Drip Portfolio Report
Tuesday, September 9, 1997
by Jeff Fischer (TMF Jeff)

ALEXANDRIA, VA (Sept. 9, 1997) -- A company's growth in operating earnings is one item that an investor must consider -- an obvious one -- when valuing a stock and assessing its future. Part of the premise of the Drip Portfolio, though, is that we want to find companies that are increasing shareholder value through other means as well, which include share buybacks, improving margins, and strong return on invested capital.

COCA-COLA (NYSE: KO) has increased shareholder value significantly through all of those activities, and no company should be shunned for improving shareholder value through whatever legal and moral means possible. Increasing shareholder value is the stated goal of Coca-Cola -- and the goal of most public companies.

As Coke's operating revenue has increased 10.3% annually over the past ten years, cost of goods sold has increased only 6.9% annually. Gross margins have improved as a result. This leads to improved margins across the board, more cash on the bottom line for share buybacks and peripheral investments, and increased investments in distribution and marketing. Alongside efficient cost control, the company has increased value through its investments, especially in its partially-owned bottling companies. Earnings per share grew 17% annually over the past ten years due to all of these activities put together. It's management that has made this happen. We want to invest in great management.

If the job of management is to not only grow operating earnings, but to manage capital in order to increase total shareholder value, then Coca-Cola is succeeding. Coca-Cola's investment in COCA-COLA ENTERPRISES (NYSE: CCE) exceeded its carrying value by nearly $2.2 billion in 1996, while Coke's investment in bottler Coca-Cola Amatil exceeded its carrying value by $1.2 billion. Much as Warren Buffett creates shareholder value at BERKSHIRE HATHAWAY (NYSE: BRK.A) by investing in companies, Coca-Cola is investing in businesses that it understands to build value as well. That's a good thing. A very good thing.

As Randy said, though, most people aren't buying Coca-Cola due to the ability of management to make shrewd investments, though certainly many shareholders appreciate the practice. And they should.

Building value of any kind at a public company, in the long run, is simply contingent upon management being able to invest money smartly, whether into sales growth or into the stock of bottling partners. In fact, a company like NOVELL (Nasdaq: NOVL) would have offered investors a much, much better return on their investment if management had simply shut down operations three years ago and invested all of the company's money into the stock of MICROSOFT (Nasdaq: MSFT). Would that have been wrong? If investing in stock is all about the bottom line -- the end return -- then how that return is generated shouldn't much matter.

Conventional wisdom holds that earnings resulting from activities other than normal business operations are of less quality than strict operating earnings. Others argue that earnings are earnings -- period. I agree that non-core earnings are of less quality, though, in part because they are less predictable. Unlike operating earnings, non-core earnings rarely increase steadily due to an increasing base of revenue. Though l believe that any increased value is good value, there are different shades of value, and steady and sustainable growth in operating earnings ranks near the top in importance. Not even considering Randy's argument that Coca-Cola's operating earnings increased only 4.4% last quarter, looking at Coca-Cola's total projected earnings growth is -- just recently -- enough cause for initial hesitation.

Though analysts are often wrong, they have lowered estimates for Coca-Cola substantially, and are now estimating only 7% total earnings growth for fiscal 1998. That slow-down from the expected 21% in earnings growth in 1997 surely frightens many investors, but -- then again -- being DRP investors a slow year may actually represent a great opportunity.

If over the next twenty years the company -- rough spots included -- can grow earnings (in the big picture, I actually won't care if they're all operating earnings or only 50% operating earnings, I just want shareholder value to increase) by over 15% annually, and the stock value can increase at that average rate of return as well, then we'll have met our investment goal of about 15.5% annually, while taking little risk relative to many other investments.

We've never hoped to make an absolute mint on Coca-Cola stock alone, but as a core twenty-year holding it still makes a lot of sense -- assuming that the company can continue to grow shareholder value (through both operating earnings and other means) at a market-beating pace. That's an assumption that we don't want to make -- or need to make -- immediately, though. We'll see how operations at the company look over the coming quarter -- or maybe even over a few quarters. We're not in a hurry on any decision.

After an overview of SCHERING-PLOUGH (NYSE: SGP) last week, I want to write about PFIZER (NYSE: PFZ) and our other healthcare choices the rest of this week, but I first wanted to address some of these issues regarding Coca-Cola (which promises to be an ongoing study, and an interesting one.) Tomorrow we'll quickly take at look at Coca-Cola's value relative to its free cash flow, which is often a better way to value a stock than on earnings. That might shed more light on the issue of waiting. We'll then begin to tackle Pfizer.

As for our first purchase, INTEL (Nasdaq: INTC): the first share has certainly been bought by now, and the transfer agent is surely in the process of enrolling us in the company's DRP program. We can't expect to be enrolled before the end of the month, though, and so we will probably be sending a significant amount of money, as a result, to buy more shares of Intel in October. We'll be adding another $100 of savings to the Drip Portfolio next week, with no place to send it yet. That's the program! The wheels are turning.

Fool on...

--Jeff Fischer