Drip Portfolio Report
Wednesday, August 6, 1997
by Jeff Fischer (TMF [email protected])
and Randy Befumo (TMF [email protected])

ALEXANDRIA, VA, (August 6, 1997) -- "Around the world, we still supply less than 2 of the 64 ounces of liquid intake the average person needs each day, and we remain resolutely focused on going after the other 62."

                         --Coca-Cola, 1996 annual report

With operations in 200 countries, there are about 66 countries in which red and white COCA-COLA (NYSE: KO) trucks don't yet roll. Last year in China, Coca-Cola opened its 23rd plant, but sales volume in the giant country of 1.2 billion people is still surpassed by the sales volume that Coke achieves in the Philippines.

Seven years ago in the former Soviet Union Coca-Cola was losing to its main competitor by a margin of 10 to 1. Investments in the early 90s have paid off, and now Coke leads that market by 2 to 1. Last year unit case sales increased 109% in Russia, and by year-end Coke was the number one cola, and yet Coke's distribution system still covers only about one-half of Russia's population.

The company states, "The emerging markets of China, India, Indonesia, and Russia combined represent 44% of the world's population, but, on a combined basis, the average per capita consumption of our products in these markets is approximately 1 percent of the United States' level (of consumption). As a result, we are investing aggressively to ensure our products are pervasive, preferred and offer the best price relative to value (in these countries)."

This needs to be repeated: the per capita consumption level in regions holding 44% of the world population is 1% that of the consumption level in the United States. It hardly sounds like Coca-Cola needs to search for new markets. Nearly one-half of the world is a new market. Where does Coca-Cola want to be? Management writes, "We want every person on this planet to be able to choose one of our products whenever and wherever thirst strikes. For us, that means reaching out to consumers where they live, work and play."

Coca-Cola released 25 new drinks last year, and as the soft drink industry increased case sales by 1% on average, Coke increased case sales by 6%. Its lead is getting larger.

With one of the most respected and efficient distribution networks in the world, Coca-Cola is steadily filling every nook and cranny on the planet with its small and affordable refreshments, placing the drinks at the fingertips of everyone, whether a person lives in Grindlewald, Switzerland, or in Moscow. The company's distribution business alone has value that is hard to estimate. If you wanted to sell a widget all around the world, the one distribution network that you would kill to utilize is Coca-Cola's.

The intrinsic value of Coca-Cola as a whole is enormous, but critics argue that the stock price already more than accounts for that. The stock trades at 42 times trailing earnings and has a price-to-sales ratio of 9. Of the thirty Dow Jones stocks, Coca-Cola by far has the highest price-to-sales ratio. Merck is second-highest at 5.6 times sales, while the average Dow stock trades at less than 2 times sales.

Part of the reason that Coke is granted a high valuation is the efficient and always-improving management of its business. Other factors include the company's consistent earnings growth, as well as the lack of perceived risk in the business. Products sold are repeat-purchase items that are nearly inflation-proof. Most consumers will still purchase a one dollar can of Coca-Cola even during hard times. The company has been profitable for 111 years.

Another factor that increases value is the fact that management is consistently buying back the company's stock, which further amplifies earnings per share. In 1996 Coca-Cola bought back 32 million shares of its own stock, for $1.5 billion. The company plans to buy back 33 million more shares by the year 2000.

Critics of Coca-Cola reiterate that the company is growing 18% annually but trading at 42 times earnings, and state that a stock is usually "fairly priced" when trading at a multiple equal to its growth rate. On that argument, a no-name company growing at 18% but with 2% margins would trade at the same multiple as Coca-Cola, if both traded at 18 times earnings. Such a simple valuation allows no room for intrinsic value, and intrinsic value -- alongside measures such as margins and return on equity -- grants Microsoft, General Electric, and Coca-Cola multiples higher than mere growth rates.

The day Coca-Cola trades at a trailing multiple equal to its growth rate is the day we're in a bear market. The stock deserves a premium. How much of a premium is a good question, though. It arguably doesn't deserve to trade at 42 times trailing earnings in any market but this one. But trading at 25 times earnings, for example, while growing 18% would arguably be very reasonable for such a leading company.

At $68 the stock trades at 35 times next year's estimate. So how overvalued is it? Arguably not very. A person could even argue that in this market it's fairly valued. But in a less robust market Coca-Cola might fall to $50 and trade at 30 times trailing earnings and 25 times next year's estimate. In a horrible market the stock might fall to $40 per share, or lose 41%, and trade at 24 times trailing earnings and 20 times next year's estimate.

