About two months ago – in March 2018 – I published my first article that was entirely devoted to a single source of competitive advantage. By analyzing four different companies – Henry Schein (Nasdaq: HSIC), McKesson Corporation (NYSE: MCK), Cardinal Health Inc. (NYSE: CAH) and Stericycle Inc. (Nasdaq: SRCL) – I focused on companies with a competitive advantage that stems from distribution systems, which are extremely hard to replicate for new companies trying to enter the market. A competitive advantage always stems from an aspect that is difficult to duplicate for new competitors as that process usually is time-consuming (sometimes taking decades) and is of course very expensive. In the following article we will focus on a different source of competitive advantage – the brand name.
Very similar to the last article I will look at individual companies, but also include a general section with theoretical basics. We will start by describing why a brand name can create a competitive advantage – we will see how companies have to build a reputation and have to earn customers’ trust and describe how a brand name is the combination of reputation and trust. In the second part, we will look at two well-known brands: Coca-Cola and McDonald’s as well as the two companies behind the brand – The Coca-Cola Company (NYSE: KO) and McDonald’s Corporation (NYSE: MCD).
Part I: Brand Name - Theoretical Framework
A brand name as source for a competitive advantage belongs to the category of intangible assets and similar to many other intangible assets, it is often difficult to put a price tag on these assets. For the outside observer it is rather hard to realize why an intangible asset is valuable. However, the brand name as a source of competitive advantage is comparably easy to understand – even for outsiders.
Simply put, a brand is nothing more than the name of a company or the name of a product. The name of every single product and the name of every small company in the world can be described as a brand, but that is not what we mean by brand name in the context of competitive advantages (as the consequence would be that every company has a competitive advantage – and that is just non-sense!). To become the source of a competitive advantage, a brand name has to fulfill a few criteria and not just be the name of a product or a company. But before we look a little closer at those criteria, we first examine which companies mostly profit from a brand name.
What Companies Need A Brand Name?
While every company can profit from a valuable and recognizable brand name, there are some companies for which a brand is especially important. On the one hand, brand names are important for companies serving the end-customer, while B2B companies are usually not as dependent on a well-known, well-recognized brand name. B2B companies mostly have only a few customers and in many cases have established, long-lasting relationships with their customers. On the other hand, brand names are important for companies with many different customers that don’t spend millions on one single purchase, but often buy items that are only worth a few dollars however buy these items regularly (a cup of coffee would be a good example for such an item). To sum up, brand names are important when many different customers make a buying decision on a regular basis.
Focus On Buying Decision
In order to understand a little better why a brand can generate a competitive advantage for a company, we have to focus on the buying decision. Let’s use the cup of coffee as example. Every time a customer likes to buy a cup of coffee he can choose from several places offering him or her a cup of coffee. Theoretically, every buying decision will depend on many different factors like price, quality, availability and many other criteria. Some theorists claim that people are always deciding on a rational basis – even if they just want to buy a cup of coffee. But that is not an accurate description of how people behave. It is rather nonsense, to assume that everyone is putting a lot of thought in every single buying decision. People like it easy and decisions are rather guided by emotions than by rational calculations about which product to buy.
You have to think about a brand name like a short-cut for your mind. Instead of believing the non-sense that people start a complex thought process, a much more accurate description of buying decisions is the following: In order to manage the complexity of our world, people are always searching for ways to reduce the complexity and brand names are nothing less than a reduction of complexity in the daily decision process of a single customer. By deciding according to a brand name, I don’t have to think about quality, price or which product to purchase. I can always order the same, know what I will have to pay (ok, sometimes companies will raise the price) and know the quality I can expect – that is what we call reduction of complexity.
The above-mentioned reduction of complexity is happening because of trust and the brand name of a company can be associated with trust. Trust will enable myself to keep up complex operations – despite the lack of information I can decide as if the future was certain. Trust will lead to a buying decision although I have only limited information about the product I will purchase and although I didn’t do any research on the product. I am trusting the company and that it will fulfill my expectations I have about the product I am going to purchase. The brand name stands for the ability of a company to fulfill expectations of different customers constantly. This is relieving the customer from the obligation to check every available information. And although many claim, they are searching for adventure, what they really want is consistency. Without consistency most of us would be overwhelmed by the number of decisions we have to make every single day, which is exhausting. Without knowing the products in every single location, I trust that a coffee-shop of Starbucks or McDonald’s in a different town (when I am on vacation or on business trip) will offer the same quality for the same price as anywhere else.
