Let's Understand the Coca Cola Company - Part II

In part I of this article series, I’ve gone through the warm-up phase of understanding Coca Cola (KO, Financial)mainly by stepping on giants’ shoulders. Now that we have learned a little bit more this business, it is time to dive into the SEC filings and other helpful resources.

You can choose to go to Coca Cola’s website or start with the most recent annual report or Form 10K. The idea to get an understanding of what exactly does Coca sell and how does it make money.

Here is how Coca Cola(KO, Financial) describes its products on its most recent 10K.

"The Coca-Cola Company is the world’s largest beverage company. We own or license and market more than 500 non-alcoholic beverage brands, primarily sparkling beverages but also a variety of still beverages such as waters, enhanced waters, juices and juice drinks, ready-to-drink teas and coffees, and energy and sports drinks. We own and market four of the world’s top five nonalcoholic sparkling beverage brands: Coca-Cola, Diet Coke, Fanta and Sprite. Finished beverage products bearing our trademarks, sold in the United States since 1886, are now sold in more than 200 countries.

We make our branded beverage products available to consumers throughout the world through our network of Company-owned or -controlled bottling and distribution operations as well as independent bottling partners, distributors, wholesalers and retailers — the world’s largest beverage distribution system. Beverages bearing trademarks owned by or licensed to us account for 1.9 billion of the approximately 57 billion beverage servings of all types consumed worldwide every day."

The highlights were the things that I didn’t know about or less familiar with as far as Coca Cola’s products and distribution system are concerned. Before I decided to delve deeply into Coca Cola, I’ve always associated it with only the original Coca Cola, Diet Coke, Sprite and Dasani Water etcetera. I didn’t know Coke has more than 500 brands and I certainly didn’t know Coke has the world’s largest beverage distribution system, which I think is one aspect of the business that is vastly underappreciated.

Now let’s move on to Coke’s products. According to the 10K, Coke actually has two operations with different economic characteristics:

"Coca Cola markets, manufactures and sells:

Generally, finished product operations generate higher net operating revenues but lower gross profit margins than concentrate operations.

In our concentrate operations, we typically generate net operating revenues by selling concentrates and syrups to authorized bottling and canning operations (to which we typically refer as our "bottlers" or our "bottling partners"). Our bottling partners either combine the concentrates with sweeteners (depending on the product), still water and/or sparkling water, or combine the syrups with sparkling water to produce finished beverages. The finished beverages are packaged in authorized containers — such as cans and refillable and nonrefillable glass and plastic bottles — bearing our trademarks or trademarks licensed to us and are then sold to retailers directly or, in some cases, through wholesalers or other bottlers. Outside the United States, we also sell concentrates for fountain beverages to our bottling partners who are typically authorized to manufacture fountain syrups, which they sell to fountain retailers such as restaurants and convenience stores which use the fountain syrups to produce beverages for immediate consumption, or to authorized fountain wholesalers who in turn sell and distribute the fountain syrups to fountain retailers.

Our finished product operations consist primarily of our Company-owned or -controlled bottling, sales and distribution operations, including CCR. Our Company-owned or -controlled bottling, sales and distribution operations, other than CCR, are included in our Bottling Investments operating segment. CCR is included in our North America operating segment. Our finished product operations generate net operating revenues by selling sparkling beverages and a variety of still beverages, such as juices and juice drinks, energy and sports drinks, ready-to-drink teas and coffees, and certain water products, to retailers or to distributors, wholesalers and bottling partners who distribute them to retailers. In addition, in the United States, we manufacture fountain syrups and sell them to fountain retailers, such as restaurants and convenience stores who use the fountain syrups to produce beverages for immediate consumption, or to authorized fountain wholesalers or bottling partners who resell the fountain syrups to fountain retailers. In the United States, we authorize wholesalers to resell our fountain syrups through nonexclusive appointments that neither restrict us in setting the prices at which we sell fountain syrups to the wholesalers nor restrict the territories in which the wholesalers may resell in the United States."

So here we’ve learned that the concentrate and syrups business has a higher margin but lower volume whereas the finished product business has a lower margin but higher volume and mainly consists of the bottling business. I came up with the following questions once I read the above.

1. Why would Coca Cola invest in the bottling business if it is a lower-margin and capital intensive business?
2. Under what circumstances would Coca Cola own, control or take a minority interest in a bottler?
3. How has the mix of concentrate versus finished products changed over Coca Cola’s history?
4. How does the consolidation or deconsolidation of a bottler impact Coca Cola’s earnings?

If you keep reading the 10K, you will come across the following explanation of Coca Cola’s bottling investment:

"Most of our branded beverage products outside of North America are manufactured, sold and distributed by independent bottling partners. However, from time to time we acquire or take control of bottling or canning operations, often in underperforming markets where we believe we can use our resources and expertise to improve performance. Owning such a controlling interest enables us to compensate for limited local resources; help focus the bottler’s sales and marketing programs; assist in the development of the bottler’s business and information systems; and establish an appropriate capital structure for the bottler. In line with our long-term bottling strategy, we may periodically consider options for divesting or reducing our ownership interest in a Company-owned or -controlled bottler. One such option is to combine our interest in a particular bottler with the interests of others to form strategic business alliances. Another option is to sell our interest in a bottling operation to one of our other bottling partners in which we have an equity method investment. In both of these situations, our Company continues to participate in the bottler’s results of operations through our share of the strategic business alliance’s or equity method investee’s earnings or losses.

