In the fall of 1988, Roberto Goizueta and Donald Keough, the chairman and president, respectively, of Coca-Cola, noticed that someone was buying large numbers of shares in the company. As it later turned out, that man was Warren Buffett. The stock had fallen about 25 percent from its pre-1987 Black Monday crash high, and Buffett was accumulating what he could. By spring of 1989, Buffett had acquired approximately seven percent of the company, at an average price of around $42 per share.1 The joke was that this was for Buffett, a huge fan of Cherry Coke, the ultimate example of putting one’s money where one’s mouth was.
To a potential investor in 1988, Coca-Cola would have been a familiar name. It was a company with a fascinating history that had some notable recent developments. Originating in the 1880s as a patented medicine drink, the company had become a national icon by the 1940s. Coca-Cola was listed as a public company on the stock exchange in 1919 and by the 1980s was a well-entrenched international company. According to Coca-Cola’s 1985 annual report, 62 percent of soft drink sales by volume were sold outside of the United States that year.
The 1970s and 1980s were also the decades when Coca-Cola fought the most striking part of the “Cola-Wars” with Pepsi. In 1975, Pepsi introduced the “Pepsi Challenge,” in which it carried out blind taste tests between Coca-Cola and Pepsi-Cola at malls across the United States. Leveraging on the preference in such tests for more sugary drinks, Pepsi continuously came out ahead in the challenge with the majority of participants. By the 1980s, this advertising victory had tarnished Coca-Cola’s image and had also led Pepsi to gain market share from Coke. The battle culminated in 1985 with the introduction of “New Coke”—a fairly radical reformulation of the original Coca-Cola that outperformed both Coke and Pepsi in blind taste tests. A likely reason was that New Coke was much sweeter than its predecessor; this, however, was ironic, as Coke had previously campaigned to differentiate its product as being less sweet than Pepsi. While the early acceptance of New Coke was fair, a large minority of very vocal customers quickly began to demand the return of the Old Coke. In a case that has become a standard lesson in marketing textbooks today, the ingrained image of Old Coke was so strong that—regardless of the taste of the New Coke in blind taste tests—there was an undeniable demand for a return of the original product. By July 10, 1985, Old Coke—rebranded as “Coca-Cola Classic”—was back on store shelves. By December 1985, it was said that Coca-Cola Classic was outselling both New Coke and Pepsi. Public opinion seemed to be that while the introduction of New Coke was clearly a marketing misstep, Coke’s brand was strong enough to carry it through.2
Figure 14.1.
This was the context of the company when Buffett invested in it in 1988. Two other facts would likely have been relevant to an investor at the time: In 1982, Coca-Cola had introduced Diet Coke, and in 1985, it had introduced Cherry Coke. Diet Coke was certainly a product that had been developing into its own powerhouse by 1988.
Of the public documents available to investors at the time, the most informative would have been the 1987 annual report, the latest full year report for someone looking at the company in 1988. On page six, Roberto Goizuetta, chairman and CEO, contends that the primary business of Coca-Cola was sales of soft drinks, which accounted for 95 percent of operating income. The structure of the overall business of Coca-Cola at the time is summarized in table 14.1.
Table 14.1.
Overview of operating segments
| Segment |
Revenues |
% total revenue |
Operating margin |
Comments |
| Soft drinks |
$6229m |
82% |
23.0% |
Coke, Diet Coke, Cherry Coke |
| Foods |
$1414m |
18% |
7.3% |
Minute Maid juices |
| Equity investments |
Not consolidated |
N/A |
N/A |
Stakes in bottling subsidiaries and Columbia Pictures |
| Total |
$7658m |
100% |
17.8% |
Figures include SG&A costs |
Source: The figures were assembled from assorted financial information from the Coca-Cola Company’s 1987 Annual Report.
As we can see, the vast bulk of Coca-Cola’s operating profitability comes from the soft drinks division. Potential investors in the company would likely have focused their analysis on this division.
Starting on page eight of the annual report, management describes its core soft drinks business as a business where Coca-Cola focuses on (1) selling soft drink syrups and concentrates to bottlers and fountain customers and (2) building a brand under the Coca-Cola franchise that facilitates the purchase of end-consumers. Management also gives clear operating metrics for 1987: six percent growth in volume overall. Given that the segmental revenue growth in soft drinks was 10 percent,3 we can infer that there was also an average price increase of four percent in 1987. A business that is able to achieve both increased unit sales and higher prices has wonderful business economics, and it is not surprising that Coca-Cola’s soft drinks division achieved a 21 percent increase in operating income in 1987, as reported in the same discussion.
