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Taking Stock in Coca-Cola (KO):

When you first examine Coca-Cola (KO) there is an immediate emotional response many individuals have to their product(s). Love it or hate it; the products of this company are consumed on a daily basis globally to the tune of nearly 1.5 billion times. To put this in some perspective that’s the equivalent of 25% of the global population consuming a minimum of one product sold by the Coca-Cola Company each and every day.

This is the brand power on a massive scale with a strong domestic history in North America dating back to 1886. Globally Coca-Cola products are sold in over 200 countries and the company is the “largest manufacturer, distributor and marketer of non-alcoholic beverage concentrates and syrups in the world.” The company sells four of the top five carbonated brands around the world (Coca-Cola, Diet Coke, Sprite & Fanta), owns or licenses an additional 450 brands and possesses the largest beverage distribution system on the planet.

Coca-Cola operates in distinct global structures currently organized in the following regions:

  • Africa
  • Eurasia
  • EU
  • Latin America
  • North America
  • Pacific
  • Bottling Investments
  • Corporate

Global sales (non-North American) accounted for 76% of total revenues for the company in 2007 and provided 10% of total worldwide sales of all non-alcoholic beverages. 10% may seem small upon initial examination, but when you consider competition from PepsiCo, Nestle, Cadbury Schweppes, Groupe DANONE, Kraft Foods, Unilever and non-alcoholic products sold by global breweries the truly dominant presence of this company can be easily grasped.

The company in the face of such global competition has done an excellent job of concentrating on my Value Rule of doing what you do best. The company has not expanded operations into food or alternative products instead deciding to focus nearly exclusively on sparking and still beverages. This concentration on beverages and syrups for drink consumption allows the company to operate from a much lower cost structure which I will touch on later in depth.

From a quality control perspective the company holds ownership in 75% of all production, bottling and distribution operations in their global supply chain representing equity positions in 46 of its unconsolidated bottling operators. This is a significant strength for the company as it enables management to maintain tight control of operations, quality control, efficiencies in production & distribution and prevents operating risks from various disruptive elements. When you manage so many brands globally worth billions of dollars your focus on control should always be very high and sustained. It would cost too much for KO to operate independently in so many global markets and partners (majority or minority owned) allow the company to maintain oversight on important aspects of their business while not absorbing the entirety of costs. Specifically any equity investment in production and distribution operations ensures the company maintains control and protects its intellectual property such as product recipes or product development research.

The global economy has shown clear evidence of contraction coming out of 2008 and any global business can anticipate a slowing of growth in a number of markets. Concerns for KO exist currently in North America, Great Britain, Germany, India, Japan and Philippines for various economic or logistical reasons. Competitive factors always need to be accurately addressed when analyzing a company and there certainly is no shortage of global or domestic competition for the market share of Coca-Cola products. Competitive factors play a very important role in how the company executes pricing, advertising, sales, promotional programs, product innovation, production efficiencies, packaging technology, vending equipment, brand development and trademark protection.

KO has direct exposure to bottling and distribution operations of its products because of equity stakes in these businesses that are responsible for bringing their products to market. One major concern of late has been the increasing material costs and energy in the production and bottling process. The largest core cost for the company is nutritive & non-nutritive sweeteners such as high fructose corn syrup, sucrose, aspartame, acesulfame potassium, saccharin and sucrolose. These products are found in high concentrations in Coca-Cola products and recent high corn prices, while down in recent months, and have led to increased costs in raw materials required for production. Energy is needed not only to ship product to market but a large amount of heat is needed in the production process to appropriately dissolve the large amounts of sweeteners placed into the company’s syrup products.

A significant threat to the company is the extent to which Coca-Cola operates globally in over 200 countries. In each country the company operates within there are abundant government regulations or restrictions on product safety, product composition and competition. Governments, regardless of their composition, tend to be unpredictable in making rational decisions at times and this can adversely affect a business that has plans for expansion but is met by political resistance. It would not be uncommon for any government (local or regional) to adjust current laws or regulations to better protect national interests or competitive issues relating to their own domestic brands. The recent issue taken by The Food & Drug Administration (FDA) on Coca-Cola’s new Diet Coke Plus demonstrates the oversight and resistance that the company can encounter when attempting to develop and market new products.Availability of key infrastructure is a current concern of mine, most specifically in India, where production, distribution and energy requirements are providing barriers to growth of the company’s operations. In order for the company to meet food and safety, operating standards and distribution schedules in various markets the company requires the proper infrastructure in order to deliver market demand. Building domestic infrastructure is beyond the financial capacity of Coca-Cola in these markets so product either needs to be shipped farther distances into new markets or not offered due to complications of such limited logistics. With such a concentrated focus on the Chinese market I feel many investors have missed the clear barriers to entry that KO faces in many other emerging economies.

