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KO in 2034

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By Tode
December 28, 2005

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Abominablenoman raised an interesting issue the other day--in light of KO's somewhat disappointing growth in recent years, would Munger still predict KO could have a market cap of $2 trillion in 2034? I would love to hear Charlie answer that question and explain any revisions to his forecast. I reread his speech and will offer a few observations for what they are worth.

As a refresher, Munger's famous 1996 talk (reproduced in Poor Charlie's Almanack and also in Janet Lowe's biography) made the following assumptions in claiming that a $2 trillion market cap was plausible in 2034.

1. 8 billion people on the planet that year, each of whom ingest 64 ounces of liquid a day (8 servings of 8 ounces each).

2. By the year 2034, 25% of those 64 ounces a day will be flavored beverages, of which KO's market share worldwide will be 50%. This would equate to 2.92 trillion servings of KO products that year (representing annual unit growth of 6% from 1996 to 2034, a rate of increase "consistent with much past experience").

3. KO nets 4 cents per serving, giving it $117 billion net income in 2034. "This will be enough, if our business is still growing at a good rate, to make it easily worth $2 trillion." In other words, a 17 P/E.

CM also gives four reasons why 4 cents a servings is a reasonable profit target for 2034: (1) the dollar will almost surely depreciate between now and then "like the Roman drachma," (2) real purchasing power of the average beverage consumer in the world will go "way up," (3) "his proclivity to inexpensively improve his experience while ingesting water will go up considerably faster," and (4) improving technology will reduce the cost of production in units of constant purchasing power.

That is the thesis in a nutshell. Now let's re-examine each assumption, nine years later.

1. I don't think there is any reason to question the first assumption on population growth and liquid ingestion (barring nuclear disasters, flu epidemics or other similar catastrophes; if that's what we get, KO's growth rate will not be at the top of my worry list).

2. The assumed 6% unit growth rate has not panned out so far. In 1996 KO sold enough concentrate to produce 13.7 billion unit cases (24 8-ounce servings=one unit case). In 2004 it was 19.8 billion, an increase of 45% in eight years. We are already about 2 billion unit cases behind where we need to be in order to be on pace at the 6% growth rate, after 8 years. Moreover, KO has now projected the long-term unit growth rate to be 3 to 4%. To get to 2.92 trillion servings a year, we need to increase 2004 unit volume of 475.2 billion servings (17.8B times 24) by a factor of 6.1. If we assume 4% unit growth from 2004 forward, volume would double every 18 years, with roughly 2 1/2 doubles needed (I am just roughing this out with the Rule of 72; one of these days I will shell out ten bucks for a calculator that can do this stuff). So that would move back the target date to about 2049--15 years later than predicted.

If we assume 3% unit growth, it would double every 24 years, which would give a target date of 2064, 30 years later than predicted. Interesting how such small differences in growth rates produce big disparities over decades.

When Munger made his speech, he was correct about 6% unit growth being "consistent with much past experience." During the 10-year stretch preceding his speech, for example, unit growth averaged 7%. But it seems fair to say that KO was a bit slow to adjust to the change in consumer tastes from 1996-2004, as many switched from CSDs to non-CSDs and bottled water. Part of this was probably the "institutional imperative" at work, and part no doubt was the realization that non-CSDs and water were less profitable than peddling CSD syrup.

3. Which brings us to the third assumption of making four cents a serving in 2034. When Munger made his speech in 1996, KO earned one cent per serving. In 2004 it was still earning one cent per serving. When I look at the four reasons CM posited in 1996 why a quadrupling of profit per unit was plausible over 38 years, all four seem perfectly sound to me today. But KO's fastest growing categories now are water and non-CSDs. Dasani is growing briskly, but let's not forget CM's entire premise--the idea is to "flavor and improve" water. If you are selling water, can you convince the world that your water is better tasting and healthier than everybody's else's? There has been lots of price competition in the bottled water market, and Dasani has been affected by this competition. They plan to offer more flavored bottled waters at a premium price to regular Dasani, which hopefully will succeed. And you all have heard about some of the other new products that are coming soon, including some coffee products (I bet Starbucks is making more than four cents a serving). I think the jury is still out on whether the new, broadened portfolio of KO beverages can be successfully marketed to create the same "mind share" that the Coca-Cola brand has enjoyed.

