Since first buying shares of soft-drink company Coca-Cola (NYSE: KO) in February 1998 at a price of $69.11 per stub, our portfolio has lost money on this investment. We're down almost 17% as of February 2.
Indeed, we paid a premium for the shares, which traded at an average trailing P/E of 48 in 1998 compared to 37 right now. We got in at the beginning of a tough time for Big Red: a product recall in Europe; the Asian economic crisis, which precipitated problems in Russia and led to expensive asset write-downs; a management shakeup; a series of onetime charges from the company's bottling partners; and a restructuring that included thousands of layoffs at company headquarters in Atlanta. Ouch.
It's not surprising the company's shares are down from our average purchase price, or that net income plunged to $2.2 billion this year, down almost 50% from $4.1 billion in 1997. We're paying the price for paying too high a price for Coke as it entered a tough stretch. That doesn't mean we bought a bad business, just that we paid a nice premium and it will take time to earn it back.
Could the Rule Maker find faster-growing investments? Absolutely. Would we have been better off the last three years invested in an index fund? Sure, but consumers will be drinking more Coke products in 10 years. I'm certain of this. The Coke brand name and distribution system provides competitive advantages that are very hard to erode and leave Coke well positioned for growth over the next 10, 20 and 30 years.
This thinking is based on Coke's 115-year history of steady -- not explosive, but steady -- expansion. This alone might not merit investing in Coke, but I'm much more certain people will be drinking more Coke in 10 years than I am that they will be buying more Cisco (Nasdaq: CSCO) routers or JDS Uniphase (Nasdaq: JDSU) pump lasers. That's not meant to be a swipe at Cisco or JDS, just a nod to the wonderfully predictable nature of Coke's business, and the growing power of an established consumer franchise. Coke might not achieve our 2x/5y objectives, precisely, but Coca-Cola may very well be a market-beating investment over the next two decades.
Let me tell you why.
At an industry conference in November, Coke President Jack Stahl offered up some interesting data. (You can listen to the presentation in the "Investors" area of Coke's website.) Historically, about every 10 years Coke's sales have flattened out. In the early 1980s, growth slowed as the company's new management worked to sell off non-soft-drink businesses, better leverage the brand (by introducing Diet Coke), and work more closely with bottlers. In the early 1990s, growth again slumped due to a slower economy, the need for new ad campaigns, and faster expansion overseas.
Now we're working through another phase of slow growth. Coke needs reinvigoration. In addition to all the reasons mentioned above, Stahl admits that Coke has been very slow to expand the range and variety of drinks it offers, especially in the fast-growing non-carbonated soft-drink market; that Coke failed to understand that people of different ages want different drinks; that Coke drifted away from strong relationships with its bottlers; and that Coke lost focus on the need for a local marketing platform that connects with consumers in different countries.
These problems are correctable, especially for a company with Coke's size and resources. How so?
First, Coke, which already has more than 232 brands, is rapidly rolling out new coffees, waters, teas, health drinks, and sodas, and seems more in touch with what different consumers are looking for in the ready-to-drink market. Having lots of brands, it seems, isn't the same as having the right brands in the right markets at the right time. "We were slow to develop a broader range of beverages," Stahl said. "There's no question consumers are looking for choice and variety." Coke expects to expand its non-carbonated drink sales from 9% of total volume to 20%-25% in 10 years.
In the first quarter of 2000, Coke rolled out an extension of its Fanta line in Germany, new teas in China and other parts of Asia, and Red Flash and Yes in the U.S. In Q2 it rolled out new products in the fast-growing market of energy drinks, potables such as Lift in Australia, Play and PlayLite in South Africa, Fanta Exotica in Central Europe, and Quatro in Venezuela. The list goes on and on as innovation accelerates.
Coke introduced 19 new beverages in Asia last year and plans to introduce another 35 in 2001. This expansion will not be easy for Coke to manage, but over time I expect the company to get the formula right, especially as it focuses on better relationships with international bottlers and local marketing partners. Overall, non-carbonated brands grew 11% in 2000, much faster than overall growth of carbonated soft drinks.
Second, while Coke's taste and brand name give it a powerful competitive advantage, the vast number of substitute products make it very difficult for Coke to raise prices. This is borne out in the slow volume growth we've seen recently after price increases in supermarkets across North America. Demand for the company's products is elastic, meaning sales are very sensitive to price changes.
As such, it's a mistake to think of Coke as a company with unlimited pricing power. Coke is in a volume business, and its bottlers give it the scale and flexibility to compete worldwide. One way the company is looking to gain an edge is through packaging. It recently provided a few examples, such as the introduction of 6.5-ounce single-serving containers in Italy to spark growth in the immediate-consumption market. Also, in Turkey it's rolling out 6-ounce, single-serving glass containers that are less than half as expensive as the company's cheapest previously available products. These small containers give Coke a way to enter markets in ways friendly to new consumers. Not only that, but unique packages are more difficult for rivals to easily duplicate and distribute than standard 2-liter bottles.
Above all, the company is working to improve its marketing. At the recent Morgan Stanley conference, it unveiled clips of six new ads pitched at consumers in different international markets, that were all developed locally, seeking to capitalize on the insights of local partners and bottlers. Until recently, ads such as these would have been developed in Atlanta.
Of course, we still need to see results on the bottom line. Coke will have to prove it can achieve its long-range unit volume growth rate of 7% to 8%, and it can't keep blaming shortfalls on everything from currency irregularities to marketing missteps.
Still, I'm inclined to believe Coke is on the right track. Will be a winning investment for the Rule Maker in the long run? Tomorrow, I'll take a look at the quantitative side of Coke, including long-term growth rates and sales trends. We'll see if Coke is up to the challenge.
In other news today, our portfolio picked up 15 shares of Nokia (NYSE: NOK) this morning at $33.14 apiece.
Have a great day.
Richard McCaffery, a co-manager of the Rule Maker portfolio, lives near the horse-racing track in Laurel, Maryland with his wife Linda. He doesn't own shares of Coca-Cola. He owns shares of Dell Computer (Nasdaq: DELL), just Dell. If you don't believe it, you're welcome to check his profile. The Motley Fool is investors writing for investors.