<THE RULE MAKER PORTFOLIO>

Flat Coke

by Rob Landley (TMF Oak)

AUSTIN, TX (May 21, 1999) -- The Coca-Cola Co. (NYSE: KO) has not been having a fun year. This is the only stock in our portfolio that's down from where we bought it a year ago, and there's a reason: Coke made LESS money in the first quarter of 1999 than in Q1 1998. Ouch. Add to that the unfavorable currency translations that turn weak foreign currencies into strong U.S. dollars, and Coke's most recent 10-Q is not a pretty sight. (You might want to open that link in another window and follow along with the class.)

First quarter fully-diluted net earnings per share fell to $0.30 from $0.34 a year ago. In the "Results from Operations" section (part of the "Management's Discussion and Analysis"), Coke states bravely, without even asking for a blindfold or a last cigarette, that it sold 6% fewer gallons of concentrated Coca-Cola syrup this quarter than the same quarter last year. The only defense poor old Coke can offer is this: "The decrease in volume is primarily a result of the impacts of difficult economic conditions in many parts of the world." Outside of the U.S., the worldwide economy is not happy, so people there simply have less money with which to buy Coke.

Fallout From Asian Economic Crisis

One big reason for this is the "Asian Economic Crisis" (bump-bum-baaaaaah!!!!), which if I understand correctly (this is not guaranteed) is the old Savings and Loan crisis after ten years of compounding. Prepare yourselves for Massive Oversimplification (tm):

Ten years ago, the U.S. confronted the "Savings and Loan Crisis" (bump-bum-baaaaaah!!!!), and our government, who art in debt, spent sagans of dollars bailing out hundreds of near-bankrupt financial institutions. These savings and loans (and a lot of large banks too) had taken advantage of poor government oversight and misguided deregulation to speculate in the booming real estate market. They didn't always do it directly, but they gave a lot of loans and mortgages to people who did, without asking too many questions about "collateral" and "solvency" and "how much money do we still have in the vault?" Then, when the bottom suddenly dropped out of the real estate market in the late '80s, they found themselves holding a lot of bad debt owed to bankrupt developers. The S&Ls were forced to foreclose on land they couldn't sell for even half of the mortgage owed on it. While they had millions of dollars on paper, in reality if their customers tried to withdraw too much money from their checking accounts the bank would run out of cash!

When the full extent of the problem became apparent, the U.S. government stepped in and fixed everything with a time tested technique called "throwing money at the problem." Uncle Sam bailed out the banks, making sure the U.S. financial industry remained solvent and in business, and that depositors didn't lose their federally-insured savings. A lot of voters were remarkably peeved about this, and there was plenty of political fallout. But it blew over in a few years, and they changed a lot of laws to try to prevent it from happening again.

In Asia, things were different. Just like the U.S., they got themselves hip-deep in real estate during the boom years of the '80s, with Japanese investors buying Rockefeller center in New York and thousands of acres of Hawaii land. But when the crash came there was honor at stake, and bankruptcy is dishonorable. Admit to bad business decisions and the firm loses face. Foreclosing on a business partner isn't just a matter of money, but relationships. Elsewhere in Asia, rich families oftentimes not only owned the banks, but also had done the speculating, and would be foreclosing on their own family members.

So most of Asia swept their financial problems under the rug. With "easy payment terms," bad debt with insufficient collateral doesn't have to be recognized. Land currently selling for $1000/acre is still worth $3000/acre until you try to sell it. They kept bad debt on the books, used recent deposits to fund recent withdrawals, and hoped everything would sort itself out in the end.

After a decade of this, the bad debt ballooned until it popped, and the entire Asian economy suddenly collapsed. When a bank ran out of money, it had to try to cash in the bad debt, and there was nothing there. Next, homes and business were foreclosed on, throwing successful professionals out of work and into the streets. But this didn't help the bank get cash because everybody else was doing the same thing and there was nobody to sell the repossessed property to. When the banks went under, people who had money stored in that bank were suddenly penniless, and the spiral continued downwards until there was rioting in the streets.

The reality of what happened was of course INSANELY more complicated than that (I didn't even mention the Korean stock market or the yen/ringit exchange rate), and played out over a period of several months, with "better late than never" intervention from just about every governmental agency on at least three continents. But the moral of the story is that if you have a big, evil problem that gets worse the longer you wait, sweeping it under the rug is probably not the smart move.

