Deliberate Practice #2: Coca-Cola (KO) in 1988

These are my thoughts on Whopper’s Deliberate Practice #2, where we look at Coca-Cola in 1988 – the time when Buffett made his big purchase of over $1 billion.

What I found most striking was that all of what Buffett saw, and later talked about, is in plain sight, right in the annual report:

We are the world’s only global soft drink company; our international market share last year grew to 47%.
In many international markets, low per capita consumption rates for soft drinks offer obvious opportunity that is reinforced by demographic trends, economic development and expanding reach of the mass media.  Last year, international per capita consumption of Company products grew 5% to more than 51 drinks per year.

Basically, KO had huge, 45% share of the soft drinks market worldwide and the best distribution system, which meant that it will be able to greatly benefit from the economic growth of developing countries, from the related increased consumption of soft drinks, and from the expanding reach of mass media that drives growing consumption.  As for developed countries excluding the USA (and Denmark, and Iceland – Icelanders, with 317 drinks* per capita, seem to have been drinking Coke like there is no tomorrow, yet Mexicans put them to shame today with their 728 servings), consumption of Coke per capita was also very low – another huge niche to be filled.  There were plenty of liters (ounces, if you will) of consumers’ daily liquid intake to be substituted for Coke.

Although the term ‘BRIC’ won’t be coined for more than a decade, KO was “most optimistic about growth potential throughout Asia and the Pacific.”  While consumption was growing in the high single to low double digits elsewhere, in this region it was growing at over 20%.  In 1988, per capita consumption of Coke products was 0.4 in China and 3.8 in Indonesia (India was not even worth mentioning) versus 290 in the USA.  Just think about the growth in sales if only those two markets started moving towards the US level of consumption per capita.  Then, think about the growth potential still remaining in the US market back then.  Today, per capita consumption in the US is just over 400.  China is up to 38, Indonesia – 14.  A fact worth mentioning is that KO predicted consumption in Indonesia to “jump to 10 drinks per year in 1998.”  Actually, it was 8 in 1998.  For a 10-year forecast, I find it very impressive.

The worldwide average has almost doubled, to 92, since 1988.  One way to look at this is as an unimpressive 2.6% annual growth rate.  Another way is to, once again, consider the growth potential in the many countries still having relatively low consumption per capita.

On the financial side, KO was generating $1.2b of cash flow and using it to repurchase its stock and grow internationally.  It was paying out 40% of earnings as dividends and had increased its dividend for 27 years straight.  ROE was 33% and had grown 12% in the past 8 years.

Buffett saw a great company that was singularly focused on “trademark enhancement, consumer and customer satisfaction, and increased shareholder value,” that delivered on its promises, and that was trading at fair value or less.

What about today?

What I found somewhat puzzling about the comments at Whopper Investments was their Captain Hindsight tone.

You have probably come across the classic quote from Forbes (1938) about Coke:

Several times every year, a weighty and serious investor looks long and with profound respect at Coca-Cola’s record, but comes regretfully to the conclusion that he is looking too late.  The specters of saturation and competition rise before him.

Now, in a complete reversal of the described phenomenon, everyone found Coke’s future (from the 1988 perspective) crystal clear.  Back in 1988, the company was ridiculously undervalued, they say.  How could anyone not see it!?

The strongest argument given is the low consumption of Coke products in foreign markets.  China, India, and Russia were barely drinking any compared to the USA.

China, India, and Russia are still below the worldwide average and way below the US level.  The most populous developing markets are still consuming negligible amounts of Coke products.

What about growth and margins?  After all, KO is much more mature now.

Look at these graphs.

I don’t see much difference between the top and the bottom pair.  Sales growth (the percentages between the bars), operating and net margins are almost the same in the past 11-year period (1978-1988) and the present 10-year period (2002-2011).  Sales CAGR was 8.4% in the prior and 9.1% in the latter period.  Operating margins have gone from ~16% to ~26%, net – from ~11% to ~20%.  ROE has improved from mid 20’s to ~30%.  EPS and dividends have grown at about the same constant rate in both periods.

If anything, Coca-Cola has only become a better company today than it was in 1988.  It may be selling at the higher end of its fair value, but it is still a wonderful business at a fair price.  No materially better or worse deal than it was in 1988.

By the same logic of huge international growth potential, high margins, high returns, and unimaginable consistency of performance throughout the years, KO is ridiculously undervalued today.  And I can’t help but wonder, are value investors buying KO hand over fist now?  Or do the specters of saturation and competition scare them off?

* What is referred to as ‘a drink,’ constitutes a serving of 8 fl. oz. or 0.25 liters.