In November of 2000 Coca-Cola (KO), with Warren Buffett on the board, convened to discuss an acquisition of Quaker Oats, the parent company of Gatorade. The offer on the table was in the amount of $15.3 billion for a company that only made $360 million in 2000 or 42.5 times earnings. This was a premium Buffett was not willing to pay as he was quoted, “We would have given up 2 billion cases a year of Coca-Cola to get something like 400 million cases a year of Gatorade.”
Gatorade accounted for the bulk of Quaker Oats sales at about 40% of revenues and controlled 86% of the American sports-drink market. Net earnings for Quaker Oats were not particularly impressive. From 1998 to 2000 earnings grew at an annual rate of 12%. There was also a huge $930 million loss in 1997 preceded by even more erratic earnings. Understandably this company was far too speculative at the given price.
There were potential synergies to be had by merging Gatorade with a beverage distributor like Coke or Pepsi because the distributor could further push that new product. But as I referenced in a prior article projected synergies have a poor record of materializing.
After about 5 hours of negotiating the Coca-Cola board decided against the acquisition. A couple weeks later Pepsi (PEP) would step in making a bid of $13.4 billion and acquiring Quaker Oats. In annual reports thereafter Pepsi would consolidate Gatorade with their beverage line. Precise figures weren’t given besides growth being described as “double digits” so we’re not able to see precisely how good of a deal it was, if it was in fact a good deal at all.
In retrospect it’s been hailed by many as a fantastic acquisition for Pepsi and perhaps one of Coca-Cola’s larger blunders. Gatorade has continued to dominate the sports drink category without any serious competitor at the moment. The deal, however, came at an exceptional price at 37 times earnings. If the Quaker Oats units were only growing at low double digits it would be difficult to justify that price. By comparison when Buffett purchased See’s Candies, which would turn out to be a huge success, the price to earnings was around 7 ($25 million for $5 million pre-tax earnings). Those are the kind of deals and risk Buffett wants to take on.
Looking at the performance of Pepsi and Coca-Cola over the previous 10 years, Coke appears to have edged out Pepsi in the critical financial metrics. Pepsi’s EPS growth was 11.72% over the period and free cash flow was 7.15% Coke’s respective figures were 11.77% and 9.13%. Pepsi’s EPS growth also hides something else; leverage. During the period Pepsi levered up, bringing their debt to equity ratio up to 64% while Coco-Cola stayed below 30%. Leverage can amplify earnings and though these two businesses are fairly solid Coke is better positioned to handle any downturn in sales.
Was this a deal Buffett should've made? I think not and I imagine Buffett hasn’t changed his stance. Coca-Cola has thrived internationally and that explains the bulk of their recent success. The company continues have success selling its bread and butter product and it doesn’t need to take any gambles on new soft drinks just yet.
Here's an examination of the more recent Cadbury deal Buffett opposed. I'll just supplement Geoff by saying that the pizza business Kraft sold off was also quite big. It accounted for a third of the frozen pizza market with Schwann's taking the second spot with a quarter of the market. The frozen pizza business was also growing faster than the overall food business. Another reason Buffett probably hated that sale so much.
Disclosure: No holdings in Pepsi or Coca-Cola