Opportunity for Coke

So meanwhile, The Coca-Cola Company is trying to sell all these people Coke -- trying very hard, I might add. And suddenly, there's a whole bunch of dirt cheap real estate for sale. What does Coke do? It BUYS it! In the first quarter of this year alone, Coke spent half a billion dollars either investing in bottling companies or purchasing property, plant, and equipment. (You still have that 10-Q open in another window, right? Check the cash flow statement under "Investing Activities".) For the past year, Coke has been able to buy Asian bottling plants for pennies on the dollar, and tap into a huge pool of skilled but unemployed labor that it can put to work making and distributing Coke. If you page back down to "Results of Operations," there's the bit about "Operating Income and Operating Margin," which states that Coke recently acquired bottling operations in India and vending operations in Japan.

Coca-Cola has done a good job investing in Asian assets, and in fact, net revenue from the Middle and Far East group is up 13% from the same quarter last year. (Go to Note F, "Operating Segments", see table.) Unfortunately, revenue from Africa, Europe, and Latin America was all down. Economic trouble spreads, and many parts of the world's economy seem to have noticeably slowed over the past year. Still, that's just more opportunity to buy production and distribution assets low, and sell Coke beverages high whenever these economies finally rebound. Coca-Cola's management has never taken a short-term view, but rather a long-term ownership position in the beverage consuming habits of the world at large.

Coke is good at taking lemons and making lemonade. After all, it owns Minute Maid. Coke still has a very healthy positive cash flow, and it's making the best use of it that it knows how. For investors who believe Coke's management knows what it's doing, hard times are an opportunity to buy in cheap. For those who believe their money is better invested elsewhere, Coke has a stock buyback program, funded from the healthy profits it still makes, that would be happy to take their excess shares out of circulation.

On Monday, Tom will kick off our week on pharmaceutical companies.

Have a great weekend,

- Oak

05/21/99 Close

Stock Change    Bid
AXP   -3 1/8    120.25
CHV   -  5/16    93.44
CSCO  -1 1/2    113.25
EK    -2 9/16    73.00
GM    +3 3/16    83.31
GPS   -  1/2     61.56
INTC  -  11/16   57.00
KO    +  1/16    68.00
MSFT  -  7/8     77.56
PFE   -2 9/16   110.25
SGP   -  1/4     48.50
TROW  -2         37.50
XON   +2 3/4     82.75
YHOO  -  3/16   151.31


                  Day     Month  Year    History
        R-MAKER  -1.02%  -4.61%   6.92%  35.29%
        S&P:     -0.64%  -0.37%   8.54%  34.27%
        NASDAQ:  -0.84%  -0.87%  14.96%  52.51%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     77.56    98.20%
   6/23/98   34 Cisco Syst    58.41    113.25    93.89%
    5/1/98   55 Gap Inc.      34.37     61.56    79.12%
   2/13/98   44 Intel         42.34     57.00    34.63%
    2/3/98   22 Pfizer        82.30    110.25    33.96%
   2/17/99   16 Yahoo Inc.   126.31    151.31    19.80%
   5/26/98   18 AmExpress    104.07    120.25    15.55%
    2/6/98   56 T. Rowe Pr    33.67     37.50    11.36%
   8/21/98   44 Schering-P    47.99     48.50     1.06%
   2/27/98   27 Coca-Cola     69.11     68.00    -1.60%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     82.75    28.62%
   3/12/98   20 Eastman Ko    63.15     73.00    15.60%
   3/12/98   17 General Mo    72.41     83.31    15.06%
   3/12/98   15 Chevron       83.34     93.44    12.11%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
   6/23/98   34 Cisco Syst  1985.95   3850.50  $1864.55
    2/3/98   48 Microsoft   1878.45   3723.00  $1844.55
    5/1/98   55 Gap Inc.    1890.33   3385.94  $1495.61
   2/13/98   44 Intel       1862.83   2508.00   $645.17
    2/3/98   22 Pfizer      1810.58   2425.50   $614.92
   2/17/99   16 Yahoo Inc.  2020.95   2421.00   $400.05
   5/26/98   18 AmExpress   1873.20   2164.50   $291.30
    2/6/98   56 T. Rowe Pr  1885.70   2100.00   $214.30
   8/21/98   44 Schering-P   2111.7   2134.00    $22.30
   2/27/98   27 Coca-Cola   1865.89   1836.00   -$29.89

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1655.00   $368.30
   3/12/98   20 Eastman Ko  1262.95   1460.00   $197.05
   3/12/98   17 General Mo  1230.89   1416.31   $185.42
   3/12/98   15 Chevron     1250.14   1401.56   $151.42

                              CASH     $70.09
                             TOTAL  $32551.40

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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