Earnings Per Share and Dividends

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1 September 2011 Coca-Cola Price: $70 Research Report by Peter Hughes, Check Capital Management Coca-Cola (KO) is the world's largest beverage company. Founded in 1886, the firm has 15 different brands with sales $4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00 Earnings Per Share and Dividends EPS Dividend/Share * Expected Results for 2011 of over $1B. Besides soft drinks like Coke, Sprite and Fanta, the company markets noncarbonated brands, including PowerAde, Minute Maid, Dasani, Evian and Vitamin- Water. KO products are sold in 200 countries worldwide and 70% of sales originate outside North America. 1.7 billion servings of the firm s products are consumed each day. Due to their vast distribution networks, well-financed marketing and stable of brands, Coca-Cola and PepsiCo have a virtual duopoly in most parts of the world. This reduces the opportunity for new competitors to emerge and helps both companies produce strong results. THE BUSINESS In a business where brand and distribution make all the difference, KO has the best in the world. Coca-Cola is frequently cited as one of the top global brands, with an estimated value of over $70B. It is very hard for potential rivals to compete with the firm s marketing machine, shelf space and customer loyalty. The New Coke fiasco in 1985 demonstrated the strength of the brand. When the firm changed its formula to one that fared better in taste tests, consumers were immediately critical and demanded that the old formula be restored. The original product returned as Coke Classic, only to quickly outsell New Coke, which was later completely withdrawn from store shelves. Few, if any, products boast such customer loyalty. Furthermore, KO has been growing its distribution system for over 100 years. Coca-Cola products can be found in many forms across the globe. It would be extremely difficult for any new company to replicate this network. As KO expands its noncarbonated portfolio, the company can quickly and easily bring new products to millions of consumers worldwide. 1 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

2 The core soda market is gradually declining in the U.S., as consumers seek healthier alternatives. To help keep its stomach share, Coca-Cola has regularly introduced healthier products, such as PowerAde, Nestea, Fruitopia, Dasani and Odwalla. Pursuing this objective has led to many acquisitions, most of them relatively small and focused on the beverage industry. In 2007 the company acquired Glaceau, maker of VitaminWater, for $4.1B. KO has expanded to 500 different brands and 3500 distinct products. There are 19 different versions of Coca-Cola, alone, including variations on flavor, calorie content and caffeine. Americans, on average, drink almost 400 servings of KO products per year. The company has been gaining share in North America and intends to reinvest these profits in higher-growth markets. Coca-Cola s biggest growth opportunities lie abroad, where burgeoning middle classes see its products as an affordable luxury. Sales in the Pacific region account for only 18% of total revenues, while much-less-populated Latin America accounts for 28%. China and India consume only 34 and 11 eight-ounce servings of KO products per capita, respectively. As the graph at right shows, this is well under half the global average and less than one-tenth the consumption in the United States. This suggests the firm still has significant growth potential and will continue to benefit from long-term demographic trends. In Q2, case volume in China grew 21%. Overall, 43% of sales go to developed markets, 37% to developing markets and 20% to emerging markets. Case Unit Sales by Region Pacific 18% Eurasia & Africa 16% Europe 16% 89 India China Global Average North America 22% Latin America 28% Annual Servings Per Capita 394 U.S. 679 Mexico Coca-Cola s recent results have been respectable. Q2 adjusted EPS grew 10% to $1.17, while worldwide volume improved 6%. Q2 net revenue rose 47% to $12.7B, but this was due mostly to the acquisition of Coca-Cola Enterprises ( CCE ). Each geographic region grew volume during the quarter. North America was the weakest area, posting growth of just 1%. Meanwhile, rising commodity costs are pressuring margins. Escalating raw-materials prices will likely set KO back $500M to $1B in The company hedges some but not all of these input costs. 2 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

