Rule Maker Portfolio
I'll give the nickel tour of the situation. In 1987, Coca-Cola spun off its bottling assets into a separate operating company, Coca Cola Enterprises. Actually, the situation is much more complicated than this. There are dozens of domestic and international bottlers, many of which are owned partially by Coke. But, like I said, this is the nickel tour. From here on out, to avoid confusion -- most notably my own -- I'm going to refer to the companies by their stock tickers.
In divesting itself of the bottling and distribution assets, KO's business model became centered on the high-margin business of producing the syrup and managing the brand, while the capital intensive -- and lower-margin -- components were, in effect, sequestered into providing vendor services. As a part of this, the bottlers on an annual basis were compensated by KO through co-marketing support and other charge-backs, on top of KO's payments to bottlers for actual rendered services.
The problem has come in the last three years when KO's "marketing payments" to certain bottlers, particularly CCE, have skyrocketed. In 1996, it was $448 million. Then, $604 million in 1997. This past year, KO shelled out $899 million in support of CCE. These payments have essentially subsidized CCE's cash-starved operations.
CCE has seen its free cash flow decrease from $396 million in 1996 to negative $588 million in 1998 (for the calculations, see this post). To compensate, KO has made these marketing payments to CCE, which, not coincidentally, were made to ensure that CCE meets its designated "cash operating profit" (net income excluding noncash expenses). I'd note that the tempest on the KO board seems quite justified by this little vignette from the CCE Management's Financial Review from the 1998 Annual Report:
FUNDING FROM THE COCA-COLA COMPANY -- Material changes in levels of funding historically provided under various programs with The Coca-Cola Company, or our inability to meet the performance requirements for the anticipated levels of such support payments, could adversely affect future earnings. The Coca-Cola Company is under no obligation to continue past levels of funding.
So in other words, there seems to be a Faustian deal with the devil here -- CCE's concentration upon the low-margin portion of the business comes with a low risk/guaranteed return caveat. If CCE is not profitable in a given period, KO will come in and cover its operational shortfall.
This is not so different from utility holding companies, which have certain regulated components (U.S. electric utilities have an implied rate of return set by an external body, the State Utility Commissions), and unregulated operations, for which operational profits are not fixed. The holding company may not transfer assets from the regulated side to the unregulated business. This division makes for separate businesses with separate balance sheets and so on.
Back to Coke. The problem lies in the language used by CCE -- that KO is under no obligation to continue funding. This means that KO may treat its payments to the bottlers any way they wish. KO may (and in fact, as far as I can discern, does) treat these annual payments as "one-time events," ones that do not count against the earnings from operations number that Wall Street uses to calculate net income and earnings per share. Therein lies the rub.
You see, I am beginning to become very skeptical of the earnings numbers that companies release, as they are so easily manipulated. In this case, because CCE is a separate company from KO, KO may treat that portion of CCE's returns attributable to KO's 42% ownership of the company as "look-through earnings," ones that add to KO's enterprise value but do not count for or against its bottom line. Warren Buffett uses "look-through earnings" as one of the key components to determining Berkshire Hathaway's (NYSE: BRK.A) return on invested capital. But in this case, KO has separated out a component of its core business and declared its profit (or loss) to be an extraordinary event that is not germane to its own bottom line.
This I don't like very much, and unfortunately, it's rampant among most companies, which are finding that it's better to jimmy the books and meet estimates than to play it straight and disappoint. I'm not alleging illegalities, but I am saying that the companies I look to invest in should be beyond reproach from an integrity standpoint. And so, although I actually agree with KO's strategy of spinning off its low-margin operations, I am concerned that this setup makes it too easy for KO to monkey with its own financials.
Just last week, another Rule Maker, Yahoo! (Nasdaq: YHOO) was the toast of the portfolio for trouncing earnings expectations, shouting from the mountaintops that its Net Income before extraordinary charges was $0.14 per share, well above the average estimate of $0.12. Oh, but by the way, this number is exclusive of the one-time merger related charges, which, when added in, bring Yahoo's profit down to only $0.05 per share.
But what gets included under extraordinary charges? Under FASB rules, the definition is quite open to interpretation, and that's where creative accounting can go a long way to deceptively beautify an income statement. Companies can speed up or slow down their goodwill amortization charges related to mergers, in process Research & Development, "purchased R&D," restructuring charges, inclusion of pension surplus, interest pooling or many other tactics, dependent upon their needs to beat estimates or to lower quarterly profits.
Warren Buffett, a Coca-Cola Company board member, is becoming increasingly critical of the creative accounting used by companies to conform with Wall Street expectations. He recently stated, "A growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it is OK to manipulate earnings to satisfy what they believe are Wall Street's desires. In fact� many believe that it is their duty."
To me the bad thing about this is not that companies do it, but that it pays for them to do so. I look at it this way: We are already seeing among the highest growth companies a trend in which meeting or even beating Street estimates does not get met with any short-term enthusiasm. Rather, they have to SHATTER the estimates in order to maintain their share prices. Is this the precursor to greater cynicism among market participants? If book manipulation is so easy and so accepted, is simply meeting estimates going to be seen as a sign that things are REALLY bad? And what about the companies that play it straight -- are they going to be penalized by the market?
I'm not done with KO, not by a long shot. As I recently opined, this is the Rule Maker component that I consider the most appropriately valued at this time. But I must say, KO and other companies are doing themselves a grave long-term disservice. If I have to spend my time doing forensic accounting each and every time I get corporate financials, you may rest assured that I'm going to spend my time, and invest my money, elsewhere.
And Doug Ivester, that last comment was directly addressed to you. Don't make your friends feel stupid, or they will punish you in the long run.