Coca-Cola: Solid Company at a Reasonable Price

Business Summary

Coca-Cola is a global manufacturer, distributor, and marketer of non-alcoholic beverages. Coca-Cola sells syrups and concentrates to authorized bottling and canning operators. Coca-Cola has equity stakes in 20% (by volume) of these operators.

In addition, Coca-Cola sells fountain syrups directly to restaurants. The company also sells bottled and canned products directly to retailers. The company’s products include sparkling beverages, juices, and bottled water.

Roughly 75% of the company’s revenue is international, and 53% comes from concentrate and syrup sales of Coke. Coca-Cola has a 10% market share of the non-alcoholic beverage market. Coca-Cola has 14 brands with sales over $1B, and owns four out of five of the worlds top sparkling non-alcoholic beverage brands.

Globally, Coca-Cola is number one in sales of sparkling beverages, juice, and ready to drink coffee and tea, number two in sports drinks, and number three in bottled water.

Operating History (3.4)

Coca-Cola has an impressive operating history, with an adjusted ten-year average operating margin, ten-year average return on adjusted assets, and return on retained earnings that are among the best of the SP500 companies (for a description of the adjustments to GAAP earnings used to compute these ratios, see the link to my book at the end of this article).

Early this year I used a web-crawler to run a screen of the SP500, which calculated each company’s operating history rating over the ten-year period ending in 2008. Only 9 companies scored over 3.2 (out of a maximum rating of 4.0). On the basis of how I evaluate a company’s operating history, Coca-Cola is one of the best companies out there.

Over the last twelve years, average case volume growth has been 5%. Even during the current recession, Coca-Cola has maintained impressive case volume growth, with global growth of 5% in 2008 and 3% in Q1 2009. Although revenue and earnings have been impacted from the strong dollar, the currency neutral numbers are solid – currency neutral operating income was up 17% in Q109 – and the dollar can’t continue to rise forever.

Future Prospects (3)

Coca-Cola competes through differentiation. The company has many strong brands that consumers prefer and are willing to pay a premium for. This preference is enhanced through advertising; In 2008 Coca-Cola spent $3B (almost 10% of revenue) on advertising. Moreover, the company’s products tend to be a very small portion of consumer’s budgets; this makes it more likely that consumers that enjoy the company’s products will absorb price increases without looking for a substitute. The most sustainable source of Coca-Cola’s competitive advantage is the scale of its advertising and distribution system, which can be used to market new non-alcoholic beverages.

So although consumer tastes can change (albeit slowly), Coca-Cola’s competitive advantage will endure. The following discussion of Coca-Cola’s competitive position is based off of the five forces of industry competition, as described in Michael Porter’s excellent book, Competitive Advantage.

Buyer Bargaining Power

The bargaining power of Coca-Cola’s buyers varies widely. Since they typically only carry a single type of Cola Beverage (usually either Pepsi or Coke), very large restaurant chains have the highest amount of bargaining power, and this is where Coca-Cola’s margins are thinnest. Although authorized bottlers purchase concentrate in large volumes, this is where Coca-Cola makes its largest profit margins. There are several reasons for this; one being that for many of the bottlers, Coca-Cola is their largest (or sometimes only) customer. There is also the risk of forward integration if the bottlers try to capture too much of the profit. Historically, overall bargaining power has been strong, allowing Coca-Cola to realize a 28% ten-year average operating margin.

Supplier Bargaining Power

The raw materials for the company’s beverages are generally readily available from many sources, giving Coca-Cola good bargaining power with suppliers. The exceptions are several artificial sweeteners that are sourced from only a few companies. The fact that Coca-Cola’s gross margins are high (65%) and very stable indicates a low risk of supplier bargaining power impacting profitability. Although some employees are unionized, the company’s high ($110,000) pre-tax earnings per employee indicate a relatively low sensitivity to changing labor costs. To date, collective bargaining has not led to a significant pension liability.

Barriers to Entry

Coca-Cola in combination with its bottling partners has an extraordinary global distribution network that through economies of scale creates a formidable barrier to competition. Coca-Cola also has a large economy of scale in advertising spending, and the company’s strong brands provide a barrier to competition. The industry is very concentrated, with Coca-Cola and PepsiCo being the largest companies.

The barriers to entry are lower for generic products sold in grocery stores under private labels. Here, due to the higher margins on private label sales, the store will be willing to allocate some shelf space to its private label products, and it is possible that if these are sold at a low profit margin and are well-received by consumers, then Coca-Cola’s bottlers may need to price their products cheaper, with the eventual result that Coca-Cola will need to drop its concentrate prices so that the bottlers can stay in business.

