Research Reports – Coke Classic Analysis – Report

KO is the fastest growing and
most consistent performer of all the large-cap consumer
stocks. The company has continuously delivered venture capital-type
returns with the relative low risk of a mature, extremely
well managed and highly focused global enterprise. To accomplish
this, KO has maintained respectable growth in established
markets while committing substantial investments to emerging
markets. KO continues to successfully realize the rapid
growth and high margins available in these markets. With
its unique product, vast bottling and distribution system
and huge international market potential, we believe KO’s
stock still offers long-term investors the potential for
over 15% compounded annual returns.

Coca-Cola is the world’s
most valuable brand name. KO has been operating
for over 100 years and manufactures and distributes products
in more than 195 countries. The Coca-Cola name has unsurpassed
brand recognition and appeal worldwide. KO is the only source
in the world of Coca-Cola brand concentrates. KO products
are leaders in all major international soft drink markets.
In fact, Coca-Cola products often take the second place
spot as well, and much of it’s competition overseas comes
from local brand soft drinks. KO’s international operating
income from soft drinks was about $2.5 billion in 1992 compared
to PepsiCo’s $112 million.

KO is more than just
a great marketing company. KO is best known
as a marketing company, but we believe that Coca-Cola’s
infrastructure is equally important to its success. We believe
that KO’s vast worldwide system of highly efficient bottling
plants, warehouses and delivery systems is as responsible
as its marketing acumen for Coca-Cola’s success. The distribution
system’s value is evidenced by the sharp contrast between
KO’s market share in Great Britain and all other major markets.
In Spain and Italy, where KO’s bottlers are particularly
strong, the company’s 1992 market shares were 54% and 55%,
respectively. In Great Britain, however, where soft drink
manufacturers do not deliver directly to retailers, Coca-Cola’s
market share was only 31%, by far the lowest of any
major market.

Coca-Cola can create
tremendous share-owner value while limiting its investment
risk. KO stock traded at a multiple of less
than 3 times book value in 1982. Today, the stock trades
at over 14 times book value. We believe the reason behind
this extraordinary increase is KO’s greater use of independent
ownership of bottlers to expand distribution and hedge risk.
Independent ownership limits risks to KO because a vast
majority of Coca-Cola’s manufacturing and delivery assets
are financed through its network of local bottlers (“System“).
We estimate that KO carries on its books less than
15% of the System’s assets but participates in 100% of the
its revenues. Local ownership and management of
bottling, marketing and distribution operations also means
highly motivated and cooperative partners. This arrangement
expands volume growth, limits risk exposure and allows KO
to focus on concentrate sales, which have an average global
profit margin of 75%.

KO obtains higher profitability
overseas where growth potential is highest.
It is anticipated that in the future KO will make its biggest
earnings strides overseas where it already earns about 80%
of its operating income. Through 1996 the Coca-Cola System’s
worldwide infrastructure investment is projected to be in
excess of $5 billion. The System has committed $1
billion in Hungary, Romania and Poland, and an additional
$450 million to former East Germany. In China, the System
investment plans include $500 million, $350 million of which
will be allocated in the next three years. Management’s
long-term global vision looks at everyone in the world as
potential customer, but until recently KO reached only 25%
of the world’s population. KO stays committed to making
its products available as soon as the local economies become
viable. Using its vast resources and experienced management,
KO should continue to develop new soft drink markets successfully
and to win market share from local soft drink companies
and other competitors. By setting up its strong infrastructure
in these new markets early on, KO can assure a dominant
market share in developing countries.

In 1997 Coca-Cola could quite
possibly earn over $3.25 per share. Given KO’s past performance,
recent earnings acceleration and its growth potential beyond
1997, today’s stock market valuation of approximately 11.5
times our 1998 earnings estimate seems quite reasonable.
In four years KO’s EPS could be growing at $0.60 per year,
which would represent over 40% of 1992 EPS of $1.43. This
growth rate exceeds KO’s 1987 to 1992 performance, which
led to a quadrupling of the stock price. In 1992 EPS grew
by $0.22, which equaled 39% of 1987’s EPS of $0.57. These
figures demonstrate the power of KO’s compounded annual
growth, which was 15.9% for the most recent five year period,
up from 11.4% in the previous five year period. In conclusion,
we believe that KO’s shares have the potential to provide
investors with a compounded annual return in excess of 15%
per year over the next five years.

United States

The U.S. is still KO’s single
biggest market. However, only 20% of KO’s operating income
comes from the U.S. where KO sells over 3 billion unit cases
a year to capture 41% of the entire U.S. soft drink market.
Even in a developed market such as the U.S. unit case sales
have grown at 3% per year over the past five years.

