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Revisiting Buffett - Coca-Cola in 1988

January 19, 2013 | About:
The Science of Hitting

The Science of Hitting

234 followers
Warren Buffett, via Berkshire Hathaway, initiated a 6.3% stake in Coca-Cola (KO) in late 1988 and early 1989 (this would be increased in 1994 to 7.8%, and grew over the years to its current level – about 8.8% due to share repurchases). Buffett would later tell Forbes magazine that a key reason for building the stake was that the stock, at the time, didn’t reflect the all but guaranteed growth that was set to occur in the company’s international business over the coming decades. We’ve seen this play out over that time period (the per capita consumption figures presented each year in the company’s annual report is a thing of beauty and one with plenty of legs in the coming years), but rarely hear about the original investment; this article will focus on the valuation of Coca-Cola common stock when Berkshire Hathaway made its original purchases, using the 1988 annual report and other public information available at that time.

In the ten years to year end 1988, here are the operating results for the Coca-Cola Company:



Year 1979 1980 1981 1982 1983
Revenue $3.895B $4.640B $4.836B $4.760B $5.056B
EBIT $644M $680M $720M $773M $828M
EBIT Margin 16.5% 14.7% 14.9% 16.2% 16.4%
Net Income $420M $422M $482M $512M $559M
Net Margin 10.8% 9.1% 10.0% 10.8% 11.1%
Shares Out 372M 372M 372M 390M 408M
Diluted EPS $1.13 $1.14 $1.30 $1.31 $1.37
ROA 16.3% 14.4% 14.8% 13.5% 12.8%
ROE 23.0% 21.1% 22.2% 20.3% 19.6%






Year


1984


1985


1986


1987


1988
Revenue $5.442B $5.879B $6.977B $7.658B $8.338B
EBIT $849M $807M $897M $1.324B $1.598B
EBIT Margin 15.6% 13.7% 12.9% 17.3% 19.2%
Net Income $629M $722M $934M $916M $1.038B
Net Margin 11.6% 12.3% 13.4% 12.0% 12.4%
Shares Out 396M 393M 387M 377M 365M
Diluted EPS $1.59 $1.84 $2.41 $2.43 $2.84
ROA 12.9% 12.5% 13.3% 11.3% 12.9%
ROE 22.2% 25.3% 29.1% 27.5% 33.3%


It’s quick to see what piqued Buffett’s interest. KO generates a sustainable and attractive mid-teens return on assets, in addition to a solid 25% to 30% return on equity with limited use of leverage (ROE was below 20% - and just barely - in only two of the fifteen years up to 1988; even while paying sizable dividends to shareholders, the company successfully reinvested in the business – resulting in earnings per share growth north of 11% in the period presented. Along with the operating figures, we have the following balance sheet data for year-end 1988:



Cash & Equivalents $1.23B
Total Debt $760M
Total Assets $7.45B
Total Capital $5.47B
Common Shareholder Equity $3.05B


As we start to think about the company’s competitive position, the ROA data from above is a good starting point. Here are some key statements from the 1988 annual report (namely the shareholders letter, written by CEO Roberto Goizueta and COO Don Keough) that provide some insight into the company’s standing in the industry and what they see for the years ahead:

“In 1988, more than 200 billion servings of our soft drinks were sold worldwide. No other company sold even half as much.”

“On a competitive basis, our position as the world's only truly global soft drink company grew stronger. Our market share of the world's flavored, carbonated soft drink sales, excluding China and the Soviet Union, climbed to nearly 45% - an all-time high - reflecting the talent, diligence and dedication of our Company associates and the people of our worldwide system.”

“On a per-share basis in 1988, our aggressive share repurchase program heightened profit growth for the individual shareholder, as net income per common share climbed 17 percent to $2.85. We are planning for continued growth in your equity.”

“Across the world, the news media cover and report the introduction of a new taste for Coke, and then the birth of Coca-Cola classic, not as business stories, but as stories of social significance. Insert any other trademark, and these stories lose their credibility. In the context of Coca-Cola, however, they are unsurprisingly familiar. Everyone knows people who are this passionate about Coca-Cola. These stories, however, are merely examples of a broader, worldwide reality that can easily be taken for granted: Coca-Cola has become such a pervasive component of the environment that its absence can be far more noteworthy than its presence.”

