Dueling Fools
Cola Wars
April 21, 1999

Coke Bull's Rebuttal
by Matt Richey ([email protected])

When buying a business to own for many years, the most important question to ask is, "How well can this company compete?" For Coca-Cola, the answer is "extremely well." Big Red's single-minded focus on the beverage market combined with its extraordinary worldwide network of bottlers has enabled the company to consistently operate more effectively and efficiently than PepsiCo's beverage division.

First, let's compare each company's beverage business in regard to effectiveness over the past five years. From 1994 to 1998, Coca-Cola grew revenue by 15.7% versus only 10.3% for Pepsi Cola. Of course, revenue growth is only useful if profits grow in tandem, and this is where Coke truly demonstrates its operational superiority. During those same years, Coca-Cola increased its operating profit by 36.6% versus a decline of 20.7% for Pepsi. All told, Coke's combined operating profits for the past five years were more than four times greater than Pepsi's combined beverage-related operating profits.

Not only are Coca-Cola's operations more effective, but they're also more efficient. My opponent stated that Pepsi Cola generated a 1998 operating margin of over 14%. Yes, but that figure is only for its North American results. Pepsi Cola's worldwide operating margin, on the other hand, was only 9.3%. Meanwhile, Coca-Cola rang in with a 26.4% operating margin. Cha-ching! For every dollar of sales, Coke raked in a shiny silver quarter, whereas Pepsi couldn't even muster a measly dime.

There's no two ways about it -- Coke's operations are simply more efficient. And, the efficiency advantage only becomes more pronounced when comparing the results over time. From 1994 to 1998, Coca-Cola increased its operating margin by four percentage points -- from 22.4% to 26.4%. Meanwhile, Pepsi Cola's operating margin declined by nearly four percentage points -- 13.0% to 9.3%. The numbers tell the story. The Big Red Machine's dominance becomes more pronounced with each passing year.

Now, let's turn our attention to Coca-Cola's valuation. By buying at today's price, can an investor expect a good return over the next decade? There's no sure answer, but to get an idea of how Coke might perform, let's consider three variables: 1) profit per serving, 2) servings per share, and 3) the price-to-earnings ratio (P/E).

Over the past decade, the profit per 8-oz. serving increased from half a penny to nearly a penny, as the company utilized technology to improve efficiency. This might not sound like much, but when extrapolated across more than a billion servings per day, this is a lot of money! The second variable is servings per share of Coke stock. One share of stock in 1998 entitled the holder to the profits of 152 servings, up from 66 servings per share a decade ago. The last variable, the P/E ratio, was an average of 30 over the past decade.

Now, let's assess what the company can do over the next 10 years. Considering Coca-Cola's increasing dominance of the worldwide beverage market and its sizable growth opportunities in countries such as India and China, the company may well be able to repeat the performance of this past decade. If so, then in 2008, Coke would generate 2.1 pennies per serving and 350 servings per share. (Now for the math -- just simple multiplication.) By multiplying those two figures, we get an estimate of $7.35 for 2008 earnings per share (EPS). Then, by multiplying the EPS estimate of $7.35 times the average P/E ratio of 30, we get a year 2008 share price estimate of $220.50. That would represent 12.9% annual growth from the recent price of $65 a share.

Can Coca-Cola do it? The company stands to benefit immensely as worldwide economies mature. As such, I believe more growth lies ahead than many skeptics predict. By focusing exclusively on the highly profitable beverage market, Coca-Cola has obliterated less focused competitors. Frito-Lay may have a great franchise, but its results will always be dragged down by Pepsi Cola. Woe to those who lie in the path of the Big Red Machine. Interested investors may want to consider the option of buying Coca-Cola stock on a regular basis (as little as $10 per month) through the company's fee-free direct investment plan.

Next: Pepsi Bull Responds