Thursday, June 19, 2014

Is Coke Undermanaged?!

OK, now that's a silly idea.  Coke (KO) is one of the most respected companies and known to be very well managed.   It is an excellent company for sure.

One great thing about running a blog is that I can just think out loud here and sometimes someone pulls on a thread and gets me thinking about other things (or corrects my mistakes).

After posting about a possible (or impossible) BUD/KO merger, someone commented that the operating margins can't be compared because BUD and KO operate under different models.  KO lets the bottlers do the heavy lifting and KO only makes the syrup.  This is increasingly less so due to the non-carbonated drinks they sell.  They also took over the bottling operations in the U.S.  But OK, that only accounts for 20% of global volume so it is still mostly a syrup selling operation; a very high margin and lucrative business.

But as I pointed out in the comment section, that makes the BUD/KO merger argument even stronger.  If KO has the better operating model, then how come BUD has an operating margin of 32.5% versus KO's 21.8%?    That makes no sense at all.

And as I went about my usual daily routines, I kept thinking about it and couldn't get over the fact that KO has been run so long by insiders, on how insiders tend to respect 'sacred cows' and respect tradition (in other words, it's been a tradition for 100 years to do it that way, so let's keep doing it that way).

Also, if you went up in the organization, that means you have a lot of subordinates that you helped promote over the years.  It's really hard to give a hard-working underling a department to run and then later take it away saying that we don't need it anymore.  The more likely scenario is, well, it doesn't cost us so much and we can still make our numbers so let's keep that department going.   It's probably also hard to give people nice offices over many years and then suddenly say, hey, no more offices!  We are all going to work in cubicles now.

I keep going back to that comment by the new Sony CEO that said they will never stop producing televisions because the engineers in that division are very proud of their work.  Is it any wonder what is happening there?  I've seen a lot of that when I worked in a big company too.

At KO, it's probably not so much product lines, but activities.  They probably spend a ton of money on all sorts of events with questionable returns.  I don't know (but I'm sure it will take a couple of days for 3G-type people to figure out).


It's Return on Capital, Stupid.  Not Margins!
And as I was thinking about this stuff all of the sudden I slapped my forehead and said to myself, geez, it's not the margins!  Well, margins do matter and the higher the better.  But the KO model was meant to be an asset-light model; let the bottlers build the bottling factories.  Let them do the capital intensive part and we'll just keep producing Super Bowl commercials.

So when this occurred to me, I rushed back to my desk to look at the return on capital figures for the relevant companies.

Operating Margins
So first of all, here are the operating margins for the businesses we are talking about.  Oh, and I also added Dr. Pepper Snapple Group (DPS) because they are in a similar business to KO but they are integrated, meaning they bottle their own drinks instead of relying on bottlers.   DPS is way smaller than KO so may not be a fair comp, but still, it would be an interesting benchmark.  Actually, the advantage should be to KO; size/scale benefit etc.

Here are the operating margins:

KO       21.8%
DPS     17.4%
BUD    32.5%
PEP     14.6%

So here it looks like KO is doing well against DPS and PEP.  But PEP is attached to a snack business which might have slightly different economics.  But the margin is a lot lower than BUD, who bottle and deliver their own drinks.

Return on Capital
But as I said, it may be the capital that matters, so let's look at some return on capital figures.  For capital, I will use the total of long-term debt and total equity.  I will look at operating earnings against this and call that return on capital.  Also, I won't use average equity or anything like that; I just use whatever is on the balance sheet at the end of the year.

So this is not text-book correct, but should give sort of an indication.

              Operating earnings /
              (LT debt + Total Equity)
KO*            24.2%
DPS            21.9%
BUD           14.5%
PEP            19.9%

For KO, I deducted the $10 billion or so of equity investments on the balance sheet as the equity income from those investments (bottlers) don't show up in the operating income line.  I also use total equity as minority interest is not deducted before the operating income line.

But here, the first thing you notice already is that KO's return on capital is better than DPS and PEP, but not that much better.  I thought it would have been a much bigger gap given the advantageous  business model.

And then you say, "aha!", look how awful BUD is!  But then we have to remember that BUD was created by a giant merger (and more mergers in the past) so there is a lot of goodwill on the balance sheet.

