Although Coca-Cola's (NYSE: KO) stock price is down about 11% so far this year, the world's leading beverage company has had a strong summer, with shares climbing 18% to about $54.25 since May.
Coke reported second-quarter sales of $5.6 billion, up 5% from last year. Worldwide case volumes increased 7% with core product sales accounting for about 5% of the growth and the rest coming from last year's acquisition of the Cadbury Schweppes brands. The growth was stronger than expected.
If you pay attention to Coke, there's another publicly traded beverage maker that reported much stronger second-quarter results worth keeping an eye on. In July, Coca-Cola Enterprises (NYSE: CCE), the world's largest soft drink bottler, reported second-quarter net income of $123 million, up from a dismal $34 million a year ago -- in part the result of a product recall in Belgium and other parts of Europe. Sales grew 8%, minus the effects of foreign currency translations, and consolidated case volume increased 3%.
What's the big deal? The heart of Coke's success may be its brand, but its legs are a worldwide distribution business that gets 232 varieties of drinks -- including Coke, Minute Maid juices, Crush, Fanta, and Dr. Pepper -- to more than 16 million customers that sell or serve its products.
The only way Coke can compete for grocery store shelf space in Texas, seed vending machines in Tokyo, or occupy the dominant spot at McDonald's (NYSE: MCD) soda fountains in Paris, is because it has a network of bottlers distributing, selling, and marketing its products worldwide.
Since the early 1980s, Coke has invested billions of dollars in bottlers, helping them build more efficient manufacturing, marketing, and distribution systems. The bulk of Coke's sales come from bottlers in which it has a noncontrolling or controlling interest. Last year, for example, 58% of unit case volume came from bottlers like Coca-Cola Enterprises, in which Coke has a noncontrolling stake, while 15% came from Coke-owned bottlers.
The beauty of the system former CEO Roberto Goizueta created gives Coke two dimensions: the high-margin syrup-selling business we own in the Rule Maker portfolio, and the asset-intensive, lower margin bottling business. Everyone knows that spinning off bottlers like Coca-Cola Enterprises, which Coke did more than a decade ago, keeps more than $10 billion in long-term debt off Coke's balance sheet. That's how the company has managed roughly a 30% return on capital over the last decade.
The other side of this, however, is that Coke's equity stake in its bottlers -- it owns about 40% of Coca-Cola Enterprises -- allows it to influence critical capital allocation decisions at companies that are closer to the customer. Before Coke owned stakes in its bottlers, it had no say in whether bottlers would invest in new, more efficient machinery and trucks, and had very little say in their marketing programs, or employee-incentive packages.
This lack of control kept Coke at a disadvantage to rival PepsiCo (NYSE: PEP), which had a domestic network of company-owned bottlers. (For more information on this topic, check out The Profit Zone, by Adrian Slywotzky, and for a much fuller treatment, read Mark Pendergrast's book, For God, Country, and Coca-Cola.)
It might not work perfectly, and from an investing standpoint Coke's syrup business is much more attractive than bottling, but Coke's relationship with its bottlers provides the best of both worlds: influence with bottlers without having to shoulder the burden of essential but capital intensive operations. This bottling farm-team system allows Coke to improve its distribution and has provided a steady string of one-time gains from spinning off part of its ownership stake in bottlers.
If you think business has been tough for Coke over the last two years, you should see some of its bottlers. Shares of Coca-Cola Enterprises have fallen almost 50% since January 1999. Slowing sales growth in North America, the strength of the dollar overseas, and lower profitability have taken a toll.
Coke can't thrive if its anchor bottlers don't perform, so better Q2 numbers from Coca-Cola Enterprises bode well, even though the company lowered full-year estimates in June mainly due to currency issues. Worth smiling about is that Coca-Cola Enterprises boosted operational cash flow to $294 million at the end of June, up from $284 million a year ago. It's beginning to feel the benefits of higher prices implemented last year, and Q2 operating income grew 5%. Coke reported $71 million in equity income from bottlers in Q2, up from just $12 million a year ago.
Coca-Cola Enterprises has plenty of problems, of course. Free cash flow per share has dropped like a rock over the last five years, from about $0.37 per share in 1995 to minus $0.18 per share last year, and debt is higher. Recently the company has used long-term debt to finance working capital needs, a situation you never want to see a seasoned company like Coca-Cola Enterprises facing. But there have been improvements and investors should keep an eye on the progress.
A final note: By a majority vote, the Rule Maker managers have decided to invest this month's $500 in Web portal Yahoo! (Nasdaq: YHOO), which has taken a beating in the market recently on fears of reduced advertising spending. It's an interesting time for Yahoo! and some changes are in the air. However, we're confident the company will thrive in the long haul. We'll make the investment in the next five business days.
Have a great day.
