Coca-Cola Bull's Pen
by Louis Corrigan ([email protected])

The Cash-King portfolio recently did a great job of making the bullish case for Coca-Cola. But to restate some of the obvious, this Atlanta-based behemoth makes, distributes, and markets soft drink concentrates and syrups. With a presence in 200 countries, the company now claims an astonishing 50% of the worldwide market share for soft drinks, selling four of the top five brands, including perhaps the planet's best-known brand of any kind.

Over the last ten years, Coca-Cola has grown revenues at a compound annual rate of 9.4%, and the growth story remains intact. With soft drink unit case volume up just 1% in the U.S. last year, Coke's case volume rose 6%, meaning it continues to grab share in its most mature market. Meanwhile, its international business (66% of revenues and 76% of profits) is stronger than ever, with double-digit unit case volume growth last year in all of its overseas groups. Overall, unit case volume fizzed 10% in the fourth quarter of 1997 and a better-than-expected 9% to 10% in the first quarter of 1998.

Because of an intense focus on its core business, Coke has turned these decent top-line gains into even better bottom-line growth, with EPS increasing at a compound rate of 18.5% over the last 10 years. Gross margins have soared from 53% in 1987 to 68% last year, while net profit margins have nearly doubled, from 12% to 22% over this same period. Although Coke maintains some ownership in bottlers representing 60% of its worldwide unit case volume sales and frequently buys up bottlers only to strengthen their operations before selling them to one of its 10 anchor bottlers. Most of the heavy expenditures for these capital-intensive operations are paid for by its largely independent distribution partners.

That is, Coke has developed a capital management strategy aimed at maximizing its return on equity (up to 61% from 26% in 1987) and return on invested capital (up to 39% from 18% in 1987) while never forgetting the absolute imperative of enhancing its distribution system. With a current after-tax average cost of capital of 11%, Coca-Cola is obviously getting superior bang for its buck, so much so that the company is prepared to let its dividend payout ratio trend down a bit to get more dollars to use to continue to build the business.

Unsurprisingly, Coke's 10-year total return (as of December 31) is three times that of the Dow Jones Industrial Average or the S&P 500, with a $100 investment in Coke growing to $1,643 during this period. The stock has more than kept pace with the strong market this year, rising about 18%.

Even so, Coke has plenty of skeptics. The stock now trades at 47 times trailing 12-month earnings of $1.64 per share, which the company will barely beat this year due to the strong dollar and substantial one-time gains in '97. In addition, with a market cap of $190 billion, it sports a price-to-sales ratio of 10. As Kent Simons of the Neuberger & Berman Guardian Fund pointed out last summer, when Coke was at $70 a share, an investor could theoretically acquire an entire diversified group of well-known companies for what Coke is valued at. (Simons' group included Chase Manhattan, Merrill Lynch, Compaq, Chrysler, Aetna, Capital One Financial, Barnes & Noble, and Federal Home Loan Mortgage -- with money to spare!)

Moreover, others complain that once you exclude profits from the periodic sale of bottlers plus the effect of stock buybacks on EPS growth, this growth company is actually turning out fairly flat, mid-single digit increases in operating profits. Finally, others question whether Coke can keep its sales carbonated now that Americans already consume more than one of the company's beverages every day. Let's take these in reverse order.

Sales Growth: Coke's reach is worldwide, but its per capita consumption in nearly every country remains relatively tiny. Countries with just 20% of the world's population account for 80% of Coke sales. Half the world's population lives in places where people consume an average of just 10 of the company's beverages each year. China, India, Indonesia, and Russia combined represent 44% of the world's population, and yet the average per capita consumption in these nations is 2% of that seen in the U.S. Put another way, the company provides just one billion of the 48 billion beverage servings we earthlings consume each day. Given the international spread of consumer capitalism and the current bargain prices for assets across Asia, Coke's growth opportunities have perhaps never been better.

Operating Income: Jeff Fischer and Randy Befumo offered a great debate on this issue last September in the Drip Portfolio reports, but I think Jeff got the better of that duel. It's simply a mistake to think that buying and selling bottlers isn't part of Coke's core operations. It is. Without an efficient, profitable, and far-reaching distribution system, Coke's business is worth a lot less. One could think of this business of acquiring, restructuring, then selling bottlers as a separate operation (and Coke should help investors by breaking out this business more clearly in its financial filings). But it's an operation designed to drive Coke's syrup sales.

Sure, selling off such bottlers can create huge one-time gains. Coke reported $583 million in "Other income" last year vs. just $87 million in '96 thanks to such sales. Yet with the company's continued expansion into huge fledgling markets, these "non-recurring" gains may become even more common. It's also shortsighted to worry about one quarter's results when Coke is building its business for the next century. Despite fears of mid-single digit growth, operating income excluding non-recurring items increased 10% in 1997.

Valuation: New CEO M. Douglas Ivester recently indicated that while '97 will be a tough act to follow (with '98 EPS estimates in the $1.65 to $1.70 range), he foresees long-term EPS growth from continuing operations in the upper teens, perhaps 17% to 19%. Given Coke's consistent track record and dominant brand, investors might reasonably value Coca-Cola's forward earnings at twice the presumed 18% EPS growth rate.

Calendar   Estimated      Year-End 
  year          EPS      Price Target 
 '98           $1.70         $61 
 '99           $2.01         $72 
 '00           $2.37         $85 
 '01           $2.79         $100 
 '02           $3.30         $119 
 '03           $3.89         $140 
 

Though Coke is slightly overvalued today, the five-year compound annual return is still 12.7%, a market-beating return for one of the most recession-proof, repeat-purchase, consumer product companies in the world.

Even these apparently generous assumptions may prove too conservative, however. What the skeptics have not fully appreciated is that corporate earnings are simply worth more today due to low inflation, which simultaneously makes alternative investments relatively less appealing. In an environment with 3% inflation in which Coke returns compound annual EPS growth of 18% while bonds return 7%, the real return is 15% for Coke vs. 4% for bonds, an 11% differential. Assuming Coke can maintain that growth in an environment with 2% inflation and a 5% bond yield, Coke's real return becomes 16% vs. 3% for bonds, a 13% differential. The value of Coke's earnings in this scenario has increased even more, from 3.75 times (15% divided by 4%) to 5.33 times (16% divided by 3%) the return of bonds. So in an increasingly low-inflation, low-interest rate environment, Coke's consistent earnings growth would be worth 42% more than it was worth just over a year ago.

Working from related calculations, PaineWebber's chief strategist Edward Kerschner told the Wall Street Journal back in December that Coke deserved to trade at 58 times trailing earnings, or about $95 today. Using that multiple and assuming interest rates just stayed flat and that Coca-Cola continued to deliver 18% EPS growth, the five-year price target for the stock would rise to $191, good for 20% compound annual growth from here. How's that for delicious and refreshing?

Next: The Bear Argument