The Drip Portfolio should wish for such an occurrence! We'd love to buy Coca-Cola at that price for several years. Let the stock languish!

This Fool doubts that will happen.

Looking forward, analysts hope for 18% earnings growth per year. Thus, with consistent earnings growth (which is only an assumption and assumes risk!), we have: 

Year   Earnings Estimate          P/E Multiple*
1998        $1.97                       35
1999        $2.28                       29  
2000        $2.70                       25
2001        $3.18                       21
2002        $3.76                       18
2003        $4.43                       15 

          *(Stock price: $68, with 18% 
            projected annual growth)

In six years we'd have a stock trading at 15 times trailing earnings. If Coca-Cola can continue to improve earnings consistently (we're not considering that it may beat estimates), the market will probably continue to grant it a premium. If the market grants the stock a trailing multiple of 25 Coca-Cola would trade at $110. If the premium is ever up to 30 times trailing earnings (which is much lower than it is now) the stock would trade at $135, or 100% above current prices. In little over six years that's more than 12% per year compounded growth, beating the average market return. This doesn't include reinvested dividends which can become substantial over time.

We know that we're making assumptions here. You can't look forward without making assumptions. Let's assume that the company doesn't continue to grow at this pace. Let's assume that it can't make estimates for a while.

Then you're going to see the stock fall hard and fast, but that's not very harmful to DRP investors who are building a position over twenty years. Actually, the earlier and harder that the stock falls now, in the next five years, the better for anyone investing in the stock regularly with a twenty-year mind-frame. In fact, anyone who is investing regularly for at least ten years shouldn't be anxious to see stocks rise -- they shouldn't be excited to see the market make new highs. They still have plenty of money to invest, and plenty of time. They should rather hope for cheaper prices.

Even so, the potential downside here on 1998 estimates doesn't appear massive. If the stock falls 40% to $40 it would be a steal at 20 times 1998 earnings. Putting all of your money into it now would never be recommended. But beginning to build a position for the next twenty years -- that appears Foolish to this Fool. Meanwhile, we'd keep rooting the stock down while we're at it!

Let's wrap this up, take arguments to the Coca-Cola message board, and see what Randy has to say tomorrow.

To close: it's difficult to find a business model that's more admirable or sustainable than that of Coca-Cola's. Critics argue that the company is only selling water, with some syrup and sugar -- nothing special. Critics somehow don't realize that this is the most attractive part of the business! The company made three billion dollars last year with 20% margins by selling water with sweeteners, for which people have an unending thirst. Coca-Cola needn't worry about the latest software application, networking technology, or semiconductor cycle. The company needn't drill for oil, build millions of cars, or design new airplanes. It needn't constantly experiment to find new drugs and keep ahead of the biotechnology curve. It isn't competing with five other long-distance providers.

If you can find a company with lower risk, spending less money on capital investment, dominating the world market with distribution in 200 countries, growing earnings 18% annually, and selling a repeat-purchase item that is nearly recession-proof -- good Fool, then invest in it! And let us know what it is, too. For now, Coca-Cola is the only such company on our radar.

For those reasons and because we're investing for the next twenty years, the Drip Portfolio would be foolish (small f) not to bet on this world leader. Hey, we admit that the stock is rich! It could and even very likely will go down. Heck, it could even get cut in half and not move for ten years, as nearly happened after 1974. That would be okay. We'll be buying more of the stock at lower prices because we have faith in the long-term business. Yes, we actually might want the stock to go down for the next five years as we begin to build a position.

Long-term investors realize that most of the returns on an investment come at the very back-end of any investing time-period, as the power of compounding off a large base kicks in. DRP investing patiently teaches this. You invest steadily for a pay-off that arrives after a decade, or two decades, or three. To do so, though, you need some degree of long-term certainty in the business that you're buying. In our opinion, Coca-Cola is difficult to top -- or at least in my opinion.

We'll see what Randy has to say as he takes over the recap for the next few days. If he doesn't disagree, then the first few dollars to leave our hands will go to the red and white stripe of the Coca-Cola Company, and we'll begin a looooong and educational relationship. Our new closing line here may be, "Have a Coke and a Fool." Or something like that.

Fool on!

--Jeff Fischer, Fool

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