RULE MAKER PORTFOLIO

Rule Maker Portfolio
Does Coke Have Pricing Power?

By Bill Mann (TMF Otter)

ALEXANDRIA, VA (Nov. 18, 1999) -- I continue to track the soap opera with Coca Cola Company (NYSE: KO) and its bottlers, most notably Coca Cola Enterprises (NYSE: CCE) with more than a passing interest. In spite of my misgivings about the recent past about KO (I'm going to refer to each by their ticker symbols for simplicity), to me it remains the most compelling "value" story among our Rule Makers. On the other hand, perhaps by including KO at all in the value category I am acknowledging that the financial and reputational hits the company has taken over the past year or so have been enormous.

On Monday, CCE had an extraordinary conference call with analysts and investors to discuss an apparent change in the company's "story." This change has much to do with the earlier announcement that KO would double its rate of price increase on syrup and other ingredients that KO provides its bottlers.

The 6% price rise for next year comes at a time when CCE and other bottlers have seen their stock prices battered. Here in the Rule Maker Port, several of us have questioned the propriety of having these bottlers operate as separate companies. And today, I'm gonna do it again.

The separation between KO and its bottlers is, in my opinion, quite specious, at best. KO claims that its bottlers operate independently, and yet these companies are completely integral to the basic delivery of KO products. These companies are clearly beholden to KO, their single, or at least vastly dominant customer (a condition known as a "monopsony," to flex my SAT muscle). The argument of bottler independence becomes most tenuous in light of the "marketing support" they receive from KO that as far as I can tell is not based upon size or even return on investment from KO, but rather upon the need of the bottlers to show good cash flow.

Why do we keep pounding on this? Because several of us here at Rule Maker World Headquarters are concerned that the financial model that separated the bottlers from KO is unsustainable and will collapse. But there is perhaps a deeper, more troubling aspect of Coke's financial woes. The simple fact is that Coke has not been able to make a price hike stick in more than a decade. Units of Coke have been the same nominal price since the '80s, as have Pepsi's (NYSE: PEP).

"But wait a minute� don't you Rule Maker guys always extol the virtue of KO and the other companies in this portfolio as being dominant in their industries, being the leaders, and having the ability to use their brand names as moats to fight off pretenders to their thrones?"

The answer, in the case of Coke, is "yes, but�" In Coke's case, it's had a number of problems in its economic model that may have begun to hurt it. Both Coke and Pepsi have tremendous goodwill attached to their brands -- they are brands that people are willing to pay extra for. But how much extra? Coke and Pepsi have been involved in a price war for the better part of this century, but particularly in the last decade both companies have extolled the benefit of their financial models as being about case volume, not return on capital. As long as the volume sales increased, then the companies could point to cash flow increases (especially at the bottlers) and thereby have investors ignore other measures such as invested capital return.

The problem now is two-fold. It's pretty clear that Coke has cannibalized margins in its biggest markets for sake of volume growth, a situation obscured by virtue of the separation out of the bottlers and the transfer payments made in between the entities. By so doing, KO could point to its profit margins for operations, and then make "one time" payments to its bottlers to prop up their cash flows and let them show a profit.

The trouble is that in order for this type of system to work, each component must continue to show top-line growth. Although KO has significant international markets that are as yet untapped, the bottlers are restricted to marketing districts and thus do not benefit from any incremental growth of sales in new regions. At the same time, sales growth of Coke products has leveled off, and additional revenue streams (vending machines, sales outlets, etc.) are much more marginal than the currently existing ones, and thus much more expensive to stock and maintain.

Any guess as to whom these maintenance costs fall? Not to KO, but to the bottlers. They are forced, by virtue of their sales growth being so closely tied to that of KO's, to put outlets in less and less optimal locations. More cost per unit, worse margins for bottlers. Worse margins, higher marketing payments from KO. All in an atmosphere in which prices have not been allowed to rise.

Now Coke and Pepsi are in a bit of a pickle. They have market power enough to charge more than generic beverages, but how much more? If Coke suddenly increases its retail price by 20%, even if Pepsi chooses to follow, there are off-brands such as Wal-Mart's (NYSE: WMT) "Sam's Choice," or Triarc Companies' (NYSE: TRY) R.C. Cola that would become more attractive at a greater discount to the premium brands. Thus, Coke, with its burden of marketing support to CCE and others, is feeling the pinch of being a "premium commodity." And thus, the internal price increase from KO to its bottlers for its basic ingredients.

CCE in turn, will raise prices to consumers. Both Coke and CCE then have the burden of proving that their products remain a good value at the higher price. Pepsi, which is also hurting due to the squeeze, is likely to follow suit. It remains to be seen whether they will succeed.

