For Coca Cola, 49% Is No Longer a Solution

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Includes: CCE, KO, PAS, PBG, PEP
by: The Lonely Value Investor

In October 1996, Fortune magazine ran a cover story entitled: HOW COKE IS KICKING PEPSI'S CAN. In it, the authors portray a Coca-Cola (NYSE:KO) management that's very satisfied with itself. The cola wars are over. They've won. Case closed.

Of Pepsico (NYSE:PEP), Roberto Goizueta said, "As they've become less relevant, I don't need to look at them very much anymore." Pretty smug for a man described as reserved, aristocratic, and cerebral. Nonetheless, the swagger seemed appropriate given Coke's performance. The anecdotes set forth by Fortune show KO was outmaneuvering PEP on every front.

And there was an element of vindication and payback! As the article says:

Coke has had a vendetta against (then Pepsi CEO) Enrico ever since he gloated about the New Coke debacle a decade ago in his memoir, The Other Guy Blinked: How Pepsi Won the Cola Wars. Says Goizueta, seeming both vindicated and vindictive: "It appears that the company that claimed to have won the cola wars is now raising the white flag."

While PepsiCo's CEO Roger Enrico and his beverage chief Craig Weatherup did sound defensive in the article, neither was willing to admit defeat, much less to offer a surrender.

When Enrico is told about Goizueta's disparaging remark--that Pepsi has become "less relevant"--he folds his arms across his burly chest, stares at the coffee table in front of him, and pauses. Smiling slyly, he says, "Good."

Weatherup went even further, saying (of Coke), "Their Achilles' heel is their own arrogance, and it eventually will be their downfall. I hope I'm around to see it."

The word "arrogance" must have been directed at Doug Ivester. The heir apparent to Goizueta, Ivester clearly believed his sharp elbows were a virtue. Of Weatherup, he said, "Craig is a nice guy." And as Fortune pointed out: Ivester is not a nice guy.

He is, in fact, the man responsible for Coke's ungentlemanly swagger of late. An intense, uncharismatic ex-accountant, he tells customers, "I want all your business." He urges managers to play by the rule of Ray Kroc, the founder of McDonald's (another PepsiCo nemesis): "What do you do when your competitor is drowning? Get a live hose and stick it in his mouth." Tenacious and unequivocal, Ivester, 49, is Goizueta's co-strategist and the senior executive in charge of operations and marketing. Says Goizueta: "Doug has the nerve of a night prowler."

As as Fortune correctly pointed out, "Unless he gets run over by a Pepsi delivery truck, Ivester will be Coca-Cola's next CEO." And for 3 short years (1997-2000), he was.

Besides his tough image, Ivester is portrayed as a financial genius... with an "ability to analyze arcane problems, concoct clever solutions, and maximize returns on investment".

One such clever solution has favored the industry for years.

As chief financial officer in 1986, Ivester devised the financial underpinnings of "the 49% solution." This innovative deal turned out to be the bedrock of Coke's global strategy, not to mention a potent stimulus to its stock price. Here's how it worked: Coke bought a bunch of U.S. bottlers that weren't performing well and combined them with its own bottling network, calling the new outfit Coca-Cola Enterprises (NYSE:CCE). Then it spun CCE off to the public but kept 49% of the stock and the right to throw its weight around. Simultaneously -- here's the magic -- Coke washed billions of dollars in debt and a low-return, capital-hungry business off its books.

For nearly 25 years, Coca-Cola benefited from having effective control of its largest bottlers, while not having to consolidate these "low-return, capital-hungry" businesses onto its pristine balance sheet. And investors willingly ignored this slight of hand, basking in the glow of earnings growth.

Whether the ownership level triggers a GAAP consolidation or not, Coca-Cola and its bottlers are connected at the hip. Unfortunately for KO, as separate companies, the bottlers didn't always fall in line. In today's world, the "49% solution" looks more like an accounting gimmick than a strategy. Effective control wasn't absolute.

That said, PepsiCo spent years trying to duplicate Coca-Cola's 49% structure. They strung together bottlers, spun them off, and held large "minority" stakes. They implicitly bought into the belief that bottling needed to be controlled, but separate. Pepsi clearly believed that KO was deriving some benefit from the arrangement.

Investment bankers were all too happy to oblige. How often have you seen companies spin-off their dreaded slow-growth businesses? But was all the asset shifting creating anything? Was it worthwhile? The debate died a cold, carbonated death in August when Pepsico acquired Pepsi Bottling Group (PBG) and PepsiAmericas (PAS). In one swift move, it reversed itself after years of following Coca-Cola's structural lead. In short, Pepsico began thinking for itself.

It became an industry leader, rather than a follower. The question became, would KO confirm this new direction? Yesterday they did. In a huge $15 billion affirmation.

The partial purchase of Coca-Cola Enterprises (CCE) by Coca-Cola confirms that the Age of Ivester is truly over. And if I may interject, a hearty "Congratulations" to LSV Asset Management for buying a huge CCE stake recently. Wish I'd followed... one can never have too much sugar water in the portfolio.

The 49% Solution lived after Doug Invester left Coca-Cola, but it is dead, or dying, now. Ironically, it was Ivester who said, "I look at the business like a chessboard... You always need to be seeing three, four, five moves ahead. Otherwise, your first move can prove fatal."

I doubt he saw this coming.

Perhaps checkers would be a better analogy. In 1996, Coca-Cola declared victory and yelled "king me". Any investor who heeded the call has paid dearly. Since 1996-1997, KO shares have been dead money (ex dividends). Pepsico has more than doubled. Craig Weatherup should be proud. (He led the PBG spin-off and then left in 2003.)

Today, Coke is still larger than Pepsico, but it is a humbler company. Despite all the talk about live hoses and drowning, both companies are doing just fine. That said, neither is particularly cheap. Their market values are either side of $100 billion and their free cash flow multiples hover around 20 times.

For an industry bargain, investors should head to Dr Pepper Snapple Group (NYSE:DPS) with its paltry $8 billion market value. The company generates $650 to $750 million a year in free cash flow. Debt repayments are largely complete and the stock repurchase plan has been increased to $1 billion, or 12% of the outstanding shares. Yesterday's earnings release was a thing of beauty.

Could this be the next beverage buyout?

Absolutely.

Disclosure: Author owns DPS shares.