Building A Reputation
The result of trust in a brand name and the ability to fulfill expectations can be called “reputation”. Every company will gain some form of reputation – either a positive or a negative reputation. This is a process companies can’t prevent – companies can only try to influence their own reputation but are not really able to control the reputation as it is influenced by many different actors (including politicians, marketing agencies, customers and so on) who might have an opinion about the company and articulate that opinion. Reputation can therefore be described as a product of communication.
Although companies can only influence the reputation, a lot of money is spent on efforts to build a (positive) reputation. This process takes a very long time – many years or sometimes even decades. However, companies not only have to try to build a positive reputation, but also have to look after and maintain the reputation as it can be extremely fragile. And while the process of building a reputation takes a very long time, one single incident can severely damage the reputation (or even destroy it completely).
Part II: Two Examples
Now we are going to examine two examples for brand names, that fulfill the above-mentioned criteria – McDonald’s and Coca-Cola.
McDonald’s is a fast-food company and the world’s largest restaurant chain by revenue with more than 37,000 outlets in over 100 countries and more than 375,000 people employed. The global system is comprised of both company-owned and franchised restaurants, but the company is primarily a franchisor with more than 90% of McDonald’s restaurants owned and operated by independent franchisees. According to Interbrand, McDonald’s is on the 12th spot on the list of the most valuable brands in the world, but the brand value was stagnating in the last years (the brand was worth between $39 billion and $53 billion in the years since 2012). Aside from its brand name – a valuable asset and competitive advantage – McDonald’s is also profiting from cost advantages. The extremely high number of “restaurants” around the world and the standardized menu makes it easy for McDonald’s to produce its burgers cheaper than other competitors but due to the brand name, the company can sometimes charge an even higher price. McDonald’s has not just achieved to be the epitome of a fast-food restaurant, but the company has also managed to become almost a synonym for companies with products, that are easy to understand and simple to purchase. The prefix “Mc” is used by many other companies and products in order to point out similar qualities that made McDonald’s so successful.
(Source: Own Work)
McDonald’s generated $22.8 billion in annual revenue last year and it seems like the company is still struggling to increase revenue. In 2013, generated revenue was $28.1 billion and since then revenue has been declining every year. However, net income could be increased over the last few years although the company still didn’t reach the net income of 2013 which was $5,585 million. The earnings per share however were higher than ever before – thanks to the share buyback program. Aside from the problems to grow revenue as well as net income over the last decade, McDonald’s balance sheet is also no reason for enthusiasm. Aside from the higher debt levels, most concerning is the fact that liabilities are exceeding assets resulting in a negative shareholder’s equity (and bookvalue). The combination of high debt levels, negative bookvalue and struggles to increase profit is nothing I like to see as shareholder.
The Coca-Cola Company
The Coca-Cola Company is a multinational beverage corporation and manufacturer, retailer and marketer of nonalcoholic beverage concentrates. The company is the world’s largest beverage company and owns or licenses more than 500 nonalcoholic beverage brands, with its flagship product “Coca-Cola” – one of the best-known brands in the world and the reason why The Coca-Cola Company is one of the most valuable companies and the brand Coca-Cola is on the 5th spot of the most valuable brands in the world. But according to Interbrand, the brand value had been declining since 2014 from $81.6 billion to currently only $69.7 billion. While McDonald’s brand value was only stagnating, Coca-Cola seems to be in bigger trouble. Nevertheless, the company owns numerous patents, copyrights and trade secrets and not only the brand can be seen as competitive advantage, but also the cost advantages from which the company can profit. These cost advantages are mostly generated by the brand name as The Coca-Cola Company has very low costs for every additional bottle but can charge – due to the brand name – a rather high price for every bottle and sell the products usually with a premium (compared to competitors). The company is also profiting from the world’s largest beverage distribution system.
(Source: Own Work)
Last year, the company generated $35.4 billion in annual revenue, but since revenue was slightly over $48 billion in 2012, the annual revenue constantly declined every year. While one single year with declining revenue is not dramatic or a disappointing EPS due to higher research or marketing expenditures shouldn’t concern a long-term investor, what we see for Coca-Cola is a frightening trend. And not just revenue declined, but also the earnings per share was $1.97 in 2012 and declining to a dramatic low point of only $0.29 in 2017. But the list goes on: Aside from declining revenue and declining EPS, the company also has rather high debt levels resulting in a D/E ratio of 2.50 and it would also take more than five times the current annual operating income to pay back the debt. These are both rather high numbers and not the sign of a healthy and stable company. High debt levels become even more dangerous when revenue and net income is declining.