In addition, from time to time we make equity investments representing noncontrolling interests in selected bottling operations with the intention of maximizing the strength and efficiency of the Coca-Cola system’s production, marketing, sales and distribution capabilities around the world. These investments are intended to result in increases in unit case volume, net revenues and profits at the bottler level, which in turn generate increased concentrate sales for our Company’s concentrate and syrup business. When this occurs, both we and our bottling partners benefit from long-term growth in volume, improved cash flows and increased shareowner value. In cases where our investments in bottlers represent noncontrolling interests, our intention is to provide expertise and resources to strengthen those businesses. When our equity investment provides us with the ability to exercise significant influence over the investee bottler’s operating and financial policies, we account for the investment under the equity method, and we sometimes refer to such a bottler as an “equity method investee bottler” or “equity method investee.”

If you really want to understand the bottling business, which I think every KO’s shareholder should, you must read Coca Cola’s earlier annual reports such as the 1996-1999 annual reports. For instance, in 1996’s annual reports, Coca Cola’s legendary Chairman and CEO Roberto Guizueta wrote the following in his letter to shareholders:

"We took numerous steps to further strengthen our world-wide bottling system, including creation of our newest anchor bottler, Coca-Cola Erfrischungsgetranke AG, in Germany. And we continued investing strategically to assist various bottlers with improvements in their operation. When the opportunity presents itself, we invest to facilitate such improvements, then sell our stake at a later date – resulting in a more efficient bottling system, stronger partnership and increased value for our share owners. You will see this process continuing, for it is an essential element in how we run the business to meet our long-range goals. It provides the Company with yet another value stream from the gains on the sale of these investments."

Furthermore, in MD&A section of the 1996 annual reports, I found more helpful discussions on the bottling operations:

"The level of our investment generally depends on the bottler’s capital structure and its available resources at the time of our investment. In certain situations, it can be advantageous to acquire a controlling interest in a bottling operation. Although not our primary long-term business strategy, owning a controlling interest allows us to compensate for limited local resources or facilitate improvements in customer relationships while building or restructuring the bottling operations. Bottling businesses typically generate lower margins on revenue than our concentrate business. However, the acquisition and consolidation of a bottler increases revenues and generally increases operating profits on a per-gallon basis. By providing capital and marketing expertise to newly acquired bottlers, we intend to strengthen our bottling territories."

Let us walk through an example to understand how Coca Cola thinks about the bottling operation. Back in 2010, Coca Cola acquired its biggest North America Bottler Coca-Cola Enterprise (CCE, Financial)’s North America business in a massive $12 billion deal.

Remember Coca Cola has business relationships with 3 types of bottlers. (1) Independently owned, in which Coca Cola has no ownership interests; (2) bottlers in which Coca Cola has a non-controlling interest and (3) bottlers in which Coca Cola has a controlling interests. Before the CCE acquisition, roughly 30-35% of the bottlers are independent and 45-50% are bottlers in which Coca Cola has non-controlling interests in. Only 15-20% were consolidated by Coca Cola historically. The relationship between Coca Cola and its bottlers is symbiotic. If Coca Cola is doing great maintaining the brand and operant conditioning, bottlers will benefit from more volume, sales and earnings. If bottlers are doing well, Coca Cola will sell more syrups and concentrates so Coca Cola has incentives to help the bottlers to do well.

My analysis shows there are a few reasons why Coca Cola bought CCE’s North America Business:

There are a few reasons why Coca Cola acquired CCE in 2010.

(1). Before the CCE acquisition, US per capita consumption has dropped from 426 in 2002 to 393 in 2010. This created a situation in which Coca Cola can buy the underperforming CCE, invest in CCE and improve its performance, which will benefit both CCE and Coca Cola.

(2). CCE took a huge write down in intangible assets in 2008, which had the effect of boosting the leverage ratio significantly, which in turn put some pressure on the financial flexibility of CCE. Since Coca Cola is in much better financial shape, it makes sense for Coca Cola to take the majority of the debt over.

(3). CCE’s stock was attractive at about 0.8 times sales so this acquisition was likely to result in a sizable gain for Coca Cola when it sells CCE in the future.

With the acquisition of CCE North America, Coca Cola’s revenue increased dramatically but at the same time margins and return on invested capital also declined. Interested readers can take a look at the pre-2010 and post-2010 financial numbers to see how Coca Cola’s profitability and capital structure changed.

Remember before the acquisition, both per capita consumption and unit case had been declining for 3 consecutive years in North America. Now we are in the 5th year post - acquisition, unit case volume has seen 4 consecutive years of growth and servings per capita has increased to 403 from the 393 level in 2010. While CCE North America is still consolidated by Coca Cola, it is foreseeable that someday Coca Cola will sell its majority ownership in it, which will again change Coca Cola’s profitability ratio and capital structure in a meaningful way considering the size of CCE.

Overall, the CCE acquisition illustrates the following aforementioned points:

"However, from time to time we acquire or take control of bottling or canning operations, often in underperforming markets where we believe we can use our resources and expertise to improve performance. Owning such a controlling interest enables us to compensate for limited local resources; help focus the bottler’s sales and marketing programs; assist in the development of the bottler’s business and information systems; and establish an appropriate capital structure for the bottler

When the opportunity presents itself, we invest to facilitate such improvements, then sell our stake at a later date – resulting in a more efficient bottling system, stronger partnership and increased value for our share owners. You will see this process continuing, for it is an essential element in how we run the business to meet our long-range goals. It provides the Company with yet another value stream from the gains on the sale of these investments."

Now it’s time for me to pause and let the readers digest. We will discover more about the Coca-Cola Company (KO, Financial) in the next part of the article series.