RULE MAKER PORTFOLIO

Rule Maker Portfolio
Is Coke Overpriced?

By Bill Mann (TMF Otter)

ALEXANDRIA, VA (September 20, 1999) -- "No, no," you're saying. He meant to say "underpriced."

Nope, I wonder if the market at large is paying too much money for a share of Coca-Cola Company's (NYSE: KO) stock.

With a recent share performance like Coke's, can this be possible? Well, sure it can.

Take a look at the 10-Q's from Coke this year. They're ugly. I'm talking "Throw Momma From the Train" ugly. I'm talking logarithmically ugly.

Coke, the most dominant brand in beverages, saw its earnings between Q2 '98 and Q2 '99 decrease by 11%. Coke's earnings have not increased in the last three years. That's right, if you try to take a price-to-earnings-to-growth ratio (PEG) for Coke from 1996 to now, you would get a null set. Can't divide by zero, we learned that in fourth grade.

Well, for those of you who flip to the end of a book because you can't stand the suspense, let me spoil it for you in advance. I don't think Coke is overpriced. I believe that quietly, under all of the death knells being rung by the financial press, in the shadow of the scandals that have rocked the company of late, Coca-Cola has been storing powder, building on its strengths, and preparing for the future.

But what has happened to the company? Well, the "Asian Flu" has happened, but at this point, has been blamed for everything from corporate losses to Yanni the inexplicable popularity of bell-bottom pants.

Call the Asian Flu what you want, but it hasn't been, ahem, helpful for the sales efforts of any company operating in the region, including Coke. Further economic contractions in Russia, Brazil, and other countries have added to sales woes. Certainly, this has hurt the bottom line in the form of reduced revenues and stranded assets.

But one can look at these issues and make a reasonable case that they are external to the business model for Coke, and that ANY company would be hurt by such economic turmoil. After all, a good deal of Coke's existing market in these countries suddenly saw their earning power and their savings decrease to such an extent that "refreshment" no longer became one of their daily concerns.

That said, this company has some significant internal problems to overcome. But there is a reason that this is a Rule Maker, not a Breaker, not a faker. Remember, the Rule Maker portfolio intends to hold these types of companies for decades, unless they really screw up. We haven't gotten to that point, not by a long shot.

This is still the First Federal Bank of Coca-Cola, as it was labeled in the Fool's You Have More than You Think.

In the classic words of Inigo Montoya: "Let me 'splain. No, take to long. Lemme sum up."

You see, a good long look at the financials show something else going on, something that would have as adverse an effect on the bottom line as reduced sales. Coca-Cola has used the low interest rates and the weakened Asian currencies to undertake its largest phase of capital reinvestment in history. It has purchased (or is in the process thereof) properties from Cadbury Schweppes (NYSE: CSG), Orangina, and Inka Cola (the largest cola company in Peru). The company has invested millions into marketing and infrastructure, strengthening local bottlers (both its own and its strategic partners) and marketing in many of the countries with the largest growth potential.

These capital investments are the sign of a company willing to sacrifice short-term returns for long-term benefit. But capital reinvestment as a cause of reduced earnings is a far superior rationale than decreased gross margins. Over the last five years, Coca-Cola's net profit margins have averaged 18%, with the best year being 1997 at 21.6%. By this standard, Coca-Cola's performance of an 18.8% net margin during 1998 was not bad; in fact, it was better than average.

But we're not about the short-term. We like this reinvestment, as it gives our company an increased base for future earnings. Coke has built 23 bottling facilities in China since 1981, and just announced its intention to expand its facilities in Beijing. That's long term. Coca-Cola showed that it could break even in 1998 in Indonesia one of two ways, by shutting down or by selling 100 million cases. They chose to pursue the latter and augmented their Indonesia commitment by accelerating their investment into infrastructure to propel future growth. That's long-term.