In addition to information showing Coke’s ability to sell more and at higher prices, the management team provides a breakdown of volume developments on a country-by-country basis (see figure 14.2 for information from page eight of the 1987 annual report).
Figure 14.2.
Worldwide consumption of Coca-Cola.
This figure alone would have made it easy for the potential investor at the time to understand the significant growth of Coca-Cola’s international markets. The inference is clear: People outside of the United States in 1987 consumed significantly less Coke compared to their U.S. counterparts, and there was huge scope for further increases. This is evidenced by the numbers, which show double-digit volume increases in many of the countries with lower absolute consumption of Coke—Spain, Japan, Brazil, and China. The potential of these markets would not have been lost on the astute investor of the time.
In table 14.2, I show the numbers for the soft drinks division between 1985 and 19874 and modeled what those numbers would have looked like between 1987 and 1990 if one assumes that the domestic and international revenue growth between 1985 and 1987 continued to 1990. Note that I am modeling no margin increase from the 1987 level. I believe these projections to be very conservative because any such business with a distribution network and ability to raise prices has inherent scales that would lead to higher margins with higher volumes.
Table 14.2.
Numbers for the soft drinks division (1985–1987)
Source: Based on information presented in appendices of the Coca-Cola Company’s 1987 Annual Report.
As one can see, even without the benefit of higher margins, which should have been the case, the core soft drinks business of Coca-Cola, would have grown EBIT by about 20 percent per annum over the next few years due to the growth of the international business, which was already the dominant business and growing at greater than 20 percent based on revenue and EBIT. Without going into detail about the financials (which I will do later in this chapter) it should have been very clear to an investor at the time that Coca-Cola was a superb business with strong tailwinds.
The management rounds out the discussion of the core soft drinks business by discussing the mostly positive operating developments in countries across the world: some restructuring in Germany, strong organic growth in Japan, the Philippines, and Brazil. They also mention that continued consolidation of bottlers has been driving efficiency gains in distribution. All of this is positive, but would likely have seemed like the icing on the cake: nice, but only reinforcing the conclusion that Coke was a superior business.
Although the financial significance of the soft drinks division to the overall Coca-Cola business is clear, management presents a less-detaled picture when discussing the other two business divisions—foods and equity investments. For foods, a potential investor finds out that the business is involved primarily with the marketing and production of fruit juices under the brand name Minute Maid. Specifically, the business has historically focused on selling frozen concentrate but is now undergoing a restructuring aimed at redirecting the business toward selling chilled (refrigerated) orange juice. Management notes that although Minute Maid is the market leader in the frozen concentrate segment, it places second in the chilled category, which is the faster-growing segment for American consumers. As such, management is investing significant resources in realigning the business and supporting the launch of new products. Financially, while revenues in the business division grew seven percent from $1.32 billion to $1.41 billion, operating income decreased from $120 million to $67 million. Adjusting for provisions related to restructuring of the division of $36 million, the operating earnings figure is less negative but still would have shown a $17 million decrease. All in all, this division seemed to be performing poorly, but the management strategy for turning it around appears quite sensible.
The last division, equity investments, is an aggregation of stakes in businesses where Coca-Cola is the minority owner. Foremost this included Coca-Cola’s 49 percent ownership stakes in its primary bottling partners—Coca-Cola Enterprises (CCE) in the United States and T.C.C. Beverages in Canada. It also included lesser stakes in bottling partners—Coca-Cola Bottling Co., Johnston Coca-Cola Bottling Group, and New York Coca-Cola Bottling Company, as well as those of several overseas bottlers. In addition to stakes in bottling companies, Coca-Cola also had a 49 percent stake in Columbia Pictures Entertainment. Columbia Pictures Entertainment resulted from the merger in September 1987 between Columbia Pictures, a company 100 percent owned by Coca-Cola since 1982, and Tri-Star, which was partly owned by Coca-Cola. The company already at that time was one of the major motion picture studios and also owned a chain of 300 theatres. While all these companies were unconsolidated subsidiaries, meaning that their financial figures were not in the revenue and income attributed to Coca-Cola, they were clearly large successful businesses with value.
Before turning to the detailed financials of Coca-Cola, I want to discuss briefly how the management team at Coke might have looked to a potential investor at the time. Roberto Goizueta had been CEO and chairman of Coca-Cola since 1980, and Donald Keough had been COO and president since 1981. Thus, in early 1988, Coke had a management team that was clearly proven and one with a fantastic financial history, even if the news flow during their tenure was not always positive. It is clear from financial reports between 1985 and 1987 that the management team focused intensely on shareholder returns and key operating metrics. The three metrics that they discuss specifically in their overall assessment of their own performance, for instance, make it clear that they care about returns on capital for shareholders and in tangible cash terms (see figure 14.3).