Over the next five years, we
believe that unit sales are likely to continue to grow at
3% a year due to continued strong marketing efforts and
new distribution agreements. In 1993, all Wal-Mart stores
will begin carrying KO products and many of the country’s
largest food chains have changed over to Coke. McDonald’s
has agreed to use KO’s orange drink in its franchises. Marketing
programs at fast food restaurants that give free refills
and sell larger volume soft drinks or “value meals” that
include soft drinks have also boosted sales. As a result,
fountain sales in the U.S. account for approximately 33%
of revenue.

Price increases equal to inflation
should add about 3-4% to profits. Operating efficiencies
gained from joints actions with bottlers such as the continued
investment in corporate information systems and the savings
gained from the consolidation of bottlers from 300 in 1985
to 120 in 1993 should add about 1% per year to earnings.

KO’s operating margins should
also continue to improve as a more profitable product mix
is achieved. Diet Coke, which has a 2-4% higher margin than
Classic Coke, has increased from 20% to 30% of KO’s U.S.
business in the last five years and continued growth is
expected. KO will also continue to introduce new products
such as PowerAde and Nestea, which have higher margins but
are still only a small part of the U.S. market. In the aggregate,
we believe all the points discussed above provide KO with
an opportunity to grow U.S. profits at 10% per year.

Latin America

Mexico, Brazil and Argentina
made up about three quarters of KO’s total Latin American
unit case sales. Mexico, which represents 43% of the region’s
unit case sales, is the only country outside the U.S. to
consume over 1 billion unit cases a year. In recent years
the Latin American economies have shown considerable improvement.
Overall the region’s governments have adopted a more cooperative
attitude toward foreign businesses.

Much of future earnings growth
will be attributable to the considerably more accommodative
regulatory environment in the region. Price restrictions
on soft drinks have been abolished in major Latin American
markets enabling KO to improve margins substantially in
1992. In Mexico price controls were not abolished until
February of this year. Longer term KO will be able to raise
prices as increases in per capita income and consumption
allow.

Restrictions on the way soft
drinks could be marketed have also been largely lifted.
Until recently, KO could only sell its products in a limited
number of packages. Now KO will be able to take advantage
of new marketing opportunities such as bigger sizes and
alternative packaging.

Higher margins will give Latin
American bottlers cash to reinvest in operations. Under
the previous price controls cash flows were maintained largely
at the sake of reinvestment, which is essential for long-term
earnings growth. Reinvestment in the region has picked up
substantially since the packaging and price liberalization.
In fact, KO has committed its own capital to the expansion
of the region’s infrastructure. In 1993 KO purchased a 30%
stake in Coca-Cola FEMSA and a 10% share of Panamerican
Beverages, Inc., the largest Coca-Cola bottler outside of
the U.S. The story in Latin America is one of unit and price
growth, increased investment and growing freer markets.
We estimate KO’s Latin American operating income to grow
by approximately 150% by 1997.

European Community

The EC is Coca-Cola’s second
biggest market region in terms of both revenue and operating
income. In spite of severe economic slowdowns in many European
countries over the past few years, the EC has been a growing
and profitable market for KO. KO held 47% of the EC soft
drink market in 1992 and its Germany, France and Benelux/Denmark
groups performed from 2 to almost 3.5 times better than
the industry as a whole. Earnings improvement in Europe
will come from a combination of persistent growth in established
markets and rapid growth in the former East German region.
Income will also improve as aggressive marketing wins market
share for the higher margin diet product “Coca-Cola light”.
In East Germany strong growth is expected to continue and
strengthen as all of the over 40 production plants and 60
distribution centers are built and operating by 1995.

Germany, Spain and Italy account
for over 60% of KO’s total unit case sales to the EC. KO
has about 55% of the soft drink markets in Italy and Spain
where the company owes much of its continued success to
the solid performance of its bottlers. These bottlers enjoy
a market with relatively little competition, and they are
dedicated to reinvesting in their operations to improve
production and distribution efficiencies. Despite fluctuating
economies and some devaluation in their currencies, these
two countries have continued to grow strongly. In Spain,
for example, operating earnings grew more than 500% from
1982 to 1988 and in the last five years have almost doubled.
We estimate that both countries will double operating income
in the next five years as tourism and other local industries
recover.

