Rule Maker To Buy
February 20, 1998
**When Rule Maker announces an intention to trade, that trade will be made within the next five business days, as opposed to the very next day. For more detail on how buys are determined and how this portfolio originated, please read the "11 Steps to Rule Maker Investing" section of the Rule Maker Portfolio.**
Rule Maker Portfolio Buy Report
Announcement: Purchasing $1,875 in Coca-Cola stock.
An Overview of the Company
The Coca-Cola Co. is the world's largest soft drink company. Coke also is the world's largest marketer and distributor of juice products. In addition, the company owns a number of bottling interests including a 45% stake in Coca-Cola Enterprises (NYSE: CCE).
One of the primary characteristics that we look for in Rule Maker stocks is consumer mindshare. We won't find it in all of our investments, but it's extremely evident with Coke, and it's a value that doesn't jump out at you on the income statement. How does it affect Coke's business? People regularly plunk down a dollar or more for a glass of Coke in a restaurant. They don't even THINK about price; the brand name and drink are a no-brainer order. Chances are that won't end anytime soon.
The company's products are also found throughout grocery and convenience stores in the aisles and the refrigerated section. They're sold in bottles, cans, and cartons. On the cover of Coke's 1996 annual report is one word in the form of a question: "Thirsty?" There's still some debate about how much of a thirst quencher caffeinated, carbonated corn syrup is, but that's why you have a marketing department! One of the beauties of Coke's business is that thirst -- a natural, necessary reaction -- sells its products. The greatest challenge for Coke is to make its products readily available, an arm's length away. That accomplished, it guarantees enormous, worldwide sales volumes.
The company's trademarks have appeared on soft drink products sold in the U.S. since 1886, and they are now sold in nearly 200 countries around the world. (And -- get this -- it has even trademarked the scripted curl that runs under the Coca-Cola logo; it's called "The Dynamic Ribbon Device (tm)".) Not surprisingly, alongside McDonald's, Coke has one of the two most recognized brand names in the world.
Of even greater attraction to us is the value-creating efficiency of Coke's business operations. In many ways, its core business involves just the production and sale of soft drink & non-carbonated beverages, concentrates, and syrups. Take water, add flavor, add color... then send it off to the distributors. Among the major soft-drink brands distributed by Coke are the number one selling soft drink in the world -- Coca-Cola -- caffeine free Coke, Diet Coke, Cherry Coke, Diet Cherry Coke, Sprite, Diet Sprite, Mr. PiBB, Mello Yello, Fresca, Fanta and TAB. Juice products include such well-known names as Minute Maid, Five Alive, Fruitopia, POWERaDE and Hi-C.
Coke also has equity positions in over 40 unconsolidated bottling, canning, and distribution operations for its products worldwide. These operations accounted for just over 50% of the company's U.S. unit case volume in 1996. Finally, around 70% of Coke's sales and 80% of its profits were in international markets in 1997.
The Basic Financials
Over the last ten years, Coke has continued to demonstrate consistent sales and earnings growth along with widening margins and steadily increasing positive cash flow. The company has driven net profit margins from 12% to 22% over the past decade -- unbelievable for such a large business. The company has also historically enhanced the returns to its shareholders through thirty-five consecutive years of dividend growth and its habit of buying back shares. In fact, the average number of shares outstanding has decreased every year since 1983. It all adds up to an extremely efficient business, our favorite sort, which has consistently provided market-thumping returns over the long haul.
Let's start with a glance at some of the income statement numbers (and, of course, the complete 10-K is available for your perusal on EDGAR):
10-year 1997 1987 ann. growth Revenue (Billions) $18.9 $7.7 9.4% Gross Profit Margin 68.1% 52.6% 2.6% Net Profit (Billions) $4.13 $0.92 16.2% Net Profit Margin 21.9% 12.0% 6.2% EPS $1.67 $0.30 18.7% Dividend $0.56 $0.14 14.9%
The company has been increasing both its gross and net profit margins in rather dramatic fashion. The margin improvements have come while the company has continued to enter new markets and diversified its product line. Also of import, although Coca-Cola has increased it dividend for 35 consecutive years, the rate of the increase in the dividend is less than the growth rate in earnings per share. This fits the company's aim to be a stable growth company -- reinvesting a larger percentage of its free cash flow into the high-return beverage business rather than doling out excessive taxable cash dividends to its shareholders.