KO's worldwide distribution infrastructure is without parallel and should give it a leg up on the competition, but in the final analysis KO is all about brilliant advertising and marketing. That is where they have stumbled badly in recent years. You would think that the owner of the world's most valuable brand could find the world's most talented ad people and somehow figure out how to come up with ads that resonate, or at least a decent slogan. It has been a disaster but hope springs eternal. They MUST get this fixed if they are going to meet their unit growth goals and increase profits per serving over the next three decades. I think Isdell and Mary Meeker realize how important this is. Whether they can execute remains to be seen. I look forward to seeing the new advertising campaign during the Winter Olympics (Wall Street was not impressed with the preview given earlier this month).

I think there is still a lot to like about KO as an investment even though 3 to 4% unit growth does not seem too enticing. For starters, the dividend yield will be nearly 3% if the dividend is increased to $1.20 as anticipated for 2006. That's back to where the dividend yield was back in 1988 when you know who was loading up (though the payout ratio was lower then). If KO reduces its share count by say 2% a year for many years, and maintains a 3% dividend yield during this time, that is a 5% economic return even if there is zero unit growth and zero growth in profit per serving. That's not a bad floor in an uncertain world, for a company of this quality selling at under 18x 2006 EPS.

If it can hit its 3-4% unit growth target, and EPS growth target in the upper single digits, its total return per share ought to be respectable. The market cap now is under $100B (20% less than when CM gave his speech eight years ago). Keep in mind also that CM's calculations on market cap do not take into account the per share increase, which is what counts. If KO goes from $100B to $2 trillion that's an increase of 20x, but if the shares are reduced by 50% during that time span, it's an increase PER SHARE of 40x.

One final thought on KO. Most of its profits today are in mature markets. Unit growth is much higher in some very large markets where unit sales per capita are low. At some point between now and 2034, perhaps sooner than we think, KO could hit an inflection point where its proportion of unit sales are much higher in the rapidly growing markets (think China). If that happens, the current 3 to 4% unit growth rate could accelerate. CM did not say the 6% unit growth had to be in a straight line over 38 years. Also, as these developing markets grow and consumers grow wealthier, KO will get more aggressive with price increases in these markets.

All in all, KO is far from perfect and may not be as inevitable as we once thought it was, but at this multiple and a 3% dividend yield that increases every year, it looks interesting to me. It may not have a $2 trillion cap by 2034, but if it keeps buying back stock steadily at these multiples, things should work out OK. After 50 years of 2% buybacks, your heirs can fight with WEB's heirs over who gets to keep the last share outstanding when it is worth $2 trillion.
Abominablenoman raised an interesting issue the other day--in light of KO's somewhat disappointing growth in recent years, would Munger still predict KO could have a market cap of $2 trillion in 2034? I would love to hear Charlie answer that question and explain any revisions to his forecast. I reread his speech and will offer a few observations for what they are worth.

As a refresher, Munger's famous 1996 talk (reproduced in Poor Charlie's Almanack and also in Janet Lowe's biography) made the following assumptions in claiming that a $2 trillion market cap was plausible in 2034.

1. 8 billion people on the planet that year, each of whom ingest 64 ounces of liquid a day (8 servings of 8 ounces each).

2. By the year 2034, 25% of those 64 ounces a day will be flavored beverages, of which KO's market share worldwide will be 50%. This would equate to 2.92 trillion servings of KO products that year (representing annual unit growth of 6% from 1996 to 2034, a rate of increase "consistent with much past experience").

3. KO nets 4 cents per serving, giving it $117 billion net income in 2034. "This will be enough, if our business is still growing at a good rate, to make it easily worth $2 trillion." In other words, a 17 P/E.

CM also gives four reasons why 4 cents a servings is a reasonable profit target for 2034: (1) the dollar will almost surely depreciate between now and then "like the Roman drachma," (2) real purchasing power of the average beverage consumer in the world will go "way up," (3) "his proclivity to inexpensively improve his experience while ingesting water will go up considerably faster," and (4) improving technology will reduce the cost of production in units of constant purchasing power.

That is the thesis in a nutshell. Now let's re-examine each assumption, nine years later.

1. I don't think there is any reason to question the first assumption on population growth and liquid ingestion (barring nuclear disasters, flu epidemics or other similar catastrophes; if that's what we get, KO's growth rate will not be at the top of my worry list).

2. The assumed 6% unit growth rate has not panned out so far. In 1996 KO sold enough concentrate to produce 13.7 billion unit cases (24 8-ounce servings=one unit case). In 2004 it was 19.8 billion, an increase of 45% in eight years. We are already about 2 billion unit cases behind where we need to be in order to be on pace at the 6% growth rate, after 8 years. Moreover, KO has now projected the long-term unit growth rate to be 3 to 4%. To get to 2.92 trillion servings a year, we need to increase 2004 unit volume of 475.2 billion servings (17.8B times 24) by a factor of 6.1. If we assume 4% unit growth from 2004 forward, volume would double every 18 years, with roughly 2 1/2 doubles needed (I am just roughing this out with the Rule of 72; one of these days I will shell out ten bucks for a calculator that can do this stuff). So that would move back the target date to about 2049--15 years later than predicted.