Coca-Cola battles this lack of available infrastructure with a focus on brand development in emerging consumer markets and establishing a very strong emotional response to their products. They sponsor large sports events, become integrated in communities through charitable events and spend large amounts of money on effective advertising. Once the brand has been successfully entrenched into a market domestic competition and governments have found it very difficult to place restrictions on their growth or to motivate change in consumer perceptions.

In recent years public initiatives have been created to restrict the sale and distribution of Coca-Cola and PepsiCo products within schools citing the concern for the recent and significant increases in obesity of young children. Some municipalities, school boards or governments have successfully implemented bans on dispensing machines in schools, but others have found strong resistance from school boards who receive lucrative donations to their sports teams, social programs or for new equipment as part of a negotiated partnership with one of the large corporations. The focus here, ethics aside, for the companies is their clear interest in funding social programs for brand development with the initiative to create lifelong loyalty to their brands and products by impressionable youth and create habit forming behaviours.

There are also a high number of serious economic, technological and social threats to the growth and profitability of KO. Each of the following items I’ve cited as a major concern for the company and are being handled adequately using a variety of methods by management:

  • The increasing trends in health awareness are here to stay and KO has been proactive with increased product development and advertising of brands such as Diet Coke and Fanta as well as the recent successful launch of their Zero products (Coke Zero, Sprite Zero).
  • Fresh water continues to be a concern as availability; prices and resources come under increased pressure in developing economies and markets. The health of consumers is a top concern of the company when they examine a market and spend considerable expense securing and treating water used in their products either directly or indirectly in the manufacturing process.
  • With the global economy likely to contract into 2009 growth and expansion into emerging markets may be more difficult than the company had previously targeted. This may put pressure on marketing budgets, but will likely lead to consolidation in the industry as smaller companies with high quality brands don’t have access to credit/financing or aren’t able to service high levels of internal debt.
  • Foreign currency and interest rates are major factors in the profitability of the company. Management balances the risk of operating in so many countries by hedging their exposure with derivatives. KO hedges operations up to 36 months in advance with most derivative instruments expiring within 24 months or less of their creation. While financial derivatives have been a toxic element to many businesses in the recent credit environment hedges held by the company help buffer cashflow from international operations from the significant volatility in the valuation of foreign currencies.
  • Unions and collective bargaining agreements (CBA) will always be a concern in any unionized environment. With 75% of sales outside of North America the company is well positioned to balance disruptions to operations in domestic markets. One part of owning equity stakes in bottling operations is to ensure that KO has a vested interest in how employees are treated to avoid such conflicts.

In May of 2007 Coca-Cola successfully acquired Energy Brands (Glaceau) for $4.1B in cash to increase its product portfolio of enhanced water drinks adding vitamin water to its list of health conscious brands. On September 3rd of 2008 Coca-Cola announced another strategic offer to purchase China Huiyuan Juice Group Limited for $2.4B in cash. KO has operated in China since 1979 and was a major sponsor of the recent summer Olympic Games held in Beijing. Still beverages have been a focus in the Chinese market in recent years and the acquisition of the Huiyuan Juice brands diversifies the product portfolio of KO in China. One strategic element that comes from this acquisition is the proposed expansion of their distribution network within the country. Costs and operations can be now streamlined with sales, distribution, manufacturing, product development and marketing benefiting from the merger of the two companies.

While we think of juice in North America as a product not associated with large-scale sales; juice products in China are an established and fast growing segment of the beverage market. Juice is actually a more profitable product from a margin perspective and the Minute Maid brand is a key complimentary product to the established Huiyuan brands in the Chinese market. KO has been looking for growth vehicles to support stronger domestic growth in China and local bottling partners between the two companies make a strategic fit. The deal is anticipated to close in early 2009 and be accretive to earnings within three years. The obvious threat to this deal is that it is conditional of Chinese regulatory approval but currently no problems with that process have been publicized or speculated upon.