So I decided to take a look at return on tangible capital.  Here, I will only deduct goodwill, and not other intangible assets as goodwill is the pure premium paid on acquisitions, and intangibles were identifiable (but not tangible) assets that were put on the balance sheet.  I don't want to get into if the intangible valuation is fair or not.  Plus, if I deduct those intangibles, DPS capital would be negative so would destroy the elegance of my argument so let's just keep that in.

Return on Tangible Capital
So deducting goodwill from the above definition of total capital, the return on tangible capital (ROTC) becomes:

                     ROTC
KO               34.2%
DPS             58.2%
BUD            52.7%
PEP             30.2%

I was a little surprised by this result too.  KO's return on capital is good, but look at DPS and BUD.  And KO's is not much higher than PEP's ROTC given it's supposed asset-lightness.  My image is that the soda business is much more lucrative than the snack business (growth problem aside), so it was surprising to me that KO and PEP were so close here.

Greenblatt Return on Capital
And for fun, as one more layer of return on capital comparisons, I decided to use Greenblatt's Magic Formula return on capital as it does exclude all intangibles.  I will again use operating earnings on top and for the denominator I will use net current assets plus net PPE.  Let's call that NCAPPE.  

Using that I get:

                Operating earnings
                 / NCAPPE
KO              55.4%
DPS            82.9%
BUD           67.2%
PEP            42.3%

Again, this was surprising.  Both DPS and BUD beat KO on this measure.  So what happened to the asset-lightness?    Is KO pissing away the benefit of the operating model with unnecessary spending?

Here is a table that summarizes the above stuff:


Again, I deducted the equity method holdings for KO from the capital.  Net current assets was negative for BUD, so that's why it's zero there.

Conclusion
I don't think anyone can look at KO and think it's poorly managed.  And there is a question as to whether everything has to be super-optimized for super-efficient, super-returns-on-capital.

But it was interesting to go through this exercise and realize that KO is not that way out in terms of performance as I thought it was.  And again, it shows partly how incredible the 3G guys are.

If Heinz, which was considered pretty well-run (people wondered what more 3G can do after years of restructuring there) can improve so much and they can get so much value out of it, imagine what they can do at KO.  From these figures, you can see that there is a lot of room for improvement.

So while Buffett has denied Berkshire Hathaway and 3G taking KO private, that doesn't mean that Buffett doesn't want some more value extracted from KO.

And KO is so big they will need some sort of vehicle to do that with, and what better vehicle is there than BUD?

Although it is more likely that BUD acquires SABMiller, PEP and even DPS (too small?), a deal with KO would be very interesting.

Some of the pieces of the puzzle are lined up already.

  • Buffett loves what 3G is doing; he would probably love to see their work on some of Buffett's holdings 
  • KO has not been a great performer recently.  It has done well, though, but not supergreat
  • Like Ackman owning Allergan (I just threw that in there for fun; not comparing Buffett to Ackman), Buffett already owns a big stake in KO so BUD would already have some votes for a deal (and a potential supporter on the board in Howard)
  • Buffett has owned BUD in the past and probably likes the business.  We know he loves the management already, so he would gladly take all stock and maybe even buy more BUD stock or preferreds if needed to get a deal done.  Buffett would love something big to put a big chunk of capital to work. 
  • Unlike an LBO, a BUD/KO merger would have the benefits of synergies.  I know, we hate that word, but there would be a lot of synergies here, including procurement.  Someone pointed out that KO doesn't do it's own bottling, but if BUD and PEP can do a procurement deal, surely KO bottlers can do a procurement deal with BUD, so the same benefits may be realized either way. 
  • etc... 
So there are a lot of things when you think about it that makes a lot of sense here.  And yes, there are things that may be difficult.  Can you imagine the uproar of a foreign firm buying Coke?  The size of the deal alone makes it look impossible. 

But again, what's the fun if we don't dream big?! 


15 comments:

  1. This reminds me of an accounting class where we were assigned 10 pairs of anonymous, common-sized income statements & balance sheets, then had to match with 10 companies. Great exercise.

    If Coke is 80% SyrupCo, shouldn't there be a much larger delta on the gross margin line? Could be accounting policy, etc. but first thing that came to mind.

    Not having done any analysis on either name please don't interpret as a nitpick, but when I look at ROIC I thinks it's worth adding back the cumulative A/T amortized intangibles to equity & amortization expense to EBIT.

    Really enjoyed the post. I've been wondering if the 3G guys would pair up with Trian to split Pepsi myself.