Germany continues to be the most
profitable country in the region, equaling 38-40% of the
profits in KO’s EC region. Management expects tremendous
growth from the former East German market, where unit case
volume grew 20% in 1992. As of early 1993, 75% of the $450
million System investment planned from 1990-1995
was already spent. In order to develop the market quickly
and effectively after the fall of communism there, KO has
owned and managed all of its bottlers in East Germany. KO
has found that the East German soft drink market is already
quite established and receptive to Coca-Cola products. In
fact, the bottlers are doing so well that KO may begin selling
them off to independent investors very soon. Eastern Germany
should continue to grow as a percentage of KO’s profits
in the region due to its rapid development.

Northeast Europe/ Africa

The NEA division presently accounts
for only about 8% of KO total operating income, but it includes
the new markets in the former communist countries. The company
continues to make significant strides in the region through
careful attention to political conditions and continuous
efforts to make Coca-Cola products available to as many
customers as possible. Although varying degrees of political
instability persist in many African markets, KO unit case
sales increased by 7% in 1992. South Africa is a wild card
until political progress is made but has significant income
potential. The greatest sources of income growth in the
past year and for the future, however, are the former Soviet
block countries. In fact, the growth has been so dramatic,
from zero in 1990 to over 110 million cases, in eastern
central Europe that KO has organized a separate division
for the region starting 1993.

In 1992, unit case sales in the
former communist block nations increased 31%. Poland, Hungary
and Romania have been among the best performers in the region
as new operations and marketing get underway. Because of
the impressive potential KO management sees in the east
central European countries, the Coca-Cola System has planned
to commit to about $1 billion to Poland, Romania and Hungary
through 1996. A considerable amount of this total investment
has already been spent, which would indicate that KO is
making significant progress in these growing economies.

The soft drink markets in the
former iron curtain countries are already quite developed.
In fact, the per capita consumption of soft drinks in eastern
central Europe is almost as high as in Japan, where consumption
is among the highest in the world. KO’s strategy is to tap
into this existing market through ongoing investments to
gain market share from local brands. In the former eastern
block countries the Coca-Cola brand name has a significant
advantage because it is perceived as the product of “freedom”
and “democracy”, which appeals to the people of these countries
who are striving toward such ideals.

Canada and Pacific

The Pacific is by far the most
profitable region for KO, accounting for almost 30% of operating
income on well under 15% of revenues. The Company includes
Canada in this country grouping. KO’s Canadian market share
in 1992 was approximately 20%, up from about 16% in 1988.
Removing Canada’s results, we estimate that the Pacific
region experienced sales of $1.5 billion and operating income
of $840 million in 1992. Although Canada is a difficult
market, the Pacific region, with some of the most rapidly
expanding economies and large populations, offers KO tremendous
growth potential.

Japan continues to be a fantastic
market for KO. In the Pacific region 42% of unit case sales
are in Japan. KO benefits greatly from the fact that all
bottlers in Japan are independent, allowing KO to generate
significantly high margins from concentrate sales. Unit
case sales have grown at 7% per year for the last 10 years.
In 1992 operating income increased 25% despite only 2% unit
case sales growth resulting from a slow economy. Profits
were aided by a hefty rise in the value of the yen against
the dollar. 32% of KO’s sales were in high margin non-carbonated
drinks. In fact, KO is the world’s largest producer of canned
coffee. A recovery in Japan over the next few years along
with the record high yen should boost dollar earnings significantly
in the future.

China represents the largest
potential market and the number one recipient of Coca-Cola
System investment in the region. From 1981 to 1996
System investment is projected to be about $500 million.
Almost 3/4 of this investment will occur in the next couple
years, which should translate into a surge in sales as the
Chinese economy continues its rapid growth. There are already
13 bottling franchises in China, which are well-capitalized
and intent on building share-owner wealth. Since 1989, production
of concentrate began in Shanghai. This has allowed KO a
tremendous cost advantage over importing concentrate from
the U.S. Now Chinese bottlers do not have to go through
the difficult and costly process of paying in U.S. dollars
and the product can be made more affordable to the average
consumer. This is a major step in tapping 1.2 billion potential
Coca-Cola customers. Already the progress is evident. Unit
case sales have gone from 1 million in 1984 to an estimated
90 million in 1993. China has a strong potential to generate
over $100 million in annual profit by 1996.

India, Malaysia and Indonesia
are markets that demonstrate KO’s long-term plan. Though
aggressive marketing and early investment, KO hopes to develop
their large populations for the future. System investment
in this region through 1996 will be about $250 million.
By 1997 these three countries could be generating over $100
million of rapidly growing annual profits.