No. 1: Coca-Cola (Drip Port) August 4, 1999

<THE DRIP PORTFOLIO>
No. 1: Coca-Cola
Granddaddy needs to get up and dance

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (August 4, 1999) -- The first company in our new food and beverage study isn't new to anybody. We've written about Coca-Cola (NYSE: KO) more often than any other company beyond the four that we own. The giant beverage king is a cash-creating bedrock of society.

Although a generally meaningless time period, over the past two years this company hasn't grown earnings per share (EPS) year-over-year, although it has always created additional value annually on top of old value (just not in a magnitude greater than the year before). It is amusing how often Wall Street can be nonplused by $3.5 billion in net income (as Coca-Cola achieved in 1998) just because it isn't greater net income than the year before. It is net income, nonetheless, and it grows shareholders' equity.

Anyway, the past five years, free cash flow at Coca-Cola has been sporadic rather than consistent: $2.14 billion in 1994, $2.10 billion in 1995, $2.41 billion the next year, and finally $3.5 billion in 1997 (which included major asset sales) and $1.2 billion in 1998. Coca-Cola represents a mountain of tremendous growth over the past 10 and 15 years, but it has been a flat plateau the past 5. Revenue since 1994 looks like this:

1994 -- $16.2 billion
1995 -- $18.1 billion
1996 -- $18.6 billion
1997 -- $18.8 billion
1998 -- $18.8 billion

The first half of 1999 saw $9.8 billion in revenue, which would lead to $19.6 billion in revenue this year (a new record) if the second half can match the first. That would mean 4.2% sales growth year-over-year.

Although additional value is added to the business each year even if growth is essentially flat, year-over-year growth is what drives a stock. A stock essentially trades up to a level that assumes a certain amount of future growth, and then it waits to be assured of more future growth before moving higher again. Coca-Cola hasn't provided any assurance and thus the stock has lingered but not fallen. Why hasn't it fallen? A cash-generating franchise such as Coca-Cola may be worth $150 billion (its current price) at the right discount rate even if it just earned $2 billion in free cash flow annually and never grew earnings per share year-over-year again.

However, we don't want to buy a company that's valued at $150 billion today and $150 billion five years from now. Incremental value is nice -- passed on through dividends and share buybacks -- but growth-driven value is our goal.

Can Coca-Cola grow rapidly again?

As of the end of 1998, Coca-Cola's five-year compound revenue growth rate was just 5%. Over the past ten years, it was 8.8%. Meanwhile, diluted net income grew 11.3% annually over the past five years and an excellent 15% annually the past ten. Dividends grew 14.9% annually in the past ten years, too. So, it is only the past five years that raise eyebrows and that have caused the stock to stagnate -- that and the near-term diagnosis which calls for anemic growth, too.

All companies hit slow periods (and if over $10 billion in free cash flow is a slow five-year period, one can't complain too much), but the problem with Coke's stock is that the stock market has assumed a certain rate of EPS growth and it is waiting for that growth to occur. While waiting, the stock will most likely continue to be flat to down. This is especially true if the rate of consistent growth that is generally anticipated (14% to even 17%, Coke's original goal) doesn't crystallize soon.

If it begins to appear that Coca-Cola can't consistently grow earnings per share at a double-digit rate again, the stock may suffer a long period of devaluation akin to the past few years. This doesn't mean that the stock would necessarily decline, it might just not rise for several years. Although we like that in order to build an investment base, we don't want that type of price movement for more than a few years, generally, and we only want this type of price movement if the stock will make up for the slow start later with above-average growth. In this case, the stock would probably grow merely at an average pace again after the devaluation period.

If Coca-Cola was our first purchase rather than Intel (Nasdaq: INTC), as was considered, we would be off to a very slow start -- one that might be difficult to overcome given the amount of early money invested. However, can the Drip Port begin to buy Coca-Cola now and reasonably expect that it will fulfill our goal of about 15% total return annually?

We'll investigate the prospect tomorrow. Tonight, please post your thoughts on Coca-Cola (and on Coca-Cola in relation to Drip Port) on the Drip Companies message board.

To close on a note of celebration, today the Fool celebrates its five-year anniversary! The Fool is, at heart, its community -- so thank you for five great years! It's fun to imagine how strong the Fool community will be in five more years, and where the online world will be.

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