Coca-Cola's Dilemma
A giant in a straitjacket?

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (April 28, 1999) -- The Coca-Cola Co. (NYSE: KO) is experiencing an interesting phase in its long, colorful life. After years of steady gain, revenue has been in the $18 billion range since 1995. The company has increased product distribution every year and increased case volume sales, too, but overseas currencies have mitigated much of the growth. Currency situations or not, the company's long-term growth prospects appear to be facing more uncertainties than they have for many years.

Coca-Cola was recently denied by French officials the right to acquire the leading soft drink company in France, Orangina, due mainly to monopoly concerns. Coca-Cola is appealing the decision. Punch number two struck Coca-Cola yesterday when it was denied by the Belgian Competition Authority its proposed purchase of Cadbury Schweppes' (NYSE: CSG) non-U.S. brands, including Dr. Pepper and Canada Dry, for $1.85 billion. Coca-Cola will restructure the deal and try again.

Coca-Cola is in a position much like Campbell Soup (NYSE: CPB). Following tremendous success, to grow sales significantly from here Coke must pursue new, typically international markets on a grand scale; it must acquire very large businesses; and it must introduce incredibly successful new products. The other growth option readily available comes in the form of steady price increases, but Coca-Cola arguably has even less pricing power than Campbell Soup.

So, the best options for growth are new markets and large acquisitions. Entering new markets and pursuing acquisitions can be less expensive and less risky than introducing new products. Plus, one dilemma with new products is cannibalization. Coca-Cola holds such a large portion of the beverage market that a new product, rather than increase total sales and earnings, might sell at the expense of another Coca-Cola beverage.

With the U.S. market saturated by an array of beverages so varied that some consumers are returning to the comfort of water -- bottled water that is, a market Coca-Cola is pursuing -- the best growth prospects for Coca-Cola are overseas. If international markets are weak, however (as they can be for years, or even decades), and if acquisitions are not allowed (as we're seeing with Coke's last two attempts), Coca-Cola's business, as powerful as it is, might be forced to tread water for any number of years.

The company has become such a giant that even a successful new product wouldn't have much impact on sales. Entering new markets incrementally is but a slow way to grow (and currently the only way), and serious acquisitions -- those large enough to make Coca-Cola notably larger -- are being denied because regulators already fear the company's size. So what does Coca-Cola do in the meantime? It buys back stock, increases the dividend payment, toys with new product ideas, continues to advertise its world-leading brand, and it hopes that tastes don't change measurably over the coming years.

People assume that Coca-Cola is certain to succeed indefinitely, and due to an incredible distribution channel, a strong Coca-Cola business of some kind should indeed be a certainty to varying degrees for our lifetimes and far beyond. However -- and this takes imagination -- what if Coke isn't the product that carries the company indefinitely? What if 50 years from now Coca-Cola's leading product is healthy?

Tastes change. Over the past 10 years American culture has largely turned health-conscious. The trend is strongest now in relation to food and drink. The country's new attitude has given rise to success stories like Whole Foods Market (Nasdaq: WFMI), a healthfood chain that I don't believe even carries Coca-Cola. (I haven't seen it on shelves, but admittedly I haven't looked specifically for Coca-Cola at Whole Foods, because I haven't been drinking Coke for at least nine months and I doubt if I ever will in great quantity again (as I did when very young). If I'm wrong about Whole Foods and Coke, I'll share a correction tomorrow.)

The tornado of new beverages selling in America, many of them healthy, should make us question what all of us will be drinking as we grow older, and therefore, what we will want our children to drink as well. What our children will drink when they are young, they are likely to continue to drink as they grow up. Most parents, increasingly aware that what they eat and drink has an impact on health, are not likely to encourage the consumption of a sugar and sodium-rich drink. They will encourage the consumption of at least moderately healthy juices.

I have not gone insane. I am not calling for Coke's demise. I believe that Coke will have worldwide appeal for as long as we can imagine. However, I don't believe that it faces very fair growth prospects in the United States given increased competition (including healthy beverages), price wars, and an aging population whose doctors say, "Lay off the sugar, skipper."

This points us back to other growth prospects. With acquisitions on hold, Coca-Cola's prospects for growth increasingly reside in uncertain and surprisingly unstable international markets.

The world believed that the Asian and Pacific Rim economies were going to boom indefinitely as recently as two years ago. Now the world hopes that Asia can dig itself out of a sweeping economic disaster within ten years. (Japan is still trying to recover from troubles begun significantly before the rest of the general region's woes.)

Eastern Europe shined with promise as the Czech Republic, Hungary, and Poland went so far as to join NATO. The shine didn't last. Now all 19 countries of NATO are effectively at war in the Balkans, even though we don't call bombing a country's major cities, bridges, airports, and oil pipelines "war" anymore.

Then there's the former USSR. If this country was a giant Etch-A-Sketch they'd want to shake the screen clean and start anew. The region was supposed to finally rise and prosper. The only thing rising are food lines and inflation.

Next, Africa was going to finally grow on a lead from South Africa. Not happening yet. And let's not forget Latin America. Much of it is trapped in much the same quagmire that struck mighty Mexico several years ago (and counting).

There. We've just shown almost every continent on Earth -- with sweeping generalizations, admittedly -- to be experiencing significant economic trouble of some kind. Trouble enough to impact Coke's bottom line.

Coca-Cola can still handily grow volume sales on every continent because its product is typically affordable where it's sold and new distribution channels abound. But with weak currency translations, an increase in volume often doesn't add to the company's total sales and hence earnings, as we've seen since 1995. Add to this the denial of large acquisitions and the company's near-term growth prospects (near term being 5 or even 10 years) appear to be more dependent on external world factors than shareholders would care to admit.

The stock is flat (not including dividends) since May, 1997. That's far from a disaster. Many food and beverage stocks have declined over the same time period. So, how can Coca-Cola's stock do so well with four years (and it looks like it'll be five) of relatively flat sales?

Perhaps because even given all of the above concerns, Coca-Cola's size and market position makes it likely to succeed (even succeed beyond expectations) in the future. Coca-Cola has so many irons in the fire that eventually a few will turn bright Coca-Cola red (the economy will recover in Asia, for example) and the company will surpass earnings expectations. So, the stock has been able to trade at above 40 times earnings over four years of relatively flat sales arguably because it trades on its established market position and on the steady cash flow produced by that position. Smart Coca-Cola shareholders know that earnings growth will return. In the meantime, they're hanging out on a yacht that is so large it can weather almost any storm.

By focusing on everything that has been working against Coca-Cola, perhaps we're reminded of how strong the company truly is -- raising billions in free cash flow every year. Coca-Cola remains on our watch list. To discuss the company or direct investing, we'll see you on the Drip Companies board.

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