Rule Maker Portfolio
Corporate Reinvention -- Microsoft vs. Coca-Cola

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (Sept. 29, 1999) -- On May 28 last year, Tom Gardner penned one of my all-time favorite Rule Maker columns, which lauded Coke and Microsoft. At the time, Coca-Cola (NYSE: KO) and Microsoft (Nasdaq: MSFT) were his two favorite American businesses, and he described these powerhouse companies as the Rule Maker portfolio's "firmest foundations." Tom admired both companies' global presence, high gross margins, and high return on capital characteristics.

Since then, the stock performances of these two great companies have diverged sharply. Microsoft has been our portfolio's second best investment, up more than 100%. And then there's Coke. Who would've guessed the hard times this company has fallen into? Our shares are now down more than 25%, making Coca-Cola the dog of the portfolio.

We've already added once to our Microsoft position. Is it now time to acquire some additional shares of the portfolio's other pillar of business quality, Coca-Cola, especially now that it's beaten down?

Before answering that question, let's consider the reasons for Tom's admiration of each company.

Here's how he summed up the reasons for Coca-Cola's century-long business success:

"How has Coca-Cola done it? By restructuring its relationship with its bottlers (distribution), by dropping vending machines in the hallways of the world (access), and by heavily committing creative energy and capital resources to build its brand name (familiarity). These are three primary ingredients to a successful consumer franchise (though there are certainly others), and Coca-Cola has been a leader in fostering each of them in the 20th century."

No doubt about it, Coca-Cola is the quintessential repeat-purchase consumer franchise. The company has an inherently great business selling a low-cost, high-margin product to consumers the world over. But, even great businesses need to reinvent themselves every so often. Whether the reinvention is a slam-dunk advertising campaign, a great new product, or a creative new way of reaching the consumer, the company needs to make changes that will re-ignite the engines of revenue growth.

For the past three years, Coke's revenues have been dead flat. Why? The Coca-Cola brass point to troubled overseas economies. Please. Management has milked the excuse of global economic woes for way too long. Heck, there will always be at least one important economy that's suffering somewhere in the world. It's time for Ivester and company to think outside the box and do something exciting at Big Red.

Coke is not alone in its difficulties. Every company runs up against growth limitations, but the best companies constantly rethink their strategy to create new growth opportunities. Corporate reinvention comes from management that is creative, forward-thinking, and risk-taking. Such management teams are able to grow earnings for decades by making smart moves into new lines of business. Johnson & Johnson (NYSE: JNJ) is a good example of such a company. Its latest move has been an increased focus on the high-margin, high-growth pharmaceuticals business.

Intel (Nasdaq: INTC) is another great example. During the past six months, Intel has reinvented itself as a provider of "bit factories" to run the world of e-commerce. Compare for yourself April's Intel on Stage Rule Maker article and yesterday's An Intel Spectacle in the Drip Port. Since the announcement of Intel's move into Web services, the company has defied its skeptics and is on track to enter a new stage of strong growth and value creation for shareholders. Like Intel and J&J, Coca-Cola has a long history of successful corporate reinvention. I have no doubt that Coke will eventually get back on track, but there's no guarantee of when.

In the meantime, I continue to agree with the same conclusion Tom reached a year-and-a-half ago when comparing Microsoft and Coke. He gave the edge to Microsoft:

"Given their present financial standing and the levels of expandability of their respective markets, I think the software maker holds the greater potential of the two. The Internet is exploding with new users just as half of the planet's population is methodically cracking its way out of the eggshell and into democracy."

Prescient words, no? Microsoft has more than doubled during our 18-month relationship with the company. In fact, we've so enjoyed our ownership of the company that we decided to add to our position in July of this year. And yes, I think we should add to this position once again.


Yep. One reason is the nebulous quality of expanding possibilities, or as Tom described it more verbosely, "the levels of expandability of their respective markets." Microsoft's possibilities extend throughout the whole universe of business productivity. Today the productivity tool is a PC, but tomorrow it will be any Internet-enabled device.

Microsoft's historical personal computer market is running up against growth constraints. According to Microsoft figures, PC sales grew 17% in fiscal '98, but only 14% in fiscal '99. That's a moderate growth rate, but it's definitely beginning to slow. Yet before PC growth has even begun to truly stagnate, Microsoft has already reinvented itself.

Upon the company's founding in 1975, Bill Gates' vision was for a PC to be on every desk. For more than two decades, that vision led Microsoft to the pinnacle of corporate success and the world's highest market capitalization -- nearly $500 billion. But in the past year, Microsoft realized that the original vision wasn't particularly relevant to its new Internet-based software initiatives. The software giant realized that people don't buy software; they buy solutions. Microsoft began thinking of software as a service. And that led to Microsoft's new corporate vision: Empower people through great software -- anytime, anyplace, on any device.

The strategy for manifesting that vision is a new development platform called Windows Distributed interNet Architecture (DNA) 2000. The goal of this platform is to enable programmable Web services.

A programmable Web opens the doors to tremendous opportunities. Microsoft President Steve Ballmer calls it the "next frontier." Originally, the Internet was just a place for techies who understood stuff like TCP/IP, FTP, and Gopher. Then, with the advent of the Web, the Internet entered what Ballmer calls the "presentation era," where Web pages are presented one at a time and we click from one to the next. We're still in that stage. But here's what Ballmer expects for the third generation of the Internet:

"This third-generation, which I think we are entering now, and I'm sure will last at least five years, is a generation in which people will program the Web, they will customize it for themselves. Developers will use services that other developers' websites provide: tax calculation, authentication, whatever the case may be. It's a generation in which the technology from a developer's standpoint has to enable software to be a service."

Software as a service, a programmable Web -- Microsoft is about to make it a reality. Over the next two years, the company will be rolling out a whole slew of new products that will support the Windows DNA 2000 platform. (See my Friday Fool Plate Special for more details on those products.) Will these products be successful? Will the developer community embrace Microsoft's new Web programming model?

I don't know for sure, but I wouldn't bet against Bill Gates. In fact, I'd like to bet another $500 that he and his company will continue to win. Microsoft's advantages are extraordinary: young and aggressive management, $34.5 billion in cash and investments (ponder that number for a moment), and 20 years of customer relationships. All the pieces are in place for Microsoft to emerge successfully from this current corporate reinvention and enter a new stage of market-beating value creation. It's mind-boggling but true: The market continues to underestimate the potential of this quintessential Rule Maker.