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?! 

Big Dream: Anheuser-Busch InBev (BUD) / Coca-Cola (KO) Merger

This morning KO's stock price popped up on a comment by David Winters that Buffett and 3G are planning to take KO private.  He said that there are indications that something is going on, including press reports in Brazil regarding something related to 3G, KO and Buffett.

Now, I don't want to speculate on mergers and that's not what this blog is about, but it can be fun sometimes to do so.  I would usually ignore this sort of noise in the market.  Oh, and Becky Quick from CNBC called Buffett and he immediately said there's no chance 3G/BRK will take KO private.  It is way too big being bigger than the Heinz deal ($180 billion versus $23 billion for the HNZ deal).

But something has been nagging me for a while now and it was reinforced after reading the very interesting book, Dream Big: How the Brazilian Trio behind 3G Capital - Jorge Paulo Lemann, Marcel Telles and Beto Sicupira - acquired Anheuser-Busch, Burger King and Heinz.

It's really a great book that tells the story of the rise of the folks at 3G.  All business success stories are very similar but what I kept going back to is how these guys started out small and kept building things up.  They tend not to buy something to sell, but to build up.  Each acquisition turns into sort of a platform for growth and further deals. And they also give a lot of freedom to employees to take risk and grow as long as they do so prudently.  Their acquisition of BUD was seen as a long shot but it eventually happened.  It was a "big dream" that was realized.

What will they do next with BUD?  I don't think they are in it to maintain the status quo.  That's why I thought they would bid for Pepsi's snack business, for example.   I also wonder about Burger King (BKW) too.  You know 3G is in it for the long haul, so they are not going to be content sitting on it; they will make it grow and at some point down the line there will probably be some deals there too once they finish modernizing their restaurants (they already finished franchising out all the restaurants).

OK, back to BUD.

A few years ago, BUD had some agreement with Pepsi on some procurement deal so they can save costs on procurement as they share many common inputs.  Of course, this should make Pepsi too a target of a potential deal for BUD  (And in South America, beer companies also frequently sell the sodas too).

This procurement deal suggests that there would probably be some significant synergies in BUD selling sodas.  Imagine the synergies in procuring aluminum cans, and maybe even media/advertising.

And look at these figures comparing BUD and KO:

                                      BUD                    KO
Gross margin:                59%                     61%
SGA % sales:                 27%                    37%
EBIT margin:              33%                    22%

BUD's SGA includes stuff that may not technically be SGA; I just took whatever came in between gross margin and operating earnings.  In KO's case, I just took SGA as reported in the 10-K and there are other things in between SGA and operating earnings.  Also, there are probably a lot of differences in accounting standards that make a direct comparison difficult.

But in any case, this is just a quick look to see if KO might benefit from Zero-Based Budgeting (or whatever it was called).

And sure enough, as high margin and amazing KO looks, BUD is even better.

KO is very highly regarded and well-managed, but I can imagine that over the years with such a lucrative, high-margin operation, maybe there is a lot of waste that has built up over the years.  And maybe KO insiders are too generous to cut wasteful spending  (lifers sometimes have too many friends they don't want to offend).

So, maybe there could be some significant synergies between the tie-up between these two.  Getting KO operating margins up to BUD levels would increase operating earnings by 50%; that alone can pay for the premium that BUD would have to offer (presumably in a lot-of-stock / maybe-some-cash offering).

And then think of the obvious synergies of selling liquids in cans and bottles to similar retailers and other points of sale (restaurants/bars).

If what is in the above book is all true (and there is no reason to believe otherwise), this can create some huge value.

As a sanity check, here are the respective market caps and enterprise values of each:

                                             KO                BUD                       combined
Market Cap:                        $180 bn          $180 bn                  $360 bn
Enterprise Value                 $198 bn          $218 bn                  $416 bn

Yeah, that would be a huge deal.  Ridiculous, actually.  But this is a blog so I can imagine and fantasize about whatever I want!

But you know, I bet that somewhere within BUD is a spreadsheet that has all of this pro-forma-ed out on what a combined operation would look like and what synergies and costs-savings can be achieved and what the value-added would be.

Who knows, maybe it's on Brito's laptop, or maybe it's just some low-level financial analyst/intern doing it as an exercise at the suggestion of a mid-level boss.  But either way, the spreadsheet is there somewhere at BUD.  To be fair, the same one would exist for PEP, SAB Miller and every other big company that might make sense (or might not make sense).

Even a combined market cap of $360 billion (of course more if you include a takeover premium) is still way lower than the $560 billion market cap of Apple!  It's a different world.

So Buffett might have said "absolutely no chance of that" to a Berkshire Hathaway / 3G deal for KO, but he didn't say "absolutely no chance" of a BUD/KO deal, right?  And Buffett may participate too; he can buy BUD common or preferreds to help fund the deal.    So in a sense, it would still be a Buffett/3G deal, and Buffett's denial would still be true (maybe that's why he needed Quick to clarify the question to make sure that he is only denying that BRK will take KO private with 3G).

Both Buffett and Munger think Muhtar Kent is a great CEO and they seem to love him, but it's also true that Buffett really loves the guys at 3G and is impressed with what they are doing at Heinz.  HNZ too was regarded as pretty well run.  So who knows?  Maybe Buffett would really support a BUD/KO deal!

Also, BUD may have trouble doing more large beer deals due to anti-trust issues, so BUD/KO might make a lot of sense.