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.
You are misunderstanding the difference between high returns and increasing returns.
The best thing, if you want to improve, is to get in the game: in order to know how to value a stock you have to know what the numbers mean.
For example, do you know that the sales and margin improvement in 2011 were acquired?
Both gross and EBIT margins have declined in the last ten years.
The return on new invested capital is 9%.
Coke today is priced with no room for error; Coke in 1989 was priced as though there was no room for improvement.
The differences are vast, significant, and obvious but a birds eye view won’t discern them. That’s kind of the point of these exercises.
[…] this valuation by Dimitar is really insightful. But I think the best part is one of the questions he asks: with hindsight, every investor appears […]
I’d ask how market share looks in modern day KO, and how do growth prospects look? I think prospects back then looked a lot better(although I’l admit this is just speculation and I haven’t checked my facts)
red,
You make a good observation about Coke’s acquisition of its North American bottlers in late 2010. But even after adjusting for it, real CAGR over the 2002-2011 period was still higher than in the 1978-1988 period.
True, margins have declined in the last 2 years, and may decline some more because of the added bottlers, but at the current level, they are still higher than they ever were in 1978-1988.
Coke would be a better proposition if margins were expanding. But was margin expansion the big factor in 1978-1988 or was it international growth? Margins were fluctuating then as much as they are fluctuating now (and that’s not much). It was the potential growth in new markets that was attracting people with both an inside and an outside view of the company.
So, with the super low consumption per capita in the most populous markets, why wouldn’t this be the driving factor today as well?
I know one reason. The product is crap and as the world becomes (relatively) more affluent, better educated, and more health-conscious, it will realize that sugar water isn’t as great as it’s advertised to be. This is probably why Coke and Pepsi are buying the bottlers. They will be pushing new products and it will be easier if they owned the bottlers than if they had to negotiate for every new product.
Oh, and if you have any tips about getting in the game, do share.
“Coke would be a better proposition if margins were expanding. But was margin expansion the big factor in 1978-1988 or was it international growth? Margins were fluctuating then as much as they are fluctuating now (and that’s not much). It was the potential growth in new markets that was attracting people with both an inside and an outside view of the company.”
It was growth with increasing margins that was important in 1989. That’s how we valued the company in that exercise. The growth margins were twice the prevailing margins.
“So, with the super low consumption per capita in the most populous markets, why wouldn’t this be the driving factor today as well?”
Because some revenue growth adds no value, some revenue growth even destroys value. Look it up, if you like.
The idea the revenue growth and high margins together drive value is wrong.
What drives value creation is growth without a deterioration in the return on investment.
In 1989 there was strong evidence (in the 10-k) of increasing returns on investment AND growth AND the share price was at the equivalent of $10. The annual return on every additional dollar invested by Coke was 59 cents, far above its ROIC of 22%. Those circumstances represent obvious value. Obvious to anyone who cared to look and cared to think even a little about it.
In 2012, there’s 9% return on every dollar of new investment, far below the ROIC of 72.8%. It can grow all it likes at 9% returns and it won’t create a dime of value Besides, the shares are now not at $10 but at $79 .
You think those two circumstances are similar? They’re not. That was the whole point of the exercise.
Cheers,
It may, but growing your 20%-margin operations while earning 10-15% on assets and borrowing at 4% for 30 years (Bloomberg) is not that type of growth.
Return can deteriorate all it wants and as long as it is above the cost of capital, value will be created. The average WACC for the beverage industry is 6.35% (Damodaran). I would expect it to be lower for KO, though you can post your calculations of WACC and ROIC, if you care to share.
Comparing absolute share prices ($10 vs $79) makes just as much sense.
Right. I take it from your passive-aggressive, indirect concession that we understand each other now, so I’ll leave it at that.
Next time, don’t use your blog to be snide about the honest effort that others are putting into becoming better at investing, especially if you yourself have only the vaguest clue about what you’re doing.
red,
Don’t try to project your issues onto other people. The passive aggressive here is you and I quote:
You desperately want to sound like an authority and what better way than calling a brand new blogger dumb!
You don’t even attempt an “honest effort” to help me improve. You just throw up some generalities and numbers pulled I don’t know from where. I explicitly asked you to share how you calculate WACC and ROIC (because your numbers really make as much sense to me as your idea that shares that cost $10 are a better deal than shares that cost $79). Why wouldn’t you send me a nice, long email with explanations if you cared so much about me “becoming better at investing”?
If you are as good as you think, yet unwilling to help basket cases like me, why would you even bother to start a conversation? Go talk to your peers.