On the other hand, even if a consumer develops a taste for the private label product, it will likely only be available at that particular grocery chain, and the consumer will likely stick with Coke elsewhere. Since these private label brands are not available at restaurants, and the brands are not reinforced through advertising, they will most likely gain share slowly due to the low level of exposure of their product to consumers as compared to Coke and Pepsi. Looking in my local grocery stores, products by Coca-Cola and Pepsi dominate the shelf space, with minimal space allocated to private label drinks.

Intensity of Competition

The economic growth of developing countries will allow the company’s penetration of many emerging markets (as measured by beverages consumed per capita per year) to approach that of developed countries. Consequently, volume growth will likely exceed global GDP growth over the next several decades. This should keep rivalry controlled, as companies will be able to grow volume without gaining market share. The strong brands of the industry incumbents should also reduce rivalry.

Threat of Substitutes

The largest risk of substitution stems from Coca-Cola’s most profitable product, Coke, and its other sweetened carbonated beverages. The risk is that as people become more health conscience, they will drink less of a product that contains “empty calories”, or calories without much health benefit, and replace this consumption with juice, bottled water, and sports drinks, which currently account for a smaller percentage of Coca-Cola’s revenues.

However, Coca-Cola is addressing this risk (which today is primarily in developed countries) by rolling out Coca-Cola Zero, which has (according to reviews) the taste of Coke without any calories. Coca-Cola’s expansion into juices, sports drinks, and bottled water should also dampen the effect of an increasingly health conscience customer base.

To date, sales of Coke are still holding up well in North America and Europe, and over the next twenty years most of Coca-Colas growth will be in emerging markets, where Coca-Cola classic should continue to sell well.

The economics of the most likely substitutes (juice, water, and energy drinks) are similar to that of sweetened carbonated beverages. Moreover, the customers and distribution channels are the same, as are the margins. This means that Coca-Cola has a good chance of following any substitution to these types of beverages and still maintain its high return on capital.

Demand for Coca-Cola’s products has historically remained fairly stable through the economic cycle, even during severe recessions (like now).

Risks to Competitive Position

The largest risk is from changing consumer preferences, as discussed under “Threat of Substitutes”. This risk is most prevalent in developed countries such as North America and the European Union, which collectively account for 39% of revenues. During 2008, North American case volume and revenue have fallen 1%, whereas in Europe case volume has risen 3%. Over Q1 2009, volume in North America and Europe both fell by 2%. Total company case volume in 2008 has increased 5%, and if international growth continues to make up for the declines in North America, this substitution to healthier beverages should not impact profitability.

Since the increased attention consumers are paying to health has been going on for several years, and case volume has still been growing, this risk is probably manageable.

The risk of competition from private label products is minor, as they do not have the scale to even come close to Coca-Cola’s level of marketing. Private label products have been around for decades, and yet Coca-Cola’s volume growth is still strong. Overall, I believe that Coca-Colas competitive advantage will be sustainable well into the future, and that the industry dynamics will remain stable.

Opportunities for Growth

Globally, per capital consumption of Coca-Cola’s beverages has grown from 32 drinks in 1985 to 55 drinks in 1995, and on to 77 drinks per person in 2005. As the following chart shows, much of this increase in the last ten years has been driven by developing countries.

As shown in the following chart, there is considerable room for growth in per capital consumption. Moreover, this consumption is more a function of marketing and consumer taste than wealth; as Mexico has the highest per capital consumption in the world, well in excess of Europe’s. Since the vast majority of the worlds population resides in developing countries, where per capita consumption is low, in the long-term, there is obviously considerable room for global growth in the beverage industry.

Considering the wide range of beverages Coca-Cola can bring to market in a country, and the company’s success with marketing, it seems reasonable that Coca-Cola will capture a large part of this growth. Another source for growth is purchasing competitors with local brands that have the potential for a wider market. When these new brands are integrated into Coca-Cola’s distribution network and marketed globally, the return on these acquisitions can be impressive, even when Coca-Cola purchases the company for a substantial premium. One recent example is Coca-Cola’s acquisition of Glaceau.

Financial Strength (3.3)

Coca-Cola’s debt should not be a problem, as maturing debt is easily payable out of retained earnings, and the company has a high fixed charge coverage ratio. Pension exposure is small in relation to pre-tax earnings. Pre-tax earnings per employee are high at $110,000, indicating a low sensitivity to labor costs. Gross margin (65%) is also high, indicating a low sensitivity to changes in the cost of input materials, distribution, manufacturing labor, and manufacturing related capital expenditures (to the extent they are captured by depreciation expense).

Summary

For a look at how each of these performance metrics is calculated (each is capped at 4.0), you can check out Chapter 5 of my book, which is downloadable from my website.

Although not the bargain it was at under $40 a share this spring, I believe Coca-Cola’s current market price is close to a conservative estimate of the company’s intrinsic value, which I estimate at $50 a share. An overview of my valuation model can be found in this article or, in more detail, in my book.

Disclosure: I own shares of the Coca-Cola Company (KO). I do not own shares in Pepsi (PEP)