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    1. Hi, Coke is actually not 80% syrup. 19% of global volume is in the U.S., and of that, 32% is still beverages (nonsoda). Outside the U.S., 25% is still beverages.

      And yes, there are refinements that can be done for ROIC so this is admittedly a rough look.

      Also, I agree that there must be a bigger difference in the gross margin line, but since that can differ greatly just because of how companies allocate cost between COGS and SGA, I just looked at the operating margin so I don't have to deal with that.

      Either way, the more I think about it, I do think something will happen in the soda business, and perhaps something big because it's not such a no-brainer, dominant business anymore, I don't think, as it used to be. The businesses are clearly getting 'tired', and that's when things tend to happen. And that time may be now or very close.

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  2. There was an interview where Buffett said Coke only needed about 4 billion in working capital to make about 7 billion. This suggests he thinks Coke is very bloated, but he knows better than to upset the care takers. I think a LBO of Coke is very possible using BUD as the vehicle. Buffett can probably put up 50 billion in equity easily or even more if he decides to tap the debt markets. 3G and BUD will have to come up with about 100 billion.

    I think they can probably increase operating margins by more than 50% and perhaps Coke has some untapped pricing power in some regions...

    Would this happen? I dunno, but Berkshire is sitting on close to 50 billion in cash and he is getting old. Very easy to see Coke staying in business 100 years from now.

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    1. I was thinking that BUD would issue new shares so don't need $100 bn cash necessarily.

      But yes, I think Buffett would love to own a BUD/KO combination, and in that case, he would probably gladly own much more than he does of KO alone (it would be like owning both BUD and KO stock, but better).

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  3. Thanks for the article.

    An outsider does not by definition manage better than one grown up in the company. A new way to do business is not always better than the old one. A manager who really knows the company possesses advantages.

    In the end it depends on the qualities of the top managers, whether these are right for this company and in this situation. Choosing the proper CEO etc. is critical for a company and very difficult.

    It may be that KO needs changes after more than 100 years of history.

    Milud

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    1. Yes, that's true. Often outsiders come in and screw things up. But that hasn't been the pattern with the folks at 3G.

      Also, the more I think about it, I think there is sort of a paradox in that businesses with great economics can really build up a lot of waste over time as they don't have the cyclical ups and downs (relatively speaking) like other sectors (banking, for example, that hae crises every few years and have to really cut costs to survive).

      Some of these businesses like KO never (at least recently) have life-threatening experiences so a lot can build up without anyone noticing.

      It sort of reminds me of economies in boom times (not a great analogy, but...). Things look great, everyone looks smart and very business looks really well-run and efficient. And then when things turn, everyone looks horrible (look at Japan in the 1980's versus the last 20 years).

      Of course KO is not benefiting from any one-time bubble or boom so it's a bit different so it's a little different.

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  4. One thing worth mentioning - Coke brought its US bottling back in house in 2010. This caused its return on capital to fall quite a bit.

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    1. Yes, I do remember that. But still, the U.S. is only 19% of global volume, and of that 32% is non-sparkling beverage. So KO should still have a substantial 'edge' which does not seem to be there.

      Thanks for dropping by...

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  5. I think you need to do a rather deeper dive for the denominator in all 3 variants of your ROIC calculations. As of now I don’t think they are particularly meaningful because they are said to evaluate business performance but in fact are mostly measuring tax considerations.

    If you follow the financial press you’ve probably seen what amounts to mania with biopharma M&A deals where US domiciled companies are trying to get out of the US tax net. By the way, today’s WSJ has some info on the subtleties of inversion in a good article called “Metronic’s Irish Tax Jig: Not as Easy as It Seems.”

    A rule of thumb is that profitable, non-capital intensive, US-domiciled companies with significant overseas operations tend to generate considerable amounts of cash overseas. This cash is essentially ‘trapped’ there because unless the companies find a loophole (consistent with their respective tax philosophy—a lot of this is very gray), they cannot repatriate this cash to a US domiciled entity, including their ultimate parent, to pay dividends, do stock buybacks or repay the parent’s debt, without incurring US taxes. So what sectors typically fall under this? Healthcare companies (in particular biopharma companies with patent or otherwise protected drugs as well as certain med device companies) as well as technology companies are the usual suspects. But selling lucrative sugar water fits in this mold too.