Figure 14.3.
Key financial indicators.
Turning to the 1987 financial statements of the company, the 10-year selected financial data on pages 34 and 35 of the annual report shows that Coca-Cola had grown revenues in each of its last 10 years with only one exception (1982). On the operating income line, there again was growth all but one year (1984). On the earnings per share front, there is a perfect record of increased EPS in each of the last 10 years. These financials are reminiscent of those of the American Express investment, and to any analyst of the day they should have been clear signs of an extremely consistent company. The actual figures show that between 1977 and 1987 Coca-Cola averaged 12 percent per annum growth both in revenues and EPS. This is without considering developments in minority stakes or any disbursements of spin-offs in the interim.
Zooming in on the financial year 1987, the fact that Coca-Cola overall had a 10 percent revenue and 12 percent operating income5 growth year-over-year is hardly surprising given the performance of each individual division, as discussed previously. What is important, however, is the analysis of the compounding ability of the business in terms of returns on capital employed. At year-end 1987, looking at the balance sheet, Coca-Cola has tangible capital base as follows:
Table 14.3.
| Category |
Amount in $ |
As a % of revenues |
| PPE |
$1598m |
20.9% |
| Inventories |
$777m |
10.1% |
| Accounts receivables |
$672m |
8.8% |
| Accounts payables |
−$1430m |
−18.7% |
| Total capital employed (TCE) |
$1617m |
21.1% |
The NOPAT calculation is as follows:
Table 14.4.
| Operating income* (EBITA) |
$1360m |
| Adjustment for tax** (34% rate) |
−$462m |
| NOPAT |
$898m |
*Given the limited amount of amortization, I have taken Coca-Cola’s reported operating income as EBITA, once again adjusted for exceptional items.
**In October 1986 the Tax Reform Act of 1986 (TRA86) was passed, lowering the top corporate tax rate from 46% to 34%. 1987 was a transition year, and a potential investor would have known to expect a 34% top tax rate going into 1988.
Based on these figures, the ROTCE is 55.5 percent. This is significantly higher than 20 percent, which is my personal internal benchmark for a high ROTCE business. It shows that Coca-Cola is able to run both a capital light business and one that is very profitable in relation to its capital intensity. Coke is clearly benefiting from not having to consolidate the capital requirements of its bottlers. From an internal compounding perspective, Coca-Cola compounds very well with its greater than 10 percent growth and high ROTCE. As a potential investor, I would have known that Coke was a great fundamental business from the prior analysis, but the numbers here would have shown me that Coke is truly one of the amazing businesses.
Finally, one must look at the valuation a potential investor would have seen at the time. Coca-Cola reported the 52-week low, high, and year-end prices of its stock in its annual report. In 1987 the low was $29, the high was $53.13, and the year-end price was $38.13. Assuming that in early 1988 the price was still roughly around the range of the year-end, a potential investor would have seen Coca-Cola stock priced at roughly $40 per share. In fact, although an investor at the time would not have read Buffett’s 1988 end of year shareholder’s letter, the share price figures just referenced are consistent with the cost basis for the Coca-Cola stock that Buffett paid in 1988. As detailed in his letter, the share price he paid was $41.8.6
Given the other information detailed in the annual report, the calculation of enterprise value (EV) would be as follows:
Table 14.5.
Calculation of enterprise value
| Share price |
$40.00 |
| Number of shares outstanding* |
375 million |
| Market capitalization |
$15,000 million |
| Net financial debt** |
$1,237 million |
| EV |
$16,237 million |
*At year-end 1987 372m shares were reported outstanding; 5.6m further share options were outstanding. As exercise prices were reported only in a range between $10 and $45, I have assumed 3m shares should be counted.
**Net financial debt was calculated based on $1,685m current loans, debts, $213m current portion of LT debt, $803m LT debt, cash balance of $1,017m, marketable securities of $451m, and pension liabilities of $4m.
As previously calculated in the discussion on financial performance, the EBITA adjusted for exceptional items was $1,360 million. Looking at EV/EBITA one sees the following:
Table 14.6.
EV/EBITA multiple
| EV/EBITA |
1987 |
| EBITA |
$1,360 million |
| EBIT margin |
17.8% |
| EV/EBITA |
11.9× |
Based on the 1987 EV/EBITA figures, Coca-Cola was trading at an 11.9× EV/EBITA. This is clearly a high number. But in assessing this multiple, no value is attributed to the several unconsolidated businesses. Let me try to address this issue now.