Coke made a conscious choice to sacrifice its short-term returns in exchange for long-term growth. As a result, the 1998 net profit was not only down by 15% from the year before, but also a reversal of trend from several years of consistent improvement of margins. We, as long term investors need to give the company time to receive the benefits from this reinvestment, just as we need to allow time for those economies crushed in the last few years to get back on their feet. When they do, Coke will be there.

I started out this article attempting to review Coke's valuation, and to take a hard view as to its performance over the last 18 months. But as soon as I began to look at the components I became more and more positive about future prospects for growth.

The end result is this: I have seen a rapid rise of doom and gloom stories saying that it will take years for Coke to get back on its feet, that its share price prospects will remain stagnant for some time. Well, maybe. But why should we worry about this? We intend to be on board when Coke's reinvestments from 1998 begin to pay dividends. And when they do, the Belgian scare, the European Union investigations, and other problems will be nothing but a distant memory.

As distant as Crystal Pepsi seems now.


 




Rule Maker Portfolio

9/20/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS-11/16$139.19
CHVCHEVRON CORP-7/8$92.13
CSCOCISCO SYSTEMS-5/16$73.19
DPHDELPHI AUTOMOTIVE SYSTEMS-1/8$17.81
EKEASTMAN KODAK-9/16$74.94
GMGENL MOTORS-1/16$65.00
GPSGAP INC-1 1/4$32.38
INTCINTEL CORP-9/16$84.06
KOCOCA-COLA CO1/4$54.25
MSFTMICROSOFT CORP1/8$97.56
PFEPFIZER, INC1/8$36.56
SGPSCHERING-PLOUGH1/4$50.50
TROWT.ROWE PRICE ASSOC-29/32$28.78
XONEXXON CORP-1 11/16$78.19
YHOOYAHOO INC1/4$168.38

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker -.30% -.30% .16% 14.22% 43.31% 24.67%
S&P 500 .01% .01% 1.15% 8.65% 36.24% 20.87%
S&P 500(DA) .01% .01% 1.15% 9.23% 38.01% 21.83%
S&P 500(DCA) n/a n/a n/a n/a 23.10% 13.58%
NASDAQ .58% .58% 5.36% 31.63% 78.23% 42.50%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$73.19122.69%
2/3/9854MSFT45.135$97.56116.16%
2/13/9852INTC46.928$84.0679.13%
5/1/9882GPS22.708$32.3842.57%
5/26/9818AXP104.067$139.1933.75%
2/17/9916YHOO126.309$168.3833.30%
2/3/9866PFE27.433$36.5633.28%
3/12/9820XON64.335$78.1921.53%
3/12/9820EK63.148$74.9418.67%
3/12/9815CHV83.343$92.1310.54%
3/12/9817GM60.400$65.007.62%
8/21/9844SGP47.993$50.505.22%
3/12/9811DPH17.190$17.813.62%
2/3/9856TROW33.673$28.78-14.53%
2/27/9827KO69.107$54.25-21.50%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/9875CSCO$2,464.86$5,489.06$3,024.20
2/3/9854MSFT$2,437.28$5,268.38$2,831.10
2/13/9852INTC$2,440.28$4,371.25$1,930.97
5/1/9882GPS$1,862.06$2,654.75$792.69
2/17/9916YHOO$2,020.95$2,694.00$673.05
5/26/9818AXP$1,873.20$2,505.38$632.18
2/3/9866PFE$1,810.58$2,413.13$602.55
3/12/9820XON$1,286.70$1,563.75$277.05
3/12/9820EK$1,262.95$1,498.75$235.80
3/12/9815CHV$1,250.14$1,381.88$131.74
8/21/9844SGP$2,111.70$2,222.00$110.30
3/12/9817GM$1,026.80$1,105.00$78.20
3/12/9811DPH$189.09$195.94$6.85
2/3/9856TROW$1,885.70$1,611.75($273.95)
2/27/9827KO$1,865.89$1,464.75($401.14)
  Cash: $104.34  
  Total: $36,544.09  


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.