    If we weren’t talking about huge amounts here, I wouldn’t bring it up. But the amount in KO’s case is massive. To be clear, the amount of cash and securities KO has laying around has almost nothing to do with supporting its business needs and everything to do with tax speculation, primarily that (a) they can repatriate the cash / profits in the future during a tax holiday (b) they can find a loophole, or (c) to a much lesser extent, they invert. The reason why (c) is to a much lesser extent is a bit beyond the scope here.

    And since KO has huge foreign operations you basically should cut the 2013 KO denominator in half (i.e. reduce it by $18Bn). There is no material adjustment for DPS. In the interest of time I only looked at these two.

    Note that Anheuser inverted via the Inbev merger though as the WSJ article on “Medtronic’s Irish Tax Jig” notes that would be just step one in a series of (byzantine) corporate tax maneuvers.

    Here are some disclosures you may find useful:

    KO disclosure in 2013 10-K
    We have significant operations outside the United States. Unit case volume outside the United States represented 81 percent of the Company's worldwide unit case volume in 2013. We earn a substantial amount of our consolidated operating income and income before income taxes in foreign subsidiaries that either sell concentrate to our local bottling partners or, in certain instances, sell finished products directly to our customers to fulfill the demand for Company beverage products outside the United States. A significant portion of these foreign earnings is considered to be indefinitely reinvested in foreign jurisdictions. The Company's cash, cash equivalents, short-term investments and marketable securities held by our foreign subsidiaries totaled $18.3 billion as of December 31, 2013. With the exception of an insignificant amount, for which U.S. federal and state income taxes have already been provided, we do not intend, nor do we foresee a need, to repatriate these funds.


    DPS disclosure in 2013 10-K
    “$6.0 billion of net sales in 2013 from the U.S. (88%), Canada (4%) and Mexico and the Caribbean (8%)”

    and

    “Cash generated by our foreign operations is generally repatriated to the U.S. annually except when required to fund working capital requirements in those jurisdictions. Foreign cash balances were $65 million and $109 million as of December 31, 2013 and 2012, respectively. We accrue tax costs for repatriation, as applicable, as cash is generated in those foreign jurisdictions.”

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    1. Thanks for the thoughtful comments. They are all good and valid points. In order for this analysis to be more accurate, for example, I should either add interest income to operating earnings or deduct the cash/investments. But interest income seems very small now in any case.

      As for taxes, this is why I focused on operating earnings; this is a pretax figure so tax rates shouldn't be a factor in comparison.

      And the cash/investments on the balance sheet is a good point too, but I didn't deduct that as there seemed to be a lot of notes and payables which I would guess is largely offset by that (KO borrows against overseas cash so as not to pay tax), so to me those cash/investments are not "net" cash. Net cash would be cash minus that stuff...

      So in the Greenblatt ROC, you will see that the net current asset is a little more than $3 billion, so doesn't really penalize the ROC figures as much as you would think.

      If there was nothing against all of that, and all of that cash/investments was "net" cash, then yes, you can deduct that (to some extent; but not all of it).

      Thanks for commenting.

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    2. There's $17.1 billion in cash and short term investments and there is $16.9 billion in notes and loans payable (current assets) against that. This is other than the usual accounts payable and other current liabilities.

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    3. oops, I meant the notes and loans payable are from current liabilities (not current assets) which pretty much offsets the cash and short term investments...

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    4. Interesting, so in essence you've already adjusted for the trapped overseas cash. My mistake.

      (This is probably a sign that I've been reading too many of these inversion articles...). Good post.

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  6. I was just reading their most recent earnings call, and I found it interesting that Muhtar Kent said that the company is going to use zero based budgeting. It will be interesting to see how well they can (or can't) improve margins / returns on capital like the 3G guys. Also, they're going to use pretax profit as their growth metric instead of operating income, which also is very Buffettesque. Maybe he's been talking extensively with management.

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    1. That is certainly interesting. Let's see if he can pull it off. I am very skeptical of a KO insider actually making a dent in it due to the reasons I say in the above post. Too many friends, too many things that "have always been done this way and has always worked! If it ain't broke, don't fix it!".

      It usually takes an outsider to make serious changes because they have no emotional baggage or friends they don't want to offend or fire.

      But at least Kent seems to realize that if he doesn't do it, then eventually someone like 3G will.

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