Ideally, for the value of unconsolidated businesses—especially when some of them are listed entities—one takes a sum-of-the-parts valuation based on market values for those unconsolidated entities. Because those numbers are not readily available, I will consider their balance sheet values as attributed to by Coca-Cola—fully knowing that these values likely understate the true value of the unconsolidated entities.7 As evidence of this, note that in the 1987 annual report under note three of the Notes to Consolidated Financial Statements, in the discussion of the partial flotation of T.C.C. there was an accounting gain made when Coca-Cola revalued the business from the historical cost basis to the market price.
Based on the balance sheet values, the unconsolidated entities have a value of $2,548 million. If one adjusts the EV taking this value into consideration, the EV drops to $13,689 million. The adjusted EV/EBITA multiple is then:
Table 14.7.
Adjusted EV/EBITA multiple
| EV/EBITA |
1987 adj. |
| EBITA |
$1,360m |
| EBIT margin |
17.8% |
| EV/EBITA adj. |
10.1× |
The price 10.0× EV/EBITA is not dirt cheap, but it seems to be a very good price given the quality of the business. Assuming that there is even more hidden value in those nonconsolidated entities that are carried at cost basis, the adjusted EV/EBITA multiple would be even lower.
Looking at the PER multiple, I have calculated both the as-reported figures as well as an adjusted figure, subtracting the value of the unconsolidated entities from the market capitalization. The adjusted market capitalization is $12.452 billion; this leads to an adjusted share price of $33.21 based on the 375 million shares outstanding.
Table 14.8.
PER multiple
| PER |
1987 |
1987 adj. |
| Share price |
$40.00 |
$33.21 |
| EPS (adjusted) |
$2.43 |
$2.43 |
| PER |
16.5× |
13.7× |
The PER multiple is roughly consistent with the EV/EBITA multiple. It should be noted that due to the lower corporate tax rate introduced in the United States in 1988 compared to 1987, the EPS would have been expected to be higher in 1988 even if operating earnings was identical; so a potential investor, without considering any growth, would have been able to calculate a lower PER for 1988 than the 13.7×.
Still, a 13.7× PER multiple, like the 10.1× EV/EBITA multiple, is a great price only for a really great business—like Coca-Cola. A conservative investor at the time, like one today, would probably be willing to pay no more than approximately 7× EV/EBITA or 10× PER for a business that was not growing. Given this, I must conclude that Buffett does pay for growth here. There were multiple tailwinds in the core soft drinks business which seemed almost obvious: (1) international expansion on the back of higher per ounce consumption in nondeveloped markets and (2) continued efficiency gains from consolidation and increased density of distribution networks. Moreover, the growth had both a very long historical consistency as well as a clear vision for decades into the future. Still, in the end Coca-Cola seems to be a clear case where Mr. Buffett does pay what most investors would consider a very fair price for a great business.
The rest of the story about this fabled Buffett investment included Buffett investing over one billion dollars into Coca-Cola between 1988 and 1989. This represented approximately 25 percent of all of Berkshire’s market value at the time.
It is easy to look in hindsight and see the miraculously accurate and profitable investment that Buffett made in Coca-Cola. However, looking without hindsight, one other lesson I draw from this case is about sorting out the real risks from the fake risks. It was clear from all the media stories and also some data on market shares that Coke was clearly facing competition from Pepsi Cola in the 1980s. However, the historical numbers do not tell the story of a crippling competitive war. From the perspective of the Coca-Cola parent company, it seemed that the biggest part of the business was international, and overall that business and Coca-Cola as a whole were doing fabulously throughout the decade. Although one could argue that Buffett only invested in 1988 and after the episode with New Coke, the larger lesson to me seems to be that he was able to focus on the concrete data and the overall picture, which was that Coca-Cola was a great business, was very successful, and would continue to be more successful in the future.
Table 14.9.
Financial summary (1977–1987)
($ in millions except per share data)
Source: The Coca-Cola Company, 1987 Annual Report, 34–35.
Table 14.10.