While conducting additional research on the company I found a Virtual Vending Machine that was fun to gain a sense of the Coca-Cola brands offered globally by the company. With a supply chain valued at over $50B US it’s easy to gain a sense of just how global this company is in all aspects of their businesses.

One key concern I always maintain with any company is a keen evaluation of their management. Executives are not only responsible for the daily operations of a company, but also establishing the corporate culture and expectations of how an organization expects to do business. No company grows to the size and scale of operations that Coca-Cola has without an extraordinary vision of where the company is going, how it will get there and a group of effective leaders to pave the way. In my evaluation of management, which I encourage all investors to do on their own, I’ve found very clear objectives and strategic priorities from management on where they expect the business to grow, operate and execute. The core competencies of the company are defined as consumer marketing, commercial leadership and franchise leadership which is clearly evident when you evaluate the company from a number of perspectives.

There was a recent transition in leadership at the company when Neville Isdell stepped down as CEO and Muhtar Kent assumed the role as new CEO. Muhtar Kent has been with the company since 1978, comes from a strong background in marketing and has a strong history of participating in the global operations of the company in many capacities. The transition between the two managers was smooth and without incidence which is something I always carry as a litmus test for preserving corporate culture and maintaining a pulse on the business.

In the spreadsheets provided I’ve listed the past five years of critical data for the company

(Data since 1988 made available via SAML or with full analysis purchase below).

Whenever I look through the operating numbers of a company I’m looking to evaluate three main items:

  • A consistent theme of performance
  • Conservative fiscal management
  • Emerging trends that hold the potential to influence the company either positively or negatively in the future

A portion of my analysis always focuses on vital criteria such as EPS, dividends, cashflows, debt/equity ratios, book value growth and other important metrics but running a successful business is more than just keeping those numbers in check. Your business has to be sustainable, flexible to meet global challenges and adaptive to changes in the consumer environment

I’ve accumulated various data on Coca-Cola and organized it in a spreadsheet very similar to my presentation of Taking Stock in COST. While each companies spreadsheet in my SA data will differ slightly based on their unique industry my focus will often concentrate on margins, return on equity, debt levels, book value growth, increases in costs and dividends. Remember that as a prospective owner in the business I want to investigate information that directly impacts my returns, my financial stake in the business and potential for future returns.

First on the list for examination are revenues and cost of goods sold (COGS). Revenue is income that the company receives from the sale of a good or service and COGS is the direct cost of producing that product or service.

Coca-Cola has successfully reported a profit over the past twenty years, but I want to evaluate the relationship and trend between revenues and COGS. This is important because I want to identify if one side of the equation is changing in any drastic manner relative to the other. The 20-year average for increases in revenues has been 7.12% and the increase in COGS has been 6.45%. This is positive in my view because I can see an established trend where overall revenues are increasing at a faster rate than overall costs. If these numbers were reversed (6.45% for revenues & 7.12% for COGS) I would be very concerned because it demonstrates that costs are increasing at a faster rate than revenues and that is not sustainable for any business. These trends affect the profit growth of a company and as a shareholder I may be concerned that management isn’t doing a good enough job of managing their cost structure. Taking the past five years (a smaller snapshot) I get an average increase in revenues of 8.42% and average increase in costs of 8.36%. The margin between the two is smaller, but the trend remains intact.

Margins are one of the first calculations I ever determine when I’ve decided to look at a company in greater depth. There are two types of margins I want to identify and examine: gross margins and profit margins.

When we examine gross margins for KO we see a very healthy average of 63.85% on a historical basis. This means for every $1.00 the company receives in revenue they retain nearly $0.64 after direct production costs. Profit margins for KO are 17.46% and for every dollar the company receives in revenue they retain a profit of over $0.17.

This is a much higher gross & profit margin than many other businesses and is a direct effect of the type of business Coca-Cola conducts. They sell higher margin products around the world and do so because their costs are relatively low and brand loyalty is very high. We can clearly see variations in each margin category through different time periods where profit and gross margins fluctuated in relation to different economic periods. One thing to notice is whenever they dropped relative to the historical average they subsequently rebounded shortly after with increases in the margins.

