What Coke Says About Pepsi
03/01/2010 3:46 pm EST
Gee, I really hate this deal.
It’s not just that I question the price that Coca-Cola Co (NYSE: KO) is paying to acquire the North American operations of its biggest bottler, Coca-Cola Enterprises Inc (NYSE: CCE). The $12.7 billion price works out to about the same multiple that PepsiCo (NYSE: PEP) paid to acquire its two biggest bottlers. After the deals both close, Coke will have control of about 90% of its North American bottling and distribution system; Pepsi will control about 80%. But while the companies are paying about the same price, PepsiCo looks like it has a much bigger opportunity to cut costs in its deal than Coke does.
It’s not that the deal takes away a major reason to own shares of Coca-Cola. Wall Street preferred Coke to Pepsi because it saw Coke as the better emerging markets play. But this deal will take Coke’s revenue from 74% overseas to 54% overseas, according to Barclays Capital.
It’s not even what the deal says about the declining market for soft drinks in North America. And the shift in power toward big box stores such as Wal-Mart (NYSE: WMT.) First, US sales volume of carbonated drinks is down across the industry, according to Beverage Digest. Sales volume fell in 2009 following a 3% decline in 2008, a 2.3% drop in 2007, and a 0.6% downturn in 2006. At the same time, the increasing market power of big box retailers has put pressure on soft drink margins and cut into the shelf space that Coke and Pepsi get for their bottled waters and the other non-carbonated drinks that they’re counting on to make up for the drop in carbonated soft drink sales volumes.
No, what really troubles me is that this deal has history, you see. And the history is one of asset shuffling and accounting razzle-dazzle. If these companies are willing to forego the financial magic that the deals brought them in 1986 and 1999, respectively, then the long-term challenges facing these companies are more serious than I thought. (For more about the implications of the current wave of deals, see this recent post.)
Coca-Cola Enterprises dates back to 1986 when Coca Cola purchased the assets of two of its biggest independent bottlers, John T. Lipton and BCI Holdings, and then combined them with some company-owned bottling assets to create the company. And then sold 51% of Coca-Cola Enterprises to the public.
The creation of Coca-Cola Enterprises had two purposes. First, it fixed a huge competitive problem for Coke. PepsiCo had always had more control over its North American bottlers than Coke had. And that diffuse network of bottlers often operated at cross-purposes with Coke and didn’t always follow Coke strategy with the kind of loyalty and efficiency that Coke would have liked. Within two years of the creation of Coca-Cola Enterprises, that company controlled about 45% of Coke’s bottling operations. Coke itself had controlled just 11% before the 1986 deals.
And second, the creation of Coca-Cola Enterprises and the sale of a majority stake to the public got a big, relatively low margin business off Coke’s books.
Coke is in the high-margin business of selling syrup concentrate. The return on the assets employed in that business is quite, ahem, sparkling. In 2009, it was 13.17%, according to Morningstar. And it is quite consistent. Return on assets (ROA) came to 13.86% in 2008, to 16.33% in 2007, and to 17.11% in 2006.
Coca-Cola Enterprises is in a business that requires the ownership of lots of bottling machines and production lines, and fleets of trucks so the company can turn that syrup into bottles of Coke and then get those bottles into stores. The return on those assets isn’t nearly as high as it is in the syrup business and it’s a lot more inconsistent to boot. In 2009, the return on assets was just 4.57%, according to Morningstar, and in 2007, it was just 3.01%. What happened to 2008 and 2006? In those years, the return on assets was negative.
By buying what would eventually be a majority of its bottlers, Coke got more control of its distribution. By then spinning off those assets to the public, Coke got those lower-returning assets off its books.
They didn’t depress Coke’s profitability because those assets belonged to another company.
At the time of the spinoff, and in the years immediately afterwards, the deal came in for lots of absolutely accurate questioning from accountants and some Wall Street analysts. Unless Coke and Coca-Cola Enterprises were indeed independent companies, the lower-returning assets should have stayed on Coke’s books. If Coca-Cola Enterprises wasn’t truly independent, the whole deal was nothing but accounting slight of hand designed to make Coke’s numbers look better.
In the years after the deal, Coke and Coca-Cola Enterprises answered some of that criticism by recruiting more outside independent directors to the Coca-Cola Enterprises board. And gradually, the accounting controversy quieted.|pagebreak|
PepsiCo resisted following Coke’s lead for years, but eventually followed suit in 1999.
But the consolidation of the majority of its bottlers in the hands of Coca-Cola Enterprises didn’t automatically align the interests of syrup maker and distributors. Coke made more money when volumes went up—even if it took price cuts and discounts to drive those increases in volume. Coca-Cola Enterprises, however, made more money if volumes increased, but only as long as prices weren’t cut too much.
In the good ole days—when carbonated drinks were the cat’s meow and Coke and Pepsi could pretty much tell retailers to jump and they’d ask “How high?”—this conflict in profit strategy between syrup maker and distributor wasn’t that important. Whatever problems the structure created were more than worth putting up with to get the benefits that came from spinning off those lower-margin assets.
The fact that both PepsiCo and Coke now see the advantages of having more control over their distribution as outweighing the cost to their profit margins from owning these distributors is a signal of how the market for soft drinks has changed.
In the case of Coke, for example, after the deal, about half of its revenue will come from the lower-margin bottling and distribution business. All of Coke’s very impressive financial numbers such as operating margin and return on invested capital (ROIC) will compress. The company won’t be nearly as profitable.
Think about what that says about how the management of Coke and of Pepsi see their businesses. They’re willing to savage their margins because unless they can get more control of their distribution system, the long-term consequences are reduced market share and slower growth.
I think I’ve been too complacent in my thinking about PepsiCo’s deals to buy its two biggest North American bottlers. Sometimes an investor can just get too caught up in what a deal means in the short term and wind up ignoring the long-term implications. I think I’m guilty of that in my recent analysis of PepsiCo, and also guilty of focusing on the short-term question of whether or not management can deliver the cost savings and profit margins it has promised.
Coke’s deal was a wakeup call to me about how big the problems are in the soft drink industry. And I’m going to take another look at PepsiCo from this new perspective.
If you’re going to do the same, one thing to keep in mind is that PepsiCo declared a dividend of 45 cents a share on February 5. It’s payable on March 31 to shareholders of record on March 5.
Full disclosure: I don’t own shares of any company mentioned in this post.