Problems With Brand Names
Before turning to the intrinsic value calculation and deciding if either of the two companies is worth an investment, we have to look at another problem both companies are facing right now. While a brand name is usually important for a company to differentiate itself among similar companies (McDonald’s can use its brand name to have a competitive advantage among fast food restaurants), it can be problematic for the individual company when the brand name is associated with attributes that suddenly are seen negative by a greater part of the population. In case of McDonald’s and Coca-Cola it is the big theme “health” and the associated trend to live and eat healthier.
When the way, how a society thinks (the so-called public opinion) is shifting because of a sentiment change, it will be problematic for the companies operating in that segment and also for those companies that benefitted from the brand name. Such fundamental shifts in thinking and a change of deep, fundamental beliefs will not happen within a few days or a few months. It usually takes years or decades, but it can be a big threat as individual companies can’t stop such mega trends even with huge marketing budgets. Companies like Coca-Cola or McDonald’s have to try to re-invent the brand and try to associate the brand name with these new ideas and stories – stories about healthy food and a healthy life.
And these fundamental shifts are a second big threat for brand names – aside from a company destroying the reputation by itself. Suddenly the brand name, which was the source for outstanding success is becoming an obstacle as the brand name is associated with negative aspects. The “good” aspect is, that these fundamental shifts happen slowly, the “bad” aspect is that companies can’t protect themselves from such trends. The only way is to try to re-invent the brand and try to associate the brand with new ideas and aspects.
Part III: Intrinsic Value Calculation
Despite the obvious fundamental problems with the brand names – these two companies are still very successful and well-established brands. In order to decide if one of the two or both companies are investment-worthy, we need at least a superficial, brief intrinsic value calculation.
The average free cash flow for The Coca-Cola Company in the last ten years was $6,697 million. As there is no real trend for the free cash flow (and definitely no growth trend), I think the average free cash flow of the last decade can be a useful number for our calculation. In the last two years, the free cash flow was even lower than the calculated average. It seems extremely difficult to talk about a growth rate for Coca-Cola as the company first has to stop the revenue decline, therefore I will tread a reverse path. In order to be fairly valued, Coca-Cola has to grow at least 6% for eternity when we take the average free cash flow as basis.
For McDonald’s, the picture is quite similar – there also seems to be no clear trend for the annual free cash flow and hence we will also take the average free cash flow of the last ten years as basis for our calculation. Considering an average free cash flow of $4,123 million, McDonald’s has to grow almost 7% every year for perpetuity in order to be fairly valued at current prices.
Despite the wide moat both companies have, I think it is rather unrealistic for McDonald’s or Coca-Cola to grow between 6% and 7% every single year. For Coca-Cola, the biggest challenge right now is to stop the decline of revenue that has been going on in the last years. It is a common sign, that wide moat companies have higher multiples as investors expect these companies to outperform, but both companies seem to be overvalued at current prices. Of course, there is another aspect similar important as the question if a company is able to grow: We also have to think about the downside risk and think about the risk of going bankrupt. For those mature, wide-moat companies the chance of going bankrupt is extremely low and justifies at least partly a higher valuation as investors not only pay for higher growth rates and growth perspectives, but also for minimized downside risk.
McDonald’s as well as The Coca-Cola Company are excellent, well-established companies with limited downside risk. But despite the wide moat, both companies are currently no investment. We can assume, that both companies will at least match the US GDP growth rates, but I am very sceptic if either McDonald’s or Coca-Cola can achieve between 6% and 7% annual growth for perpetuity. But lower growth rates automatically mean, that McDonald’s as well as Coca-Cola are overvalued right now. Although both companies have proven to be very inventive in the past (McDonald’s had many different ideas like McDrive or introducing breakfast), growth rates in the high single digits are rather unrealistic for both companies. And we should not forget, that the current trend towards healthy food and beverages will make it difficult for both to ensure high growth rates. The flagship products – burgers and soft drinks – are certainly not considered to be healthy for anyone and this could become a problem. I therefore would advise to add both companies to your watchlist, as both are wide-moat companies with an impressive record of annual dividend increases, but certainly no bargain at the moment.
Disclosure: I am/we are long SRCL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.