SGAE as % of net sales is another category I always focus on that provides insights into how management is managing their own spending and not just that of the corporation. SGAE stands for “Selling, General and Administrative Expenses” and tracks the spending of non-core expenses that aren’t linked to the production or operating process. Management may be great at minimizing costs and boasting a fat gross margin, but I want to focus on the question: Can they control the spending that directly impacts the profit margins their company achieves?

Readers will notice a stark contrast in SGAE versus my previous stock analyses with KO reporting its average SGAE as % of net sales of over 40%. This means that non-core production costs are 40% of total revenues! Normally this should be an alarm bell going off for any prospective investor, but we first need to put this number into the proper context. We can see that the historical trend has fallen over the past few years, but 38% is still a relatively high number in 2007.

We first need to identify that Coca-Cola’s business is much different than other businesses. Although they have low production costs and significant gross margins, they spend a lot of money on advertising promoting their products around the world. KO didn’t become the biggest and wealthiest brand in the world by restricting spending on promotion of their products and this commitment to effective advertising has led to sales increasing globally for the past twenty years. KO also operates in a variety of challenging markets where they may be focusing on conservation of market share for mature products and heavy spending for promoting new innovative products that are fuelling future sales growth.

To really put this into the proper perspective we need to compare margins to a company in the same industry: PepsiCo (PEP)

(Margin Analysis, Valuation Model & Dividend Discount Cashflow Calculator available via SAML or with full analysis purchase below).

Coca-Cola has a simple business model to understand and this benefits an individual investor who wants to focus on fundamentals. They sell carbonated & still beverages and syrups for consumption around the world, have a dominant brand image in hundreds of products, own stakes in nearly all their bottling operations, possess strong brand loyalty, are expanding into new markets with conservative acquisitions and focus on doing what they do best.

The company is profitable and by a large margin because they keep costs low and focus on maintaining very high margins. Despite slower sales growth than their main competitor (PEP) their growth of expenses has been lower resulting in revenue growth outpacing expense growth and this too is by a wider margin than PEP.

The company has made accretive acquisitions by not overpaying and continues to focus on growth of products domestically (Coke Zero) and abroad (Huiyuan Juice Group Limited). Although they’ve had a change of management the new CEO steps into a role that the company has adequately prepared him for as seen by his past leadership roles.

I’ve found that there are times when focusing on the simplest facts of a business result in some of the best businesses to invest in over the long-term. An individual who drinks one Coca-Cola product today is likely to drink another one tomorrow and again in the near future. A Coke tastes the same at 9am in the morning as it does at 5pm in the evening regardless of if those two drinks are consumed in opposite parts of the world and this creates the perpetual demand that the company has enjoyed for so many decades.

One of the most distinct and sustainable competitive advantages held in the world today is possessed by Coca-Cola. It’s not a patent, a manufacturing process or real estate; it’s the products, brands and operating structure that allow Coca-Cola to operate at a much more cost effective position than their global competition.

I don’t want to discount that there are significant long-term threats due to an increase in health awareness and the short-term global economic dynamics. Management has done an admirable job diversifying their product portfolio to more health conscious brands and the one wonderful thing about a lower cost structure and significantly higher margins is that as a company you are well protected to weather any significant storm. While I never advocate that a company compete on price higher margins provide Coca-Cola with an adequate buffer to cushion any economic volatility so that the bottom line of the business is minimally affected.

Disclosure: I own shares of Coca-Cola (KO), Kraft Food (KFT) and IGM Financial (IGM) at the time of this post.

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{ 13 comments… add one }
  • Scott January 12, 2009, 9:24 am

    IMO this is a very professional presentation which is far superior to the typical sell-side analysis that one sees on discount brokerage web sites. What is most impressive to me is the depth of the business analysis rather than spending an huge amount of effort on projections and value estimates that are rarely accurate. It is easier in my mind to make an accurate case for ownership based on business analysis rather than some sort of numeric justification. Past history should teach us that efforts to predict investment performance based solely on numeric analysis is mediocre at best.

    scomac

  • Blitzkrieg January 12, 2009, 10:51 am

    I have to agree with scomac. It is obvious that a lot of time and effort went into this analysis – especially on the business side. The “Taking Stock” posts on this blog are the best I have found online. As someone who is just learning the whole fundamental analysis game, I find these posts extremely helpful. Thank you Nurseb911!