If we assume 3% unit growth, it would double every 24 years, which would give a target date of 2064, 30 years later than predicted. Interesting how such small differences in growth rates produce big disparities over decades.

When Munger made his speech, he was correct about 6% unit growth being "consistent with much past experience." During the 10-year stretch preceding his speech, for example, unit growth averaged 7%. But it seems fair to say that KO was a bit slow to adjust to the change in consumer tastes from 1996-2004, as many switched from CSDs to non-CSDs and bottled water. Part of this was probably the "institutional imperative" at work, and part no doubt was the realization that non-CSDs and water were less profitable than peddling CSD syrup.

3. Which brings us to the third assumption of making four cents a serving in 2034. When Munger made his speech in 1996, KO earned one cent per serving. In 2004 it was still earning one cent per serving. When I look at the four reasons CM posited in 1996 why a quadrupling of profit per unit was plausible over 38 years, all four seem perfectly sound to me today. But KO's fastest growing categories now are water and non-CSDs. Dasani is growing briskly, but let's not forget CM's entire premise--the idea is to "flavor and improve" water. If you are selling water, can you convince the world that your water is better tasting and healthier than everybody's else's? There has been lots of price competition in the bottled water market, and Dasani has been affected by this competition. They plan to offer more flavored bottled waters at a premium price to regular Dasani, which hopefully will succeed. And you all have heard about some of the other new products that are coming soon, including some coffee products (I bet Starbucks is making more than four cents a serving). I think the jury is still out on whether the new, broadened portfolio of KO beverages can be successfully marketed to create the same "mind share" that the Coca-Cola brand has enjoyed.

KO's worldwide distribution infrastructure is without parallel and should give it a leg up on the competition, but in the final analysis KO is all about brilliant advertising and marketing. That is where they have stumbled badly in recent years. You would think that the owner of the world's most valuable brand could find the world's most talented ad people and somehow figure out how to come up with ads that resonate, or at least a decent slogan. It has been a disaster but hope springs eternal. They MUST get this fixed if they are going to meet their unit growth goals and increase profits per serving over the next three decades. I think Isdell and Mary Meeker realize how important this is. Whether they can execute remains to be seen. I look forward to seeing the new advertising campaign during the Winter Olympics (Wall Street was not impressed with the preview given earlier this month).

I think there is still a lot to like about KO as an investment even though 3 to 4% unit growth does not seem too enticing. For starters, the dividend yield will be nearly 3% if the dividend is increased to $1.20 as anticipated for 2006. That's back to where the dividend yield was back in 1988 when you know who was loading up (though the payout ratio was lower then). If KO reduces its share count by say 2% a year for many years, and maintains a 3% dividend yield during this time, that is a 5% economic return even if there is zero unit growth and zero growth in profit per serving. That's not a bad floor in an uncertain world, for a company of this quality selling at under 18x 2006 EPS.

If it can hit its 3-4% unit growth target, and EPS growth target in the upper single digits, its total return per share ought to be respectable. The market cap now is under $100B (20% less than when CM gave his speech eight years ago). Keep in mind also that CM's calculations on market cap do not take into account the per share increase, which is what counts. If KO goes from $100B to $2 trillion that's an increase of 20x, but if the shares are reduced by 50% during that time span, it's an increase PER SHARE of 40x.

One final thought on KO. Most of its profits today are in mature markets. Unit growth is much higher in some very large markets where unit sales per capita are low. At some point between now and 2034, perhaps sooner than we think, KO could hit an inflection point where its proportion of unit sales are much higher in the rapidly growing markets (think China). If that happens, the current 3 to 4% unit growth rate could accelerate. CM did not say the 6% unit growth had to be in a straight line over 38 years. Also, as these developing markets grow and consumers grow wealthier, KO will get more aggressive with price increases in these markets.

All in all, KO is far from perfect and may not be as inevitable as we once thought it was, but at this multiple and a 3% dividend yield that increases every year, it looks interesting to me. It may not have a $2 trillion cap by 2034, but if it keeps buying back stock steadily at these multiples, things should work out OK. After 50 years of 2% buybacks, your heirs can fight with WEB's heirs over who gets to keep the last share outstanding when it is worth $2 trillion.


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