Staying the Course With Coke

As part of researching Coca-Cola (NYSE: KO), the world's most valuable brand and leading soft drink company, I spent some time looking at Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett, Coke's most famous investor.

In his book Buffett: The Making of an American Capitalist, Roger Lowenstein takes a close look at Buffett's big bet on Big Red. Buffett believed Coke had created a virtually unassailable moat with its brand name, and that, with plenty of growth opportunities overseas, Coke represented a safe and market-beating investment opportunity at just 13x forward earnings back in 1988. You bet it did.

Lowenstein tells us (and you can read about it yourself in Berkshire's annual reports) that Buffett invested more in Coke than in any other stock up to that point, about $1.02 billion, for a 7% ownership position. His stake soared to $3.75 billion in 1991 as Wall Street changed its perception of the company -- the key to Buffett's big return. Rather than a mature franchise, investors suddenly saw the world's dominant soft drink brand poised to grow rapidly overseas. Buffett caught the growth wave as Coke's earnings grew quickly and its stock multiple grew even faster.

Now travel back in time to February 1998 when the Rule Maker Portfolio first bought shares of Coca-Cola. I'd estimate we paid roughly 37x forward earnings, almost three times per dollar of earnings compared to the price Buffett paid. Our underperformance over the last three years has as much to do with the steep price as it does with Coke's operational and managerial struggles.

We knew we were paying a high price. Tom Gardner wrote about this in a February 1998 Rule Maker report. Tom had his eye on the company's prospects over the next 20 years, not the next three, and I agree with his assessment of the company's growth prospects and brand strength. As a result, Coke will continue to trade at a high premium to the market. Right now it's trading at a 70% premium to the S&P 500, compared with the 15% premium Buffett paid in 1988.

I think it makes sense for us to be more careful in the prices we pay for the best companies, especially since the market gives us chances to buy them at decent prices, but overall I agree with Tom. I wouldn't need to see Coke trading at 13x earnings to jump at a chance to buy additional shares.

So much for yesterday. What should we do with the stock now?

For starters, Coke had a much better year in terms of growth in 2000 than it did in 1999. (When you talk about growth at Coca-Cola, you're talking about unit case volume growth. Management has long believed this is the best way to think about top-line growth since it measures the strength of sales at the retail level.)

Unit Case Growth   '99       '00
Worldwide         nearly 2%   4%
North America       1%        1%
Latin America       3%        6%
Middle & Far East   1% 
Africa & Mid East             3%
Greater Europe      flat      6%
Asia-Pacific                  8%

Over the long term, Coke expects to grow worldwide unit case volume 7% to 8% annually, with 5% to 6% of the growth coming from carbonated soft drinks (CSDs) and 1% to 2% coming from the fast-growing non-carbonated soft drink market.

This is an aggressive estimate compared to the company's historical growth rate in that it assumes slightly better performance than the historical trend even as Coke gets larger and larger. From 1976 to 2000, Coke's unit volume growth averaged 6.5% annually. I wouldn't expect Coke to do any better than that long-term, but I don't think the last two years are representative of what we should expect over the next 5 or 10 years. Some of my optimism is a leap of faith in the Coke system, to be sure, but I'm encouraged by the recent changes detailed in yesterday's story, such as Coke's better focus on the non-carbonated beverage segment.

Over the last five years, the domestic growth rate for non-carbonated beverages has grown in the 13% to 15% range on the strength of brands such as Dasani water and Minute Maid juices. Now, Coke, which has not really pushed its non-carbonated drink business outside the U.S. and Japan, expects that business to grow internationally at a 14% to 16% annual rate.

Coke is still a growth business in some of the world's biggest markets. Unit volume grew 15% in China in 2000 and yet the company believes it's only reaching 50% of the country's estimated 1.2 billion population. Unit volume in India grew abut 8% in 2000, but it's very difficult for Coke to reach much of this country's population with its marketing messages. Over the long haul, Coke expects India to be a high-growth market.

At the end of 1999, the average person consumed roughly 20 Coke products per year in the Middle and Far East, compared to 93 in Europe, 198 in Latin America, and 409 in North America. There's room to grow.

Meantime, Coke's management expects to grow earnings 15% annually. Fortune recently ran a story on the myth of 15% earnings growth that included an interesting fact on Coca-Cola: Over the last 40 years, it has grown earnings 12%, on average, annually.

Let's run a scenario, based on the assumption Coke hits this mark over the next five years. Minus a boatload of nonrecurring charges, Coke had net income of $3,672 million last year. Grow this 12% annually, allow for 3% share dilution through 2006, and multiply by Coke's five-year average P/E of 43.7 and you come up with a price of about $110 per share. That's up about 90% from its current price of $59, and up about 60% from our average purchase price. Given that this is, in my opinion, a best-case scenario, these aren't great results.

I think it's pretty clear the company won't meet our 2x/5y objective. Still, I'm strongly in favor of keeping Coke in the Rule Maker Portfolio. (We haven't had any discussions about selling it, mind you.) First, I have my doubts the market will do better than Coke over the next 5 or 10 years. Second, as Wharton professor Jeremy Siegel pointed out in Stocks for the Long Run, established consumer franchises have been very hard to outperform in the long run. Finally, the 2x/5y yardstick is a useful way to think about the kind of growth we'd like to see when we invest new dollars in a company. I don't think, however, we should necessarily sell a stock because it will have trouble reaching this watermark.

Why? If Coke grows 7% annually, it doubles in roughly 10 years. The interest rate on a 10-year Treasury bond is 5.75%, and while it's safer than Coke, the bond doesn't offer much more upside than its coupon rate. It's also a lot less interesting to be invested in a 10-year bond than a living, breathing company. That's warm-and-fuzzy thinking I suppose, but it's relevant for me. I hope the Rule Maker holds onto its Coke shares for the long haul.

Before signing off tonight, I want to remind you that sign-ups have begun for our upcoming Rule Maker seminar: The Art of Rule Maker. Beginning on March 5, we'll deliver eight lessons to your email box over four weeks. The theme for this year's seminar is how to assess a Rule Maker candidate's sustainable competitive advantages, management quality, expanding possibilities, and current valuation. If you thought Rule Maker investing was all about reading a balance sheet, this seminar will show you that it's much more than that! As part of the seminar, you'll also receive our special report, The Rule Maker Top 25 -- a ranked list of our favorite Rule Maker investment ideas, each one summed up in a short essay. It's going to be a great learning experience as well as a great opportunity to get acquainted with the best investment ideas across the Rule Maker universe. And, of course, the entire Rule Maker team will be there both as teachers and as students learning with you. We hope to have you join us! Learn more (or sign up now).

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.