Drip Portfolio Report
Thursday, October 30, 1997
by Jeff Fischer (JeffF@fool.com)

ALEXANDRIA, VA (Oct. 30, 1997) -- Yesterday in the mail we received the slip from Moneypaper's Temper of the Times service stating that our order for JOHNSON & JOHNSON (NYSE: JNJ) had been received. If you received this as well, it is only to confirm that this is the stock you want, and that the information for your account (name, address, social security number) is correct. You needn't send anything back unless there is an error, and then you need to fax corrections to Temper of the Times. Johnson & Johnson does not require a W-9 or anything else, so don't worry about that. If you've sent away for the first share and to enroll in the plan, you've done all you need to do. Our first share should be bought on Monday.

An interesting note: some people say that Temper of the Times is slow. Our first statement that we received from Intel's transfer agent, though, states that our first share of INTEL (Nasdaq: INTC) was in the account on September 14. We didn't receive the statement from the transfer agent until a month later. So, Temper had our share purchased and in the account within two weeks, and the lag was the result of the transfer agent. This is usually the case. Also, sometimes the transfer agent won't send you an initial statement until the first additional investment is made (which means, the first quarterly dividend reinvestment if you're not sending them any money). In Johnson & Johnson's case, we'll be calling the transfer agent during the third week of November in order to get our account information and send more money to buy shares. We won't sit around waiting to receive confirmation in the mail.

The past two days we've looked at COCA-COLA's (NYSE: KO) earnings growth from its core business of selling beverages. In the recently reported third quarter the company had $863 million in net income, or $0.36 per share, not including $148 million in after-tax net income from the sale of interests in four bottling companies. Today we'll see how that compares to last year, though looking at one quarter isn't incredibly important. What is important is the long-term growth, while in the short term taking into consideration the many factors affecting the current growth (one of which is currencies). When we laid out some of the criteria that we're looking for in our investments, one is double-digit earnings and sales growth. Coca-Cola hasn't had that recently, but the strong dollar overseas and the sale of bottlers have impacted both revenue and earnings comparisons year-over-year. Delving deeper into the numbers over the past two days, while it is interesting, has begun to make me feel a bit Wise and over-analytical. Today is the last day that we'll get even more Wise. Why?

On perhaps all counts, Coca-Cola is a great company. We don't argue against that. Revenue, earnings, and cash flow have all increased steadily over the past ten years, over the past twenty years, and over this entire century. Last quarter represented another new record in the amount of free cash flow generated. Management plowed much of that cash right back into its distribution business. Coca-Cola has its core product line down cold, obviously, so most of the cash made at the company is invested in more distribution systems around the world, marketing, launching new beverages, and is used to buy back more company stock. Since 1984 Coca-Cola has bought back 31% of its outstanding stock at an average cost of eleven dollars per share, and last quarter it bought another nine million shares.

What we're learning, though, is that the business isn't as simple as it first appears -- and the Drip Port purports to invest only in things that it understands. Arguably, we somehow had less trouble breaking down Intel than we've had with Coca-Cola. Coca-Cola's numbers have consistently had the buying and selling of bottlers included, investments in distribution counted as one-time charges, considerations regarding currency fluctuations and the hedging of currencies, and more. But we'll find a similar situation with Johnson & Johnson when we look at that company's recent earnings, too. Growth was lower than it would have been due to the strong dollar overseas. When investing in international companies, currency fluctuations and some lack of clarity is going to be the case from time to time over the next twenty years.

What I'm getting at is this: maybe we're missing the forest for the trees by looking at Coca-Cola too closely. Step back, look at the numbers from the past ten or twenty years, and you see an incredible story of consistent growth and improving margins. So I want to make it clear that we recognize that Coca-Cola is and has been a great business. The main concern is the slowing growth and the valuation granted the stock despite the real possibility of disappointment. At this price, if Coca-Cola's earnings growth slows below the 18% expected, we could see very little stock appreciation over several years. We'd be receiving the dividend, yes, and the company will certainly do all it can to increase earnings per share every year, but considering other options in the meantime isn't a bad idea while keeping abreast of this company, too.

Before too long, Randy and I will begin to look at several other food and beverage companies, including Campbell Soup, Sara Lee, Kellogg, Quaker Oats, Pepsi, and a small handful of others. For now, let's lock down Coke's last quarter, conclude, and move on.

Recall from the numbers listed yesterday that Q3 revenue grew 6% year-over-year, even though worldwide gallon shipments grew 14% and selective price increases were implemented and market share increased (combating some arguments we've heard that Coca-Cola isn't able to increase prices effectively). Revenue growth was lower than it would have been due to the sale of some bottling interests in 1996 and due to a strong U.S. dollar. Operating income of $1.24 billion grew 10% over last year's third quarter operating income excluding several one-time charges in 1996 that were mentioned yesterday and again below. To find the stripped-down earnings per share, we return to the 1996 10-Q for the quarter and look at the 1996 numbers and charges. (See the 10-Q for all the following figures. And if you want to skip the entire next two paragraphs of numbers, please do so. They're history. The point is at the end of this column.)

