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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Coca-Cola

1 Analysis

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 that
each have 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.

Revenue by Geography

Africa
4%
Eurasia
Bottling 4%
Investments
European
25%
Union
16%
Latin
Southeast America
Asia & 11%
Pacific
14% North
America
26%

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Revenue by Product

Domestic
Juice Fountain
Domestic
4% Sales, includes
Bottlers
Fountain Sales restaraunts &
14%
4% fountain
wholesalers
8%

International Finished
Concentrate Products,
Sales (non- primarily juice
juice) and water
67% 3%

Sales of Case Volume To:

Fountain Bottlers
Operations where Coca-
and other Cola has no
finished ownership
beverages interest
11% 25%

Bottlers
where Coca-
Cola has a
controlling Bottlers
interest where Coca-
10% Cola has an
equity
interest
54%

Operating History (3.1)

Ten Year Operating History


ROAA OPM RORE RORE+D GM Capex/E+D E/FCF E/E+D-C
27.6% 28.6% 11.3% 8.6% 64.5% 18% 1.03 1.02
3.5 3.5 2.3 <- Rating
ROAA: Return on Adjusted Assets; OPM: Operating Margin; RORE: Return on Retained
Earnings; RORE+D: Return on Retained Earnings & Change in Debt; GM: Gross Margin;
InvTurn: Inventory Turnover; E/FCF: Earnings to Free Cash Flow; E/E+D-C: Earnings to
Earnings+Depreciation-Capex

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Monotonic revenue growth and earnings have covered dividends since 1982. Coca-Cola
has had uninterrupted dividend growth since 1972. Over the last twelve years, average
case volume growth has been 5%. Earnings have consistently exceeded free cash flow,
largely due to capital expenditures exceeding depreciation. This is reasonable
considering the company’s expansion over the period. Earnings grew from 1972 to 1997
at an annualized rate of 13.5%; this period covered multiple recessions, two of them
severe1. Over the same period, the SP500 had an annualized EPS growth rate of 8%.

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; Coca-Cola spends $2.8B a year (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.

Customer Bargaining Power (2)

The bargaining power of Coca-Cola’s customers 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. Large grocery chains that typically
have multiple brands of the same product type, but still buy in large volume, have
considerable bargaining power but less than the large restaurant chains. 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 (3)

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 ($81,000) earnings per employee and gross margin (64%) indicate a
relatively low sensitivity to changing labor costs. To date, collective bargaining has not
led to significant pension liability.

1
From Jeremy Siegel’s “Stocks for the Long Run”, chapter on nifty fifty.

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Barriers to Entry (3)

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 expense, 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 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 its 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 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.

Store-brand awareness rose from 86% in 1991 to 91% in 1995, with the percentage of
consumers who regularly purchase private label brands rising from 77% to 83%. 90% of
consumers who purchased private label brands thought them equal to or better than name
brands, and planned to purchase private label in the future. Retailers have an incentive to
stock private label products, as the gross margin is sometimes over 35%, as compared to
25% on name brands. Retailers have started stocking more private label brands, often at
the expense of 2nd tier or lower name brands, with 3rd tier or lower hit particularly hard.
So to some extent, the increase in private label competition is reducing competition from
other name brands. During this time, and more recently, Coca-Cola still managed to
increase volume while at the same time increasing price per unit, indicating that as yet,
private label product is not significantly impacting Coca-Colas sales (and since case
volume has kept pace with concentrate sales, demand is still strong for the bottled and
canned product). Looking in my local grocery stores, products by Coca-Cola and Pepsi
dominate the shelf space, with minimal space allocated to private label drinks. Even if
private label products do gain market share, because each store has an effective
monopoly on its private label product, pricing should be stable, which would not be the
case if several private label manufacturers offering the same product were competing in
the same store..

Intensity of Competition (3)

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. Volume growth will likely exceed global GDP
growth over the next twenty years. This should keep rivalry controlled, as companies

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

will be able to grow volume without gaining market share. The strong brands of the
industry incumbents should also reduce rivalry.

Threat of Substitutes (2)

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 small 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 maintain its high return on
capital.

Demand has historically remained fairly stable through the economic cycle, even during
severe recessions.

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. To date in
2008 (Q3), North American case volume and revenue have fallen 2%, whereas in Europe
case volume has risen 3%, and revenue 10% (due to the fall in the dollar over the period).
Total company case volume in 2008 has increased 4%, 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 years, and yet Coca-Cola’s volume growth is still strong.

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

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 (3)

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.

5 & 10 year Volume CAGR by region (2005)

9%
8%
7%
6%
5%
CAGR
4%
3%
2%
1%
0%
10 Year CAGR
Africa

Eurasia

5 Year CAGR
European Union

Latin America

North America

Southeast Asia &


Pacific

region

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 capital 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 acquistion of Glaceau.

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Per Capita Consumption by Region

450

400

Per Capita Consumption


350

300

250

200

150

100

50

0
Africa Eurasia European Latin North Southeast
Union America America Asia &
Pacific
Region

Financial Strength (3)


Credit Rating Ave. Maturing Debt to Earnings Fixed Charge Pension Benefits
Debt to RE Cov. Paid / PBT
AA3 0.67 1.23 17.7 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 earnings. Earnings per employee are high at $80,000,
indicating a low sensitivity to labor costs. Gross margin (65%) is also high, indicating a
low sensitivity to changes in the cost of inputs.

Summary

Future Prospects Financial Strength Operating History Combined Rating


3 3 3.1 3.0

Coca-Cola’s historical performance indicates that is possesses a strong competitive


advantage, and the review of the company’s future prospects indicates a strong likelihood
that this advantage will be sustainable. And Coca-Cola’s strong financial strength means
that the company is well positioned to withstand economic shocks.

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

The company estimates that there is a $9B gap between the fair value of its investments
in bottlers and the amount carried on the balance sheet. With a current market cap of
around $105B, this is a significant source of excess value.

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