Coke / CCE Deal: A Unique Chapter Rather Than New Playbook for Coke’s Operating Model

Includes: CCE, KO
by: Value Expectations

Coca-Cola Co (NYSE:KO) announced its acquisition of the North America operations of its top bottler, Coca-Cola Enterprises Inc (NYSE:CCE) at a value totaling approximately $12.2 billion, by assuming $8.8 billion of CCE debt and relinquishing its 34% equity ownership in CCE, valued at $3.4 billion. This acquisition, which is expected to close in the 4th quarter of 2010, is largely viewed as a strategic reversal to close a competitive gap after a similar deal by Pepsi Co. (NYSE:PEP), which just completed the purchases of its largest bottlers, Pepsi Bottling Group Inc (PBG) and PepsiAmericas Inc (PAS). In a concurrent agreement, CCE also agrees to buy Coke’s bottling operations in Norway and Sweden for $822 million. CCE will also have the right to acquire Coke’s 83% equity stake in its German bottling operations 18 to 36 months after closing for fair value.

Prior to Tuesday’s announcement, Coke CEO Muhtar Kent has repeatedly said he was committed to Coke’s franchise model forged in the late 1980s, which has kept bottling operations off Coke’s books but gave it a large stake in its bottlers, up to 49%, to ensure significant control. Bottling businesses are more capital intensive, more leveraged, and less profitable. The acquisition of CCE will bring Coke $9 billion in additional debt, relative to its own $11 billion, although CCE’s asset base is just 35% of Coke’s.

However, capital intensive businesses are not inherently inferior so long as they can earn a rate of return in excess of their cost of capital. Wal-Mart (NYSE:WMT) is very capital intensive, with over $173 billion of assets 60% of which are in Net PPE – yet few firms rival its ability to create shareholder value. Wal-Mart consistently earns returns above its cost of capital, thus when it invests a dollar of capital it tends to create more than a dollar and thus enhance the wealth of its owners.

From a wealth creation perspective, CCE has consistently generated returns above its cost of capital or maintained positive Economic Margins for the past decade, although in a declining mode. From a valuation perspective, CCE is worth about $18 a share, assuming a long term top line growth rate of 2% a year and 80 bps of EBITDA margin expansion in the next 5 years. Coke said it expects to reap $350 million in synergies from the deal over four years and realize 75% of the synergy by 2012. Applying all the synergies to CCE’s assets, CCE is worth about $27 a share, vs. its trading price of $25. It is important to point out, however, that Coke is getting just the North America operation of CCE, which generated about 70% of CCE’s net revenues and operating income in 2009. Therefore, Coke is paying a premium for this acquisition, if we make the simple assumption that North America operation accounts for 70% of CCE’s value.

For decades, Coke management has been complimented for operating on an asset light model. Today, Coke CEO claims the CCE acquisition is a unique chapter rather than the beginning of a new playbook for Coke’s operating model. Unlike many other global markets, Coke already owns and manages a significant part of its business in the U.S. including the production and distribution assets for the fountain business and much of the still-beverages finished goods business. Therefore, North America presents itself as a unique, big structural play for Coke, but not a game changer for Coke’s global bottling franchise model. This is further evidenced by Coke’s decision to sell the Norway, Sweden, and possibly Germany bottling businesses to CCE, essentially refranchising those European businesses.

In right hands, CCE North America could see its EM improve through realized energies with Coke. In addition, the landscape has evolved so much in the past 20 years that Coke’s U.S. customer base has significantly consolidated with top 10 retail customers representing approximately 40% of the package U.S. volume. The CCE acquisition will allow Coke to negotiate with retailers directly.

Separately, the role of being both an investor and supplier to bottlers creates conflict of interest sometimes. In October 2008, for example, Coke’s CFO departed from CCE’s board and Coke cut funding to CCE operations by $35 million and raised concentrate prices more than expected, in response to a price increase CCE took earlier on the soft drinks it packages. The Coke + CCE North America union could streamline costs and priorities, spur innovation, and create more flexible distribution of new drinks, especially in the face of consumers’ changing drinking habits which are in favor of noncarbonated beverages that CCE’s manufacturing assets are not traditionally geared towards.

In short, we believe the criticism Coke gets shouldn’t be that it will be running a more capital intensive business but that management overpaid for the acquisition.