  • Jae Jun January 12, 2009, 1:06 pm

    This is a fantastic analysis Brad. Not only is the fundamentals of the business analysed extremely well, but also how the fundamentals work together to create the awesome company that is Coca Cola.

    I’m looking forward to your next analysis and as always find many useful things to learn from your writings.

  • Vlad January 12, 2009, 8:25 pm

    Wow! I bought the full version this morning after a coworker who is a subscriber told me about how good her copy of the analysis was. $20 is a steal in my opinion. The two decades of data was very well organized and how you brought that into your analysis was spectacular. You put everything in perspective so well about such simple things like margins and product development that I would have never thought of looking on my own. I’ve owned this stock for nearly a decade and was seriously thinking of selling it recently with how bad the markets were and other economies hurting bad. Now I’m glad I didn’t. What was even more compelling was the comparison to Pepsi and how focusing on what Coka does best has paid BIG dividends for all these years. I agree with the scott fellow. I’ve read numerous brokerage reports or watched analysts on tv talk about their buy or sell targets and estimates. No analyst has ever talked about the basics of a business like this. Not even close. Even if I wasn’t a owner of the stock I would benefit from your insights. Good job nurseb!

  • Susan January 13, 2009, 12:19 am

    Got this in the Stock Analysis Mailing List on Jan.5 and have spent some time going over the numbers and have learned a lot. Fundamental analysis has always been a challenge (which numbers can you trust? which make the most sense to use?) and this analysis is very helpful. I always learn something from your postings, but your stock analysis is the best! Thank you.

  • Mark January 13, 2009, 1:40 am

    Brad – excellent analysis as per usual, thanks.

    Interesting reading through the latest Buffett bio ‘Snowball’ and following his transition from a strictly Graham ‘cigar butt’ approach to the view toward buying excellent businesses as Charlie Munger grew on him. Competitive advantage is a major factor in analysis and you’ve summed this up wonderfully with KO.

    Mark

  • Nurseb911 January 13, 2009, 5:55 am

    Thanks to everyone for the kind words. The effort was well worth the outcome and I'm very proud that readers have enjoyed both the public & SAML versions.
    Thanks for taking the time to post your thoughts and opinions on the analysis.

  • Paul (augustabound) January 13, 2009, 9:43 am

    Hey Brad, great analysis. I used to think Pepsi’s diversity was their asset but their recent re-focus along with your analysis has made me rethink that.
    A lot of work seems to go into your taking stock series and it’s much appreciated.

  • T. January 17, 2009, 3:10 pm

    As always, great analysis. Even though I don’t invest in equities outside of Canada, I will look out in the future for your analysis of potentially amazing Canadian companies.

  • jberendsen January 19, 2009, 3:16 am

    Hi Brad, Great Analysis. You cover all the topics that I find important.
    The only thing I would like to see more about is the evaluation method further explained.
    I reqally like how you explain the relation between various numbers like margins, COGS, etc. and how you bring those together in your analysis.
    Looking forward to more of them!

  • Nurseb911 January 19, 2009, 7:59 am

    jberendsen,

    Thanks for the comment. Can you please be a little more specific on what in my evaluation method you would like explained further? Are you referring to my valuation method, situational analysis or another item that I’ve included in the full analysis?

  • jberendsen January 19, 2009, 2:49 pm

    Hi Brad,
    Thanks for your comment. I thought your analysis was excellent. I always learn a lot from them!
    What I would like to learn more about in your KO analysis regarding the valuation method is a more detailed explanation of how you came to your fair valuation price and – more importantly – why you choose to use the variables that determine the specific outcome (e.g. growth rate, p/e etc.) In other words, what is the thought process behind it. Do you know what I mean? I am interested in learning more about this to help in my own learning process.

  • Nurseb911 January 19, 2009, 2:53 pm

    jberendsen,

    Have you read my four part series, Taking Stock in IGM? In parts III & IV I got into a very detailed description of how I select my numbers, my reasoning and a complete walkthrough of the process. Let me know where the process is breaking down for you and maybe I can use another company as an example in a future post demonstrating again my valuation model.

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