In certain ways KO is reaping what it has sown. Even though on a retail basis the company markets its products as a premium brand, there can be no doubt that consumers notice the endless sales promotions and occasional dirt-cheap prices the company has charged in return for increased market share. In this case the subliminal message has been that consumers do not have to wait very long to get a 2 liter bottle of Coke for $0.89, so why not wait, or just get something else until prices come down from a relatively pricey $1.39. By doing so, KO and the bottlers have cheapened the premium value of their products, and destroyed some of the goodwill their brands should have otherwise commanded.

If the price increase does not stick, and consumers move to off-brands rather than buy into the added value of Coke's brands, then Coca-Cola's system could be in big trouble. Unfortunately, the grave it lies in is of its own making.

Shifting gears for a moment, The Motley Fool Radio Show is looking for some thankful Fools in anticipation of next week's Thanksgiving holiday. Do you have a personal financial experience for which you're especially thankful? Perhaps, there's a stock that's treated you nicely, or a piece of advice from a Foolish friend, or a broker that you've thankfully rid yourself of. If you'd like to share your thankfulness on the Fool's Radio Show, e-mail producer Mac Greer (MacG@fool.com) with a short description of what you're thankful for and a daytime phone number where you can be reached on Friday and Monday.

-- Bill Mann

What do you think?
Come post your thoughts about tonight's report on our Rule Maker Strategy board. Alternatively, if you have ideas, analysis, or questions about a particular Rule Maker company, take a seat at the roundtable discussion on our Rule Maker Companies board. Finally, if you're new to all this stuff, the Rule Maker Beginners board is the place to get your questions answered.


 




Rule Maker Portfolio

11/18/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS1/4$154.88
CHVCHEVRON CORP-1 5/16$95.25
CSCOCISCO SYSTEMS3/16$87.94
DPHDELPHI AUTOMOTIVE SYSTEMS-1/8$16.13
EKEASTMAN KODAK-1/16$66.56
GMGENL MOTORS-1 1/4$69.81
GPSGAP INC-1 9/16$36.81
INTCINTEL CORP3/4$78.50
KOCOCA-COLA CO1/2$60.44
MSFTMICROSOFT CORP-1/16$84.94
PFEPFIZER, INC-1/8$33.69
SGPSCHERING-PLOUGH-3/4$56.13
TROWT.ROWE PRICE ASSOC-5/8$37.50
XONEXXON CORP13/16$81.06
YHOOYAHOO INC11/16$213.88

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker .93% 1.76% 3.57% 20.54% 50.08% 25.41%
S&P 500 1.01% 2.07% 4.55% 15.92% 45.36% 23.19%
S&P 500(DA) 1.01% 2.07% 4.55% 16.50% 47.13% 24.03%
S&P 500(DCA) n/a n/a n/a n/a 30.41% 15.96%
NASDAQ 2.38% 3.91% 12.83% 52.65% 106.69% 49.91%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$87.94167.57%
2/3/9859MSFT49.352$84.9472.10%
2/17/9916YHOO126.309$213.8869.33%
5/1/9882GPS22.708$36.8162.11%
2/13/9859INTC50.624$78.5055.07%
5/26/9818AXP104.067$154.8848.82%
3/12/9820XON64.335$81.0626.00%
2/3/9866PFE27.433$33.6922.80%
8/21/9844SGP47.993$56.1316.94%
3/12/9817GM60.399$69.8115.59%
3/12/9815CHV83.343$95.2514.29%
2/3/9856TROW33.673$37.5011.36%
3/12/9820EK63.148$66.565.41%
3/12/9811DPH17.202$16.13-6.26%
2/27/9827KO69.107$60.44-12.54%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/9875CSCO$2,464.86$6,595.31$4,130.45
2/3/9859MSFT$2,911.79$5,011.31$2,099.52
2/13/9859INTC$2,986.79$4,631.50$1,644.71
2/17/9916YHOO$2,020.95$3,422.00$1,401.05
5/1/9882GPS$1,862.06$3,018.63$1,156.57
5/26/9818AXP$1,873.20$2,787.75$914.55
2/3/9866PFE$1,810.58$2,223.38$412.80
8/21/9844SGP$2,111.70$2,469.50$357.80
3/12/9820XON$1,286.70$1,621.25$334.55
2/3/9856TROW$1,885.70$2,100.00$214.30
3/12/9815CHV$1,250.14$1,428.75$178.61
3/12/9817GM$1,026.78$1,186.81$160.04
3/12/9820EK$1,262.95$1,331.25$68.30
3/12/9811DPH$189.22$177.38($11.84)
2/27/9827KO$1,865.89$1,631.81($234.08)
  Cash: $135.63  
  Total: $39,772.25  


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.