Price: $68 1/2 Trailing earnings: $1.67 Calendar 1998 Est.Earnings: $1.72 Calendar 1999 Est.Earnings: $1.97 P/E on Trailing Earnings: 41.1 P/E on 1998 Est.: 39.9 P/E on 1999 Est.: 34.8
Basic Rule Maker Criteria*
Market Capitalization...............$160.1 billion Gross Profit Margin...................68.1% Avg. Net Profit Margin................21.9% Cash (and short-term securities)......$2.2 billion Long-Term Debt........................$947 million Cash as a multiple of Long-Term Debt...2.33x Flow Ratio.............................0.61
* All balance sheet data as of 9/30/97
Consensus 5-Year Annual Growth Rate.....17.3% Debt as % of equity.....................13.0% Debt as % of revenues....................5.1% Dividend Yield...........................0.8% Return on Equity........................59.4% Return on Invested Capital..............26.6%
*All balance sheet data as of 9/30/97
A Concentrated Look at the Business
The business of the Coca-Cola Co. is nonalcoholic beverages -- principally soft drinks, but it also pours Minute Maid into cartons across America. From an operating management perspective, Coke is made up of five geographic groups plus the separately defined Minute Maid Co. The geographic groups include the following: Africa (2% of sales and 3% of profits in 1996); Greater Europe (32% of sales and 28% of profits in 1996); Latin America (11% of sales and 18% of profits in 1996); Middle and Far East (22% of sales and 30% of profits in 1996); and North America (33% of sales and 21% of profits in 1996).
What exactly does Coke make? It manufactures and sells a variety of liquids in the form of soft drink and noncarbonated beverages, concentrates, and syrups. The syrups consist of sweeteners, water, and flavoring in the form of a concentrate. Coke then sells the concentrates and syrups to authorized bottling and canning operations, who then either combine the syrup with carbonated water or combine the concentrate with sweetener, water, and carbonated water. That all results in the production of finished soft drinks.
Once the soft drinks are in finished form, they're packaged in authorized containers bearing the company's trademarks that we all know so well. They're then delivered to retailers or wholesalers in cans, refillable & non-refillable glass, and plastic bottles. Coca-Cola also makes fountain syrups sold directly to fountain retailers in the U.S. The fountain syrup sold outside the U.S. is often actually manufactured by the bottlers via Coke's concentrate. The company's juice products are sold both directly and through a broker network to retailers and wholesalers in North America and, to a limited extent, outside North America.
Now some of you are probably thinking that we've taken a business that's rather simple and made it sound a lot more complicated than need be. That's certainly true, but in doing our Foolish research we want to make sure that we really understand the business that we're buying, so we carefully read through material like the company's 10K. You might be thinking, "Hey, gimme a break... it makes simple drinks, Fools. The products are sometimes lightly drugged with caffeine and they have bubbles. All Coca-Cola really does is make colored, flavored, caffeinated sugar water."
Ok, we'll show you what our research came up with. You say sugar water? Well, as a matter of fact, the principal raw material used in the Company's business in the United States is not cane sugar, but high fructose corn syrup. Outside the United States, it's another form of sugar, sucrose. You might win on Jeopardy with this information -- it was brought to you by Phil Weiss, one of your Rule Maker researchers!
Let's get serious again...
When it comes to selling repeat-purchase consumer products, Coke clearly is it. We listed some of it products before, but take a look at them again. The following list from the Company's 10K represents the brand name products sold over and over by Coca-Cola every day around the world: Coca-Cola, Caffeine Free Coca-Cola, Diet Coke (sold under the trademark Coca-Cola Light internationally), Caffeine Free Diet Coke, Cherry Coke, Diet Cherry Coke, Fanta, Sprite, Diet Sprite, Mr. PiBB, Mello Yello, TAB, Fresca, Barq's Root Beer, Surge, POWERaDE, Fruitopia, Minute Mai, Saryusaisai, Aquarius, Boanaqa and Georgia brand ready-to-drink coffees.
The Minute Maid Co., which primarily produces juice products, operates mainly in the U.S. and Canada. It produces, markets, and distributes Minute Maid juices, Five Alive, Bright & Early breakfast beverages, Bacardi brand tropical fruit mixers, and Hi-C fruit drinks. Coca-Cola has also entered into a joint venture with Nestle S.A. -- Coca-Cola Nestle Refreshments -- which produces ready-to-drink teas and coffees abroad. The company also recently purchased Orangina, one of the most popular drinks in Europe.