Last year the company had $2.419 billion in selling, general and administrative (SG&A) expenses, before removing about $670 million in one-time charges (mainly for expansion of its distribution system and for Minute Maid development). The company also took a $320 million tax credit in a favorable ruling with the IRS, which was added to net income. Recall that 1997 operating income was $1.243 billion, 10% above 1996's operating income when the charges are not included, which means operating income in 1996 would have been around $1.13 billion rather than the stated $454 million that includes charges. Removing the one-time charges, this $1.13 billion figure is in line. Then adding $38 million in interest and equity income and ignoring the one-time tax gain of $320 million and another one-time gain of $125 million, we find net income of about $1.168 billion. Third quarter last year the company didn't need to pay taxes but instead received a tax credit, but if you slap the normal 32.8% tax rate on the income you end with $784 million in net income. Compare that with $863 million this year and you have 10% earnings growth, the same as the normal operating income growth.

Are you confused yet? Don't worry. We're not even mentioning the non-cash gains the company scored of $283 million, $130 million, $74 million, and a whopping $936 million for the sale of interests in bottling operations during the third quarter last year. These have no place on the income statement.

Anyway, despite mom's early wishes, I'm not an accountant, and there are certainly some differences in this accounting and how the company accounted for earnings, but in the end it comes out even. Coca-Cola showed real earnings growth of 5% for the third quarter, as it should, yet states that operating income would have been 10% if not for the several one-time charges. But taking out one-time charges as was just done -- when much of the money is actually being plowed back into the company's distribution network -- doesn't make much sense. These are investments in the business and are included as expenses. But we didn't hit all the bases at all. In the 10-Q, statements such as the following are strewn throughout: "In addition, the decision to curtail concentrate shipments to bottlers decreased operating income by an estimated $290 million in the third quarter of 1996." And when the 1996 numbers are compared to 1995, you need to consider all the special situations in 1995 as well.

This all gets me to this point: you can't simply look at operating earnings for one year or quarter, as some do, and write the company off as a slowing-growth business. It certainly isn't a light business, but it is growing. On average, each American drinks one Coca-Cola every other day. In France, it's once every six days (except for my Brother who lives in Paris and drinks eighteen per day), while in the former Soviet Union it's once every three months. Asia and Russia represent the largest growth opportunities, and boy, have you seen the currencies in those areas lately? Not pretty. The company does make local currency investments that impact the books back in the U.S., and despite the argument that you can hedge everything and smooth everything out, you can't always do that successfully. I'm going on a ledge here and giving Coca-Cola the benefit of the doubt -- trusting that management is doing all that it can to grow by investing, building distribution, accepting the downfalls of the world market currencies, and doing all this now for the long-term good.

The other day in an email a woman in Florida wrote to say that she already owned 600 shares of Coca-Cola in a DRIP, and she wondered what she might do with it and what she might buy instead. My answer -- the only answer that I might give -- is that I wouldn't consider selling those shares for anything else. The cost-basis is low, the taxes would be painful, and where would you put the money? What business is more admired than Coca-Cola, aside from probably Microsoft? And in this market, what beverage or food stock is better? Looking at the other industry stocks listed above may be eye opening. Quick glances at many don't show any immediate bargains. A person just might end up favoring Coca-Cola over the others, even at this price.

Randy and I have agreed to agree on each purchase that the Drip Port makes, but for two. We each get one purchase that the other doesn't need to agree with. With Coca-Cola at this price and staring at a 1998 that is expected to be pretty flat, I won't be jumping on the chance to begin a position immediately. But seeing how things shake out, Coca-Cola just may be the company that I eventually pull my Trump card on and put into the Drip Port without Randy's approval. First, though, due diligence must be done by looking at other stocks in the industry. I'm not in a hurry to begin buying Coca-Cola while it is arguably as overvalued as it is, but I'm also looking twenty years out while I think about it.

Tomorrow we'll take a look at Coke's margins over the last nine months compared to a year ago, all the extras be damned... (those are part of business, anyway), and then we'll move to Johnson & Johnson's review of earnings, which should be much simpler. We already bought that stock, after all.

Fool on...

--Jeff Fischer


              Stock   Close    Change
              Intel  $80 1/4   -4 5/8

            Day   Month Year  History
        Drip:    +0.00%   0.00%  0.00% 0.00%
        S&P:     +0.00%   0.00%  0.00% 0.00%
        NASDAQ:  +0.00%   0.00%  0.00% 0.00%

        Rec'd   #    Security         In At 
       9/8/97   1      Intel         $94.69

                        Base: $800.00
                    Expenses: $ 55.50 (Moneypaper)
                   Purchases: See above
                        Cash: $649.10
                 Total Value: $735.00 apprx.