“Perhaps the most direct measurement of the emotional attachment between Coca-Cola and its consumers is to be found in three independent worldwide surveys conducted in 1988 by Landor & Associates. The surveys went well beyond confirming Coca-Cola as the best known and most admired trademark in the world. They quantified the huge gap between Coca-Cola and all other brands: the point spread between Coca-Cola and the second place trademark was greater than the spread between that runner-up and the l0th-ranked trademark. As a national business magazine noted in reporting the U.S. results, ‘Coca-Cola is so powerful it's practically off the charts’

“Our worldwide system is not a proposal or a promise. It is real, the model to which our competitors can only aspire… And through aggressive, thoughtful investment, it is continuously expanding its ability to place our soft drinks within "an arm's reach of desire'.' In Japan last year, for example, the system added 26,000 new vending machines to the more than 700,000 already in place; in the United States, it added more than 100,000. The system expanded in the Middle East, adding six countries and 16 million consumers.”

Soft drinks are the fastest- growing beverage in the world, easily outpacing wine, beer, tea, milk and even tap water. We take responsibility for continuing this growth.”

“Evaluated from any perspective and in any locale, The Coca-Cola Company is accelerating, growing profitably, building on the assets, and the advantages, that we alone possess.

In many international markets, low per capita consumption rates for soft drinks offer obvious opportunity that is reinforced by demographic trends, economic development and the expanding reach of the mass media. Last year, international per capita consumption of Company products grew 5 percent to more than 51 drinks per year.”

For the sake of comparison, per capita consumption of Coca-Cola products in the U.S. was 289 in 1988.

Every quote cited above came from the first 10 to 15 pages of the 1988 annual report. In those few sentences, we find something quite desirable: a company focused on its core business (Columbia Pictures was sold in 1987), one in which it has a commanding lead and with plenty of opportunity for continued global expansion (international share was even higher than global share, at 47%) that is centered on selling a product that is the most admired trademark in the world (the “New Coke” fiasco of 1985 made this quite clear); in addition, the company is focused on “aggressively” repurchasing common stock, a move that will increase owner’s stake in a great business with time – and hopefully avoid value destroying “deworsification.”

Even with all this, the price still needs to be right for attractive returns; here was the share price and market capitalization at year end, in the five years ending Dec. 31, 1988:



Year Average Shares Year End Price Market Cap
1984 396M $20.80 $8.2B
1985 393M $28.15 $11.1B
1986 387M $37.75 $14.6B
1987 377M $38.10 $14.4B
1988 365M $44.60 $16.3B


To put these numbers into content, 10 year average ROA was 13.5%. Using year-end 1988 figures, we come up with the following estimate as a proxy for sustainable earnings power:



Metric 10-Yr Average Current Earnings Power
ROA 13.5% $7.45B Roughly $1B


KO had a safe and attractive dividend (doubled in the previous decade, to $1.20 per share – or a 2.7% yield at year-end 1988) and a solidly profitable and growing business - one in which it had a commanding lead and plenty of opportunities for international growth. When plugged into a reverse DCF model (with a discount rate of 10%), the valuation at 1/1/1989 implies growth of 3% in perpetuity – as noted by Buffett, this back of the envelope math suggests the market was essentially disregarding the global growth opportunities for Coca-Cola.

Deeper analysis (which I intend to do and publish) over this time period may shed led on expecting mean reversion in ROA to the mid-teens figure we see in the years prior to 1983 (and as we see now, in the years after 1989/1990) - an adjustment that yields marginally higher growth figures to those presented even at a discount rate of 12-15%. With worldwide volumes increasing at a rate of 7% in 1988, the disconnect begins to become apparent.

CONCLUSION

Warren and Charlie concluded that this was grossly pessimistic, and made a big bet that the company would capitalize upon this opportunity with time: the company’s trademarks and its system were two unique and invaluable assets that would time and again all but assure success in new regions. Looking back, with 20/20 vision, we can see that this has played out nicely for KO: per capita consumption across the globe has more than doubled since 1988, and the company is still a dominant leader in the industry; in addition, India and China recently (2011) reported per capita consumption figures of 12 and 38, respectively - suggesting that there is still plenty of work to do for the boys in Atlanta.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.1/5 (26 votes)

Comments

coryashpt
Coryashpt premium member - 1 year ago
The only large company today that I think could replicate this kind of scenario would be Google. The question with Google is will it ever trade at a level that would give an investor a margin of safety?
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Coryashpt,