How does it work with its bottlers? Coca-Cola enters into separate contracts with each of its bottlers regarding the manufacture and sale of its products. Generally, these contracts authorize the bottler to prepare, package, distribute, and sell particular trademark beverages in authorized containers in an identified territory -- sounds lawyerly!
Recently, the company had a change in management when Douglas Ivester assumed the role of Chief Executive Officer upon the death of company architect, Robert Goizueta. Mr. Ivester is 50 years old, and the rest of his management team ranges in age from the early 40s to late 50s.
A Look at Historical Stock Performance
Coca-Cola defines strong historical stock performance. One share of Coke purchased at the end of 1919 (the year of the company's IPO) was valued back then at $40. By the end of 1996, stock splits would have multiplied that single share into 4,608 shares with a pre-tax value of over $242,000. That's an annualized return of 12.0%.
Although that return on investment may sound unthinkable, consider what would have happened if you had reinvested your dividends. As of the end of 1996, after splits and annual dividend reinvestments, that single share of stock would have been worth in excess of $5.1 million -- an annualized return of 16.5%. How much did 20th century owners of Coca-Cola pay to brokers and mutual-fund managers to turn $40 into $5.1 million?
Through the best and worst markets over the last 77 years (and there have been some really bad markets), if you had held shares of Coke from its IPO onward, you'd have a compound annual return on your investment that trounced the market's performance, and other than some taxes on your dividends, you wouldn't have paid a single dollar in transaction fees along the way. That lesson of small savings, compound growth, consumer-franchise investing, and an irreverent patience should be taught in schools across our fair nation.
Concerns Going Forward
That history is all well and good, and congratulations if your ancestors had the insight and foresight to buy and hold Coca-Cola since 1919. But what about the rest of us blokes here in 1998, trying to put together a portfolio for the future?
Critics of Coke have a very long list of complaints about the company's business and stock today. They often focus on the following.
- The stock currently is trading at 41 times trailing earnings while the S&P 500 is trading at around 22 times earnings.
- The company is projected to grow earnings at a rate of 17.3% per year, falling notably short of the P/E multiple of 41x earnings.
- Coke's revenue growth is slowing dramatically. Between 1995 and 1997, the company has shown total sales growth of 4.7% (or 2.3% annually).
- Coke has approximately 48% of the soft drink market. It'll be difficult to expand its market share.
- The company's earnings growth has been supported by accounting tricks with its bottling operations that have resulted in profits from sales of bottling assets being treated as part of operating income.
- Even though Doug Ivester was groomed to take over the CEO position at Coca-Cola, the new leadership might not match the old.
Some of the above are subjective statements, but nearly all have some merit. On the first two points, as Rule Makers, we believe that the quality of the business far outweighs any temporary valuation issues. If the company does grow at a rate of 17% per year over the next five years, we're comfortable paying 41x present earnings for the stock. Furthermore, there is hidden value in those earnings. The Flow Ratio shows us that the company collects its receivables aggressively, turns over inventory with celerity, and is in a strong position on payments to its suppliers. We believe that the "E" (earnings) in your standard P/E ratio doesn't reflect the power of Coca-Cola's brand of "E" (earnings).
Regarding points #3 and #4, we're primarily concerned with the company's earnings growth. We believe that Coca-Cola bears underrate the value of pure earnings growth. After all, Coke's $4.1 billion in profits comes from $18.9 billion in sales. Exxon turned $2.2 billion in profits off $29.6 billion in sales. We believe that when you're looking at mature companies, pure earnings growth is considerably more important than sales growth. We'll be watching the growth in profits more closely than "land-grab market-share sales growth." At present, Coke's earnings per share are projected to rise at 17% per year going forward, after a projected 1% rise this year.
As for #5, Coke accounts for its investments in its bottlers under the equity method of accounting. This means that it adds its share of the bottlers' earnings to its own, but does not include its share of any of the related assets, liabilities, or capital expenditures. This is one of the primary reasons that Coke's return on equity (ROE) is so high. If the accounting rules are changed, this could have a dramatic impact on Coke's stock price as it may be viewed differently by the market. This is something that the Financial Accounting Standards Board has considered.
