Drip Portfolio Report
Monday, September 8, 1997
by Randy Befumo (TMF Templr)

ALEXANDRIA, VA (Sept. 8, 1997) -- On Friday, I said that my confidence in the ability of COCA-COLA (NYSE: KO) to grow operating earnings has decreased over the past few months and that it was this concern that made us decide that INTEL CORP. (Nasdaq: INTC), not Coca-Cola, should be our first Drip Portfolio purchase. People have been confused about why this decision was made and I wanted to clear that up. My concern, simply put, is that the expectations for Coca-Cola's continuing high rate of earnings growth has peaked at a time when the actual quality of that earnings growth appears to be diminishing. As my concerns center around some pretty complicated accounting issues, I will do my level best to make this as clear as possible.

Currently, analysts look for 17% to 18% annualized growth in earnings per share. Earnings per share growth is the number you almost always see people refer to when they are discussing how much a company's earnings grew. What this means is that after taxes and after the earnings have been divided by the number of shares outstanding, Coca-Cola will grow the bottom line at 17% to 18% per year. Just as Coca-Cola is not the only soda around, "earnings per share" is not the only flavor of earnings. The other flavors we will look at today are earnings from operations and pre-tax earnings.

Earnings from operations is a measure of how much money a company generates from what is defined as the company's basic business, or operations. For Coca-Cola, this is the business of making syrup and other beverage components and selling these to bottlers. Growth in earnings from operations is the touchstone of earnings growth. If a company cannot substantially improve its earnings from operations but has to generate earnings growth from other sources, many investors call this "lower quality" earnings growth, with growth in earnings from operations being the highest quality.

Off hand, without looking at the latest Coca-Cola filings with the Securities Exchange Commission (SEC), how much would you guess that Coca-Cola has been increasing its earnings from operations? Of course, not all of the company's earnings come from operations. With their cash hoard, they get interest income, and as they buy and sell bottling plants, any profits on these sales would not constitute earnings from operations, as this is not its main business. With its share buybacks, it can magnify earnings per share growth by reducing the number of shares outstanding. So given all this, how much has Coca-Cola been increasing earnings from operations? 15%? 12.5%? 10%?

Try 4.4% last quarter. Or 5.5% the quarter before that. Or how about that 2.8% decrease in earnings from operations that it reported in fiscal 1996. "Wait a minute," you say. "This is not the Coca-Cola I know and love. The Coca-Cola I hear about has double digit earnings growth and has done so since it came public in 1919." Well, the Coca-Cola you know also employs some of the best financial and accounting minds in the world, and these folks have done a lot to earn their keep. Pre-tax earnings growth, or growth in earnings before taxes are paid, shows the kind of gains people like to see -- the profits that are being engineered by these financial pros. Last quarter, pre-tax earnings jumped 27.1%. The quarter before was 38.5%.

So where is all of this earnings power coming from if it is not coming from the basic business the company runs? It comes from buying bottling operations, investing in them, and selling them off to other companies -- normally companies like COCA-COLA ENTERPRISES (NYSE: KO) and COCA-COLA BOTTLING COMPANIES (Nasdaq: COKE), in which it has some equity stake. In fact, last quarter the company had $1.26 billion in gains on "investments" versus $782 million in "costs," a net benefit of $478 million pre-tax. Two quarters ago it was more like $561 million. In both quarters, the difference between minuscule operating growth and big earnings per share growth was buying and selling these bottlers, not growing the basic business.

Before I go too far here, I should say that it is Coca-Cola's contention that profits from buying and selling bottlers to other companies, some of which it controls, is that these earnings are as legitimate as anything else. My concern, however, is that investors do not buy Coca-Cola because they think it does a bang-up job of buying bottlers, investing in them, and then selling them. They buy Coca-Cola because they see the basic soda business, or the beverages business in general, as a real winner. When Coca-Cola pre-announced that growth in earnings from operations would only be around 10% this quarter, my concern increased to a level where I actually think that investors might not want to pay 30-40 times earnings for a company growing its operating earnings 10% or less.

I think if most people knew how much of the earnings per share growth was coming from buying and selling bottlers and not from "operations," particularly given all of the talk about Coca-Cola as a "light" business that is not very capital intensive because it does not own the bottling operations, they might reconsider. In fact, the irony of the company making most of its money from bottlers even as some stress that not owning the bottlers is its strength is almost comical. Certainly the money being invested here is not money that is buying back stock, the other argued strength of the business model. Suffice it to say, I am in "observation mode" on Coca-Cola for the Drip Portfolio and will wait until next quarter's results are released and look for some sign that this trend has changed.

--Randy Befumo