns obtained by the shareholders of Coca-Cola (NYSE: KO) with envy. So far this decade (through the end of September), Coca-Cola investors who have reinvested their dividends have enjoyed annualized returns of over 24%, compared with about 16% for the S&P 500 index. While an 8 percentage point difference is big in absolute terms, it is even more profound when the power of compounding is considered. To put the difference in dollar terms, $1000 invested in the S&P on December 29, 1989 would have turned into $3,664, while the same amount in Coke would be worth $6,568. Total difference: $2,904. In other words, the S&P investor made a more-than-respectable $2,664, but the Coke investor made over twice as much.

Unfortunately, with a value bent, I've personally never been able to pull the buy trigger on Coke stock, which, of course, has been my loss and other investors' gain. I agree that with a 20 or 30-year time horizon, an investor in Coke will make a lot of money. In the meantime, however, I am not comfortable paying 44x trailing earnings for a company with estimated future growth of 14%-18% per year (according to analyst estimates). I would prefer investing in companies with lower valuations and higher growth (which usually is accompanied by a higher-than-Coke risk that long-term growth will not be achieved).

While stock in Coke is not an appealing investment for me, there is obviously an enormous amount of money made by the company, its suppliers, and its customers. For example, fountain beverages are one of the more profitable items for restaurants. At the same time, most people believe Coke's continued success will be driven by expanding into new regions. Combining those two ideas leads one to what might be an interesting investment for Fools. Lancer Corp. (AMEX: LAN), based in San Antonio, is one of Coke's prime worldwide suppliers of soda and juice fountain machines.

As stated in the company's 10-K, "substantially all of the Company's sales are derived from, or influenced by, The Coca-Cola Company." In fact, direct sales to Coke accounted for 24% of 1997 sales. A heavy concentration of sales like this can be a double-edge sword. When the going is good, investors receive terrific returns. If something happens to the relationship between supplier and customer, however, there can be a wipeout for the supplier's shareholders. The loss of Coke would, without a doubt, be devastating to Lancer.

In fact, due to the company's dependence on Coca-Cola, just a rumor of a rift between the companies would likely cause a major spill in Lancer's stock price. Nonetheless, investors can probably take comfort in the fact that the companies have a long, close relationship. In addition, while Coca-Cola could certainly do the manufacturing of dispensing equipment itself, it has demonstrated over the years that it prefers to stay out of this area. In many ways, Coke's partnership with Lancer mirrors the one it has with its bottlers: it is a partnership that advances Coke's objectives while minimizing the outlay of Coca-Cola capital.

Sales between 1995 and 1997 at Lancer grew at a compound annual 25% rate, reaching $119 million last year (of which 48% were international). Sales are up another 19% through the end of September. Gross margin has increased from 21.5% in 1995 to 25.9% in the first nine months of 1998. Net earnings increased at a compound 22% between 1995 and 1997, with a significant portion of that growth occurring in 1996. Net earnings for the first nine months of 1998 have grown impressively, rising 32% over the prior year (EPS is up 35%). Earnings in 1997 were hampered by the strategic purchase of operations in Brazil and New Zealand to broaden its international efforts and significantly increased research and development investment. While "international" is not regarded highly in the current market environment, sentiment will likely change in the future (wait a minute, has it already?).

The cash flow statement is not quite as rosy as the income statement, given that the company has been reinvesting into its business. Operating cash flow for the first six months of this year was a negative $1.7 million, thanks to increased accounts receivables and inventory. Receivables have been growing slightly faster than sales (something to watch), while inventory was up a little less than sales (a positive sign).

The balance sheet in the company's recently announced third quarter earnings release was more positive, showing a decrease in receivables and virtually flat inventory from Q2 (a Q3 cash flow statement has not yet been released). To fund increasing working capital and capital expenditures over the past couple of years, Lancer has been increasing debt, which as of Sept. 30, 1998, stands at $46.5 million, or 49% of capitalization. While this level of debt is manageable, investors should closely monitor trends in inventory, accounts receivable, and cash flow in future quarters.

Whither to from here? Zacks consensus estimates for 1998 call for earnings of $0.81 in 1999, increasing to $0.92 in 1999. That means at the current price around $12 investors are paying 14.8x this year's estimates and 13.0x next year's. The long-term estimated growth rate for the company is 15%.

I am much more comfortable paying 15x earnings for Lancer, growing at 15% a year, than 44x earnings for Coke, which is estimated to have up to 18% annual growth. (I'll be, ahem, "courteous" to Coke and assume it will rebound dramatically from this year's earnings decline and the estimated 9% growth for 1999). Now, don't get me wrong, these stocks are not interchangable. Lancer is not another Coca-Cola and will never achieve the high valuations given to dominant worldwide consumer brands. Lancer is in the moderate margin equipment manufacturing business, not the high margin, recurrent soda biz. Quarterly results at Lancer have been (and will be) much more erratic than at the Atlanta giant, although the historical long-term trend looks pretty good at both. As Coke grows, so should Lancer. Call it a value investor's play on Coca-Cola.