3 BOTTLING ACQUISITION For many years KO granted franchises to regional bottling companies to mix, bottle, and distribute beverages using syrup concentrate from Coca-Cola. Company management could then focus on marketing and product expansion. [Advertising expense, at 8% of sales, is one of the firm s larger costs.] It also vastly reduced capital expenditures, since bottling facilities, delivery trucks and other physical assets were owned by the bottlers. KO now has 300 global bottling partners. Overseas, the strategy of partnering with local firms provides Coca-Cola strong allies in markets that might otherwise be hostile. KO often owns a minority share in these bottlers. The company recently adjusted this strategy. In 2010 KO agreed to buy for $12B the portion of its largest North American bottler (Coca-Cola Enterprises) that it didn t already own. This gives KO more power and flexibility in marketing its products in the U.S. The primary reason for the purchase was rising sales of non-carbonated brands, which are more difficult/costly for smaller bottling companies to bottle and deliver. The company hopes that acquiring CCE will not only reduce costs but guarantee quality for its juices, teas, water and sports drinks. The acquisition exposes Coca-Cola to some risks. It now operates a more capital-intensive, lower-margin business. As the adjacent graph shows, return-on-capital is being negatively impacted by debt from the acquisition. In 2011 KO s net margin is expected Financial Metrics to be 19%, 4% less than last year. 35% These changes do not mean that buying CCE was ill-advised but do 30% marginally increase the firm s risk 25% profile. Because of the acquisition, 2010 reported earnings were inflated 20% by a $5B asset write-up. This 15% accounting anomaly arises from 10% increasing the value of the 33% of the bottler that KO already owned to 5% the level of the acquisition price. 0% This noncash gain is excluded from all figures reported here. FINANCIAL METRICS Return on Capital Net Profit Margin Coca-Cola s business strengths enable it to achieve enviable financial metrics. The firm pro- Key Statistics (trailing four quarters ending 6/30/2011) Revenue Net Income EPS Net Margin Debt Cash ROC $42.2B $8.5B $ % $13.9B $13.9B 18.7% 3 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

4 duces a roughly 20% net profit margin. The return-on-capital, long near 30%, has dropped below 20% since buying CCE. Excluding the bottler acquisition, KO s results are remarkably consistent over time. $4 $3 $2 Deployment of Cash ($ Billions) Furthermore, Coca-Cola is a cash-producing machine. The firm has relatively low capital needs, freeing it to invest a high percentage of its cashflow in growth $1 $ Share Repurchases Dividends Capital Expenditures Acquisitions opportunities and return money to shareholders through dividends and share repurchases. From 2001 to 2010 KO generated $65 billion in cashflow from operations and returned $45 billion to shareholders. The firm has raised the dividend for 49 consecutive years, and the stock now yields 2.7%. Management has retired 9% of shares since KO has achieved all of its success while using very little net debt, ensuring a safe capital structure. $80 $60 $40 Price 15 times Earnings Per Share VALUATION / CONCLUSION Coca-Cola has many advantages: a highly sophisticated distribution system, a universally recognized brand, deep customer loyalty and profound economies of scale in advertising. Given the strength of the company s business, it is likely to perform well for many more years. Management has stated that its long-term goal is to annually increase sales volume by 3%- 4% and operating income by 6%-8%. With stock repurchases and dividends, this would produce a total return of 10%-11% over time. $20 $ P/E Ratio Check Capital Management Inc. Costa Mesa, CA. (714) (800)

5 Because of Coca-Cola s global market position and strong financial metrics, the stock has historically traded at a relatively high price. As the graph on the prior page shows, for two decades KO stock has usually traded at more than 20 times earnings and often at far higher levels. However, in the past few years shares have fallen to prices that we feel are compatible with Coca-Cola s valuation. The stock has recovered from its low in early 2009 and now trades at 19 times earnings, near its median valuation over the past five years. This appears to be a fair-tofull price for one of the world s great companies. [Please see footnotes below] CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness. 5 Check Capital Management Inc. Costa Mesa, CA. (714) (800)