Consolidated balance sheet (1986–1987)
($ in thousands)
| |
Year ended Dec. 31 |
| Assets |
1987 |
1986 |
| Current assets |
|
|
| Cash |
1,017,624 |
606,848 |
| Marketable securities, at cost (approximate market) |
450,640 |
261,785 |
| Trade accounts receivable, less allowances of $13,429 and $11,657 |
672,160 |
672,568 |
| Inventories |
776,740 |
695,437 |
| Prepaid expenses and other assets |
674,148 |
932,630 |
| Notes receivable—Columbia Pictures Entertainment, Inc. |
544,889 |
— |
| Total current assets |
4,136,201 |
3,169,268 |
| Investments and other assets |
|
|
| Investments in affiliates |
— |
— |
| Columbia Pictures Entertainment, Inc. |
989,409 |
1,436,707 |
| Coca-Cola Enterprises Inc. |
749,159 |
709,287 |
| T.C.C. Beverages Ltd. |
84,493 |
87,696 |
| Other |
435,484 |
212,194 |
| Receivables and other assets |
289,000 |
217,046 |
| Total investments and other assets |
2,547,545 |
2,662,930 |
| Property, plant, and equipment |
|
|
| Land |
112,741 |
98,842 |
| Buildings and improvements |
763,317 |
695,029 |
| Machinery and equipment |
1,488,464 |
1,390,689 |
| Containers |
275,120 |
287,672 |
| Total |
2,639,642 |
2,472,232 |
| Less allowances for depreciation |
1,041,983 |
934,679 |
| Total property, plant, and equipment |
1,597,659 |
1,537,553 |
| Goodwill and other intangible assets |
74,155 |
114,377 |
| TOTAL ASSETS |
8,355,560 |
7,484,128 |
| Liabilities and shareholders’ equity |
|
|
| Current liabilities |
|
|
| Accounts payable and accrued expenses |
1,430,193 |
1,198,407 |
| Loans and notes payable |
1,685,408 |
697,743 |
| Current maturities of long-term debt |
213,609 |
4,628 |
| Dividends payable in-kind |
335,017 |
— |
| Accrued taxes, including income taxes |
454,313 |
344,141 |
| Total current liabilities |
4,118,540 |
2,244,919 |
| Long-term debt |
803,352 |
907,676 |
| Deferred income taxes |
209,880 |
239,813 |
| Due to Columbia Pictures Entertainment, Inc. |
— |
576,741 |
| Total liabilities |
5,131,772 |
3,969,149 |
| Shareholders’ equity |
|
|
| Preferred stock, $1 par value—authorized: 100,000,000 shares; no shares issued and outstanding |
— |
— |
| Common stock, $1 par value—authorized: 700,000,000 shares; issued: 415,977,479 shares in 1987 and 414,491,987 shares in 1986 |
415,977 |
414,492 |
| Capital surplus |
338,594 |
299,345 |
| Reinvested earnings |
3,783,625 |
3,624,046 |
| Foreign currency translation adjustment |
−5,047 |
−118,087 |
| Total |
4,533,149 |
4,219,796 |
| Less treasury stock, at cost (43,621,336 shares in 1987; 29,481,220 shares in 1986) |
1,309,261 |
704,817 |
| Total shareholders’ equity |
3,223,888 |
3,514,979 |
Source: The Coca-Cola Company, 1987 Annual Report, 36–37.
Table 14.11.
Income statement (1985–1987)
($ in thousands except per share data)
| Year ended Dec. 31 |
1987 |
1986 |
1985 |
| Net operating revenues |
7,658,341 |
6,976,558 |
5,879,160 |
| Cost of goods |
3,633,159 |
3,453,891 |
2,909,496 |
| Gross profit |
4,025,182 |
3,522,667 |
2,969,664 |
| Selling, administrative, and general expenses |
2,665,022 |
2,445,602 |
2,162,991 |
| Provisions for restructured operations and disinvestments |
36,370 |
180,000 |
— |
| Operating income |
1,323,790 |
897,065 |
806,673 |
| Interest income |
207,164 |
139,348 |
144,648 |
| Interest expense |
279,012 |
196,778 |
189,808 |
| Equity income |
118,533 |
155,804 |
164,385 |
| Other income, net |
34 |
33,014 |
66,524 |
| Gain on sale of stock by former subsidiaries |
39,654 |
375,000 |
— |
| Income from continuing operations before income taxes |
1,410,163 |
1,403,453 |
992,422 |
| Income taxes |
494,027 |
469,106 |
314,856 |
| Income from continuing operations |
916,136 |
934,347 |
677,566 |
| Income from discontinued operations (net of applicable income taxes of $7,870) |
— |
— |
9,000 |
| Gain on disposal of discontinued operations (net of applicable income taxes of $20,252) |
— |
— |
35,733 |
| NET INCOME |
916,136 |
934,347 |
722,299 |
| Per share |
|
|
|
| Continuing operations |
2.43 |
2.42 |
1.72 |
| Discontinued operations |
— |
— |
0.12 |
| Net income |
2.43 |
2.42 |
1.84 |
| Average shares outstanding |
377,372 |
386,831 |
393,354 |
Source: The Coca-Cola Company, 1987 Annual Report, 38.