Many also question the company's inclusion of profits from the sale of bottling assets in its operating earnings as well. It should be noted that the treatment of these items is currently in conformity with the applicable accounting standards. Coca-Cola is what we would call conservatively aggressive in its accounting. We grant that. But we also think there's good reason to be conservatively aggressive while meeting accounting standards. Perceptions help drive intermediate-term values... and intermediate-term values can drive long-term growth.
And, on point #6, only time will tell what sort of efficiency and growth that CEO Douglas Ivester can bring to the business.
Finally, we're not putting all of our Rule Maker money into Coca-Cola stock. We recognize that each of our investments brings with it a unique brand of risk. For the record again, we are considerably less concerned (as long-term investors) in the temporary valuation the market has placed on Coke's shares. We'll be focusing on Coke's business developments around the world and measuring performance in years, not moments.
Prospects Going Forward
The company's publicly stated mission is to create value over time for the owners of the business -- and that means us! We're all rah-rah about that mission, and we're not shy about sharing our belief that every public company is beholden to their shareholding owners. Coca-Cola has clearly exhibited an ability to do just this in the past through increasingly profitable growth, product-line extensions, entrance into new markets, regular share buybacks, and cash dividends.
The company's annual report asks, "Can you imagine a day when you'll no longer get thirsty?" Neither can we. We're convinced that our opportunities for growth are virtually infinite. That's why we're so focused on building our business -- and our returns -- for the long-term."
Despite the company's significantly large share of the soft drink market, according to the 1996 annual report Coke still provides only 2 of the 64 ounces of liquid intake that the average person on this planet needs each day. The company is focused on taking an increasingly larger share of the other 62 ounces -- meaning more non-soft-drink offerings are on the way. Bottled water? Absolutely.
Furthermore, although Coca-Cola is sold in 200 countries around the world, right now it only has a small share of the beverage market in countries like China, India, Indonesia, and Russia. Those four countries combined represent 44% of the world's population. The average per capita consumption of the company's products in those markets is approximately 1% of the U.S. level of consumption. What happens when that starts balancing out? We think it means very good things for the beverage company best positioned to take advantage of global demand.
According to Zacks, the eighteen analysts that follow Coca-Cola's stock currently forecast a mean 5-year annual EPS growth rate of 17.33%. The range of estimates is between 13% and 20% per year. Coke has demonstrated an ability to grow at these levels or higher in the past, and given the opportunities, we believe it can meet or beat those expectations. Maybe not in the next year, but three years out, ten years out, and beyond -- we have a hard time imagining a beverage company building out a worldwide distribution network and a top-flight marketing campaign that can seriously compete with Big Red. Notes Warren Buffet, "If someone presented me with $100 billion and said, 'Beat Coca-Cola,' I'd give it back and say, 'It can't be done.' "
Now, importantly, the company trades at a premium to its expected 5-year growth rate. This premium is based on the company's long-standing history of consistent and solid growth, as well as the high margins earned on its sales. The market rewards companies that deliver consistently by discounting that growth forward. On a YPEG (5-year growth rate times projected year-ahead earnings) basis, the growth is being discounted forward at least two years. This may cause the stock price to go sideways for a few years, heck, maybe even down a bit in the next year. But we're buying our piece of the business now with an eye on what it might mean to us when we retire. We expect that our patience with this stock in the short term will reward us with years of market-beating business growth over the long term.
Now, Coke is generally considered a shoe-in, a can't-miss prospect, a lock for future. For that reason, the stock ain't cheap. We have to admit that we're not taking that attitude all the way to the bank. We'll be watching the business quarter by quarter, assessing the domestic and international expansion, and making our investment decisions accordingly.
Is The Coca-Cola Company a Rule Maker Stock?
We'll keep this one short. Coca-Cola passes all of the Rule Maker tests with flying colors. A market capitalization above $5 billion. Sales above $1 billion. Gross margins above 50%. Net margins above 7%. Cash & equivalents equal to more than 1.5x long-term debt. A flow ratio below 1.25. And qualitatively, a worldwide, name brand, consumer-franchise business that offers inexpensive, repeat-purchase products.
'Nuff said. We'll be adding Coca-Cola to the Rule Maker portfolio at some point in the next five business days. Now I'm headed to fridge for a mongo-large glass of Minute Maid Lemonade.
- Phil Weiss ([email protected])