Deliberate Practice: Coke ($KO) 1988 analysis
The first thing that jumps out at you when reading the annual report is just how good the qualitative is. Admittedly, I read almost exclusively annual reports of companies with market caps under $100m and that are trading for under book value…. but I’ve never read a report like this. The entire report is filled with references to how dominant Coke is and how bright the future looks.
One of the first things that jumps out at you when reading the report is this chart
There’s clearly a ton of room to expand international. Almost every country could increase their per capita consumption by 5x and still not drink as much per capita as the U.S. does. China, the largest company in the world, barely consumes anything, and India and Russia, two other enormous countries, don’t even appear on here. True, the political situation was much different back then, but it’s not unreasonable to think that Coke would eventually gain a toe-hold in all of those countries.
And speaking of reaching U.S. per capita consumption… it doesn’t look like Coke is anywhere close to hitting their limit in the U.S. Perhaps my favorite line in the entire 10-Ks,
So Diet Coke is encountering “no limits” to growth and growing double digits every year while both Sprite and Coke grow high single digits??? Looks like that U.S. consumption metric is only headed higher! There’s also this gem
And return on equity has actually increased since the start of the decade. It’s pretty incredible when you can grow at the rapid a rate while increasing returns on equity. Granted, some of this is due to divestiture of non-core businesses, but still pretty outstanding.
Margins are also increasing as the company grows- they’ve gone from 15% in 1986 to approaching 20% in the most recent year.
Last “qualitative” thing. Looking throug the footnotes (p. 46) you can see that not only is international growing much faster than domestic, but margins are much higher too.
So I think Buffett saw all those things. And he saw a company that had committed itself to disposing of non-core businesses and only investing in areas where it had a huge competitive advantage. This left them with a huge amount of excess cash flow, and the company had shown they were content to simply return that cash flow to shareholders through dividends and share repurchases.
Remember- capital allocation is huge to Buffett. I can’t think of a single investment of his in the past 20+ years where he bought into a company that wasn’t buying back stock. Some of this is due to the fact he’s buying into huge companies w/ excess cash flows, but I think a big piece of it is he wants to buy into companies forever…. and you can’t do that if you don’t trust their capital allocation.
So let’s try to figure out how much we could pay for the company with a good margin of safety. I mentioned in the introduction to keep in mind that interest rates were much higher in the late 80s than they are now. That actually has a big effect on valuation. A company trading at a 12x P/E and distributing all of its cash flow as a dividend has an 8.33% yield. That might look awfully attractive when long term government bonds yield 2% (today)… but it’s a horrific investment when long term bonds yield almost ten percent (1988).
Well, fortunately, the company discloses what they believe their after tax cost of capital is- 12% (assuming a reasonable amount of leverage, see p. 24). As a side note, inflation was 4% back then, so this equates to about an 8% real cost of capital after taxes… which is roughly equal to the today’s real cost of capital, perhaps a bit higher. Funny how inflation can distort things!
I’m going to equate this 12% after tax cost of capital into a 15% pre-tax cost of capital. Now I’m going to do something a bit different here. Given the competitive advantages we’ve talked about so far (and their brand name!), I have zero doubt that Coke is going to be able to pass through inflation rather easily and with basically no incremental invested capital. So let’s subtract that 4% inflation rate and get an 11% real pre-tax cost of capital.
If I use this rate and apply it to Coke’s operating income of $1.6B, I can value Coke in its present form as an inflation protected bond. This would basically mean I assume Coke will never grow again, but will simply raise prices to match inflation and distribute all proceeds to shareholders. This would give me an enterprise value of $14.5B (1.6B / 11%). I then back out Coke’s debt and add up their cash and equity investments (at book value), I get $1.7 billion in net cash and a projected equity value of $16.2B. Subtract the $300m in book value of preferreds (which actually may be worth less than book, given they carry an interest rate below government bonds!) to get to a market cap of $15.9B. With 355m shares out, that’s a per share price a $44.80.
Do I think that’s a reasonable price to buy? Absolutely not. I think Coke would be an absolute steal at those prices.
Remember, that’s valuing Coke as basically an inflation protected bond. But Coke is growing faster than inflation in both its core market and its international market. In fact, it’s growing significantly faster than inflation in its international markets, and international markets carry much higher margins. So not only is it growing rapidly… it’s growing rapidly in its most profitable markets!!!!
So what value would I put on Coke?
It’s tough to say. But like Buffett says, you don’t need a scale to know a man is overweight.
And I personally don’t need a scale to know that Coke is undervalued if you can buy it at a price that discounts no real growth. Which, apparently, the market is giving you plenty of opportunity to do.
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