I wouldn't count it out - GOOG has been quite volatile in the past, and I wouldn't be surprised if that continues (such wide swings in sentiment among tech firms in general, in my view). Thanks for the comment!

traderatwork
Traderatwork - 1 year ago
Hi TSOH,

Thanks for the article. IMHO, in 1986 KO PE is< 16 (15.66 from 37.75/2.41), according to the original Graham Formula (8.5 + 2r) , that's like expect KO to grow 3.58% for the next 7 to 10 years which is way too low. As we can tell from the past 7 years (1979 - 1986) KO been growing their EPS almost 11.43% (Annual Compound Rate)

Now the question become simpler, what is the chances that KO will grow higher than 3.58% every year for the next 10 years. If the conviction is high that the growth rate is too low then invest in Coca-Cola. I think that's the reason Buffett never need DCF because Ben Graham already create the E=MC^2 of investing. It's the same story he mentioned Aesop's "a bird in hand worth two birds in the bushes" story, the question is how long? and how sure? (that such that we are willing to give up the bird/cash in our hand).

My 2 cents.
Koheleth
Koheleth - 1 year ago
Thanks for writing this up.

I wonder how much of Buffett/Munger's decision to invest in Coke was a 'qualitative' versus a quantitative decision. No doubt about the growth figures but there was no apparent MOS in terms of price, not a Graham type discount at least.

And given his initial prices he paid, where is the day-one 15% return on his investment per Alice Schroeder, who said Buffett always wanted that in all his investments?

But Buffett and Munger have said Coke had "pricing power" and "unit growth". That plus the buybacks must have made it compelling. The margin of safety then was in the brand of the company, the share in people's minds, so it was worth paying a full price, since as Munger said in a BBC interview "it was plainly evident what was going to happen" (I presume he is referring to the international growth).

I enjoy reading your articles and look forward to more.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Traderatwork,

Very similar to what my math shows; thanks for taking the time to comment!

Koheleth,

My math suggests that for the 15% day one return, the implied growth rate is somewhere in the mid-teens (this assumes normalized ROA a bit higher than in the few years leading to 1988, but inline with longer term numbers - I plan on addressing in a future article); when you consider the two key factors - as you mentioned, pricing power and unit growth - I think it quickly becomes apparent that the margin of safety was sufficient at the market prices in mid-late 1988. Add in the fact that the management duo of Keough and Goizueta already had a solid track record by this point and were dedicated to per share value creation, and I think it makes KO start to look like a no brainer (of course, easier to say to say in 2013 than it was in 1988).

Thanks for the comment and the kind words!

jayb718
Jayb718 - 1 year ago
Interesting piece. I enjoyed how KO really laid out what it's durable competitive advantages were in it's annual report. Plain english in annual reports is so refreshing.

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Jayb718,

Same here - thanks for the comment!

toto-san
Toto-san - 1 year ago
Great article and an excellent subject, thank you! Let me question your math though. 10 year Treasuries in 1988 were a bit over 9% + long term of ~ 6% equity premium gets you to 15% discount rate (at least). Using Earning as a Proxy for Cashflows I could get to about 9% implied growth rate g (using 44.6=2.84/(15%-g)), not 3%.

Using Graham's modified formula for interest rates, according to my calculations, gives 13% for implied growth rate http://en.wikipedia.org/wiki/Benjamin_Graham_formula


?

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Toto-san,

As I noted in the article, that 3% figure is assuming a 10% discount rate; as mentioned in the next paragraph, when this figure gets up to the 12-15% area (6% certainly is a hefty ERP), the implied growth rate increases to 6-7%, ASSUMING a slightly expansion in ROA (a justified one - I'll address this in a future article).

Without any assumptions on the ROA front, then your figure of 9% sounds about right. To put that figure in perspective, worldwide volumes increased at a rate of 7% in 1988 - and don't forget about continuing share repurchases, common stock dividends, etc.

Thanks for the comment!

cinderblue
Cinderblue - 1 year ago
Thank you for starting a dialogue on this topic. The quotes directly from the annual report provide valuable insight into their durable competitive advantage. I'm really surprised there isn't more information out there on such a historic event. I really look forward to your follow-up article.

Keep up the great work!
acaciom
Acaciom - 11 months ago
Great article, very concise and interesting.

Where I can get those past annual reports? I am collecting a bunch of pdf's (Enron, Lehamn, Webvan S-1...) to study shorts. But hey, I don't want to be a net-short :)

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