The relationship between Coca-Cola (NYSE: KO) and its bottlers is an ongoing topic on The Motley Fool discussion boards. Much of the scrum involves Coke's method of accounting for its minority investments in bottlers such as Coca-Cola Enterprises (NYSE: CCE), the world's largest soft drink bottler. Coke owns 40% of CCE; CCE accounted for 17% of Coke's revenue last year.
For those unfamiliar with the setup, here's a quick summary. Coke reports its proportionate share of income or losses from CCE on its income statement, but doesn't report any of the expenses associated with generating those profits on its balance sheet. This is perfectly legal, but does it mislead investors?
Clearly, the bottlers are a critical part of the Coke franchise. Not only do they bottle and distribute the beverages, they manage relationships with retailers. If Coke owned more than 50% of Coca-Cola Enterprises, however, it would have to consolidate the two companies' financial statements, which would mean adding roughly $10 billion in long-term debt to Coke's balance sheet. Ouch.
This was the whole idea behind spinning off the bottler in the late 1980s: Coke's core operations became focused on selling high-margin syrup to bottlers and building the Coke brand name, while the bottlers remained focused on bottling and distribution, a capital-intensive business with low margins.
However, if you don't understand the importance of bottling and distribution to Coke's franchise, you probably shouldn't go anywhere near the stock. As such, if you don't feel like keeping up with Coca-Cola Enterprises' financial statements, at least to get a feel for the distribution side of the business, you're going to be in the dark. It's kind of like watching your favorite football team only when its offense is on the field -- you're missing half the game.
The debate isn't new. I have a textbook that presents the two companies' 1995 financial statements as a case study on the issue of equity accounting. Here's the dilemma: Does sweeping all those low-margin, asset-intensive items off the balance sheet distort Coke's economic reality, since it needs healthy bottlers to grow? Or, does separating the two very different aspects of Coke's business give investors a better feel for the economic characteristics of each entity?
Personally, I don't think there's a right or wrong answer here, just a lot of opinions, mostly from reasonable people on both sides of the issue. Investors should decide for themselves where they stand. Since financial statements for both entities are disclosed, investors can treat the companies anyway they want. If you don't like the present arrangement, it's possible to combine the financial statements for a wholistic view. Be assured you'll see a lower return on assets and a slew of altered ratios, including a higher debt-to-equity ratio.
This isn't exactly a secret, and the problems the companies face are well documented: weak volume growth, too rapid expansion into territories such as Russia and India, management struggles, a resurgent competitor in PepsiCo (NYSE: PEP), a weak euro, and too much inventory in the channel until recently. None of this is obscured as a result of equity accounting, and I don't have to combine financial statements to see these problems clearly.
I will say this, however. Ignoring the position Coca-Cola Enterprises has gotten itself into over the last five years isn't smart. Since we own Coke in the Rule Maker, I think there's reason for concern. (FYI, I wrote about Coca-Cola Enterprises' second-quarter performance a few months ago and probably didn't take a wide enough look to represent where the company stands. Also, the Coca-Cola discussion board is a great place to get educated about many of these issues.)
The biggest problem I see is Coca-Cola Enterprises' debt. It acquired eight bottling companies last year alone and, from 1986 through 1999, spent $13.1 billion on acquisitions.
Here are a few relevant figures from Coca-Cola Enterprises (numbers in millions).
1995 1999 Sales $6,773 $14,406 Owner Earn. $ 496 $ 559 LT Debt $4,138 $10,153 Interest $ 326 $ 751 Cap Ex $ 501 $ 1,480
First, Coca-Cola Enterprises spends a lot of time focused on cash operating profits, a measure of its earnings before interest, taxes, depreciation, and amortization (EBITDA). I think it's a mistake for investors to think of cash operating profits as cash flows, since it doesn't include changes in working capital or needed capital expenditures. While it might, to some degree, reflect Coca-Cola Enterprises' earnings power, this figure doesn't represent cash the company is free to deploy as it chooses. Here's how Coca-Cola Enterprises reported cash operating profits at the end of last year:
Cash operating profit as a percentage of revenues
1999 1998 1997 15.9% 14.83% 14.77%
It looks pretty good. However, I calculated Coca-Cola Enterprises' owner earnings, a measure of operating profits, plus noncash charges minus capital expenditures, a number that better represents Coca-Cola Enterprises' earnings power. Basically, this number takes into consideration how much Coca-Cola Enterprises is spending to expand and maintain its property, plant, and equipment (PP&E), costs that are essential to maintaining its competitive position. Things aren't sparkling by this estimate.
Owner earnings as a percentage of sales
1999 1998 1997 3.9% 3.3% 6.2%Now compare Coca-Cola Enterprises' owner earnings with its interest payments. Last year, the company didn't earn enough to fund PP&E and make its annual interest payments. Owner earnings came in at $559 million while annual interest expense on its debt totaled a whopping $751 million. This is the second year in a row that Coca-Cola Enterprises has been in this fix, and while I understand the need to expand its bottling footprint, investors aren't crazy to expect Coca-Cola Enterprises to expand prudently. Looking at its cash flow statements you can see that Coca-Cola Enterprises regularly issues debt and taps its credit line to help finance the business. On the whole, that's just not what we want to see for companies in this portfolio.
So, what's the take-away from this? I'd like to see Coca-Cola Enterprises spend a lot more time paying down debt than buying new bottlers and repurchasing shares. While Coke needs a global footprint to distribute its beverages, it also needs healthy bottlers.