Gee, I really hate this deal.
It’s not just that I question the price that Coca-Cola (KO) is paying to acquire the North American operations of its biggest bottler Coca-Cola Enterprises (CCE). The $12.7 billion price works out to about the same multiple that PepsiCo (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.
Or 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.
Or 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 (WMT.) First, U.S. 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% falling 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’s are willing to forgo 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 my post https://jubakpicks.com/2010/02/26/can-ceos-destroy-shareholder-value-in-an-acquisition-just-watch-them/ )
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 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 book. They didn’t depress Coke’s profitability because those assets belonged to another company.
At the time of the spin off 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.
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, yes, but only as long as prices weren’t cut too much.
In the good ol’ 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? that 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.
It’s a signal of how the market for soft drinks has changed that both PepsiCo and Coke see the advantages of having more control over their distribution as now outweighing the cost to their profit margins from owning these distributors.
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 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 business. 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 analysis of PepsiCo recently and 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 wake-up call to me about how big the problems are in the soft drink industry. And I’m going to take another look at Jubak’s Picks 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.
DJ and Ed. i say post all you want like like hearing your opinions and they add to a lot of what Jim is talking about. Always providing diiferent set of eyes on the maket. The more information we ahve the better.
Jim,
Thanks for the update. I own PEP, but sometimes worry about the CEO who never had been individually responsible for bottom line of any organization before being appointed to the current position. Food industry was in the fashion of naming a female CED at the time. I believe that got her in. It takes time to destroy a large company. Just look at GE.
To DJBarber:
I appreciate your posts. I doesn’t matter if they are on or off topic. You could help us your fellow Jubaksters better though by telling us in one sentence why your post is important instead of just copying and pasting from or giving us a headline and link to another website. Thanks again.
Thank you Jim on an insightful article and paulf for answering the questions I was asking myself: what does Buffett think? I must admit I am still in the dark. What does “rationalize” mean? Buffett was so against KO’s acquiring of Quacker for Gatorade and now he is OK with CCE? Something is wrong here… But if I had to choose between KO and PEP, I would go with PEP which also has the profitable FritoLay snack business. In fact, superimposed long term (10yrs?) charts both companies says PEP is superior to KO.
DJ… I say post away. The way this site is structured, current news sometimes must be posted under a topic to which it may not be relevant, but IS relevant to previous points or discussions. If there is a comment/link that does not interest me, I just skip over it… from any poster.
francolargo,
While I will buy inverse ETF’s/ETN’s, I am not a fan of buying short options directly. It’s too much like betting on a horse to show rather than win. But that’s just me.
I agree with EdMcGon. DJ’s work is helpful and easy to skip if your are not interested.Keep it up.
I recognize the general internet rule of blogs is to stay on topic with one’s comments. However, I find DJ’s comments useful even when they stray from the topic at hand. I am more than delighted to overlook his protocol faux pas in order to be more informed.
I come to Jim’s blog to get information and perspective. DJ performs a valuable service with his informative links.
I feel compelled to agree with ticktock comment. Everything is an algorithm that equal to zero. Models (simplified versions of reality) are interconnected more than we can think of. Just an example: in the ’70 a drop of 2 degree of pacific ocean water ultimately resulted in a huge increase of agricultural and beef price for years. Every bit of information is useful to build a truly investor mental map. Keep in mind who has the information(s) is already wealthy.
Put me down as someone who does appreciate the varied and detailed comments/links of DJBarber and several others here.
No man is an island and no stock exists in a vacuum. The happenings in Greece or China or local customer’s change of soda drinking patterns all have connections to other investments, some of which are obvious whereas others are not.
Jim is very good at picking up bits and pieces of economic, social and political movements and being able to extrapolate future trends. Others on this site who do the same thing simply add to the overall picture. Profits will not be made in yesterdays news but in tomorrows successes and failures. Those who accurately anticipate future directions will gain.
Let’s say a new Chinese directive promots massive increases in agricultural production of soya which would mean a decrease in imports from Brazil. EWZ and BRF. That also means increased need for fertilizer. POT and YARIY. The Baltic Dry Ships, and Jim has had stocks in this index in the past, probably goes up. That means freight cost for other materials goes up, such as iron ore. VALE, BHP. And other bulk minerals. FCX, TC, IMPUY, LYSCY. And all this extra activity makes the workers thirsty so they drink a Coke or Pepsi from Wal Mart. Everything is connection.
Cheese Burger, Chip, no coke. Pepsi!
Sorry to have only included the link above to Nooyi’s side. Buffett’s comments are here: http://www.cnbc.com/id/15840232?video=1428088871&play=1
Great analysis! An interesting alternative view on this is in the exchange between Warren Buffett, THE major shareholder of KO and Indra Nooyi, CEO of PEP. Buffett is, in my opinion, lukewarm on the KO/CCE deal – he says KO needs to “rationalize” their relationship with the bottlers and on balance he favors it. Nooyi is, of course, quite a booster of their deal. Some video here: http://www.cnbc.com/id/15840232?video=1428167525&play=1
I read a lot of business magazines, and in one of them it said that if the English pound falls, that is the signal that the dollar is next to go.
DJ
I say post away. If I don’t want to read it… I won’t.
Full Disclosure: The Pigs I like are of the mascot variety, not the European countries.
Sorry about the form of that last post, slight mistake with cut and paste… hopefully you get the idea…
I Usually don’t post anything that Jim hasn’t talked about previously.
For instance, The above
“Greece Now, U.K. Next as Scots Ready for Pound Plunge (Update2)”
Is directly related to something that Jim posted some time ago, where he mentioned that once people got around to “talking about the UK debt problem, it wasn’t a big jump to talking about the US debt problem. “ And when and if THAT happens we were looking at problems a lot bigger then Greece, and the EU.
The above “Harvard’s Rogoff Gives Legs to China Crash Talk: William Pesek” (This was posted simply because we are seeing more and more talk along these lines lately, and seems like a good idea to be aware of them, as they hold a kernel of truth, and many of Jim’s watch list pertain to China.
And
The above “Beijing is trying to control explosive bank lending growth that has set off concerns about asset price bubbles and the creation of a fresh crop of bad debt.”
Are directly related to the Jims post “8 reasons for investors to worry”
Particularly, worry #2
The above “Monday Market Monitor – Iron Ore WEEK 08 – Frenzied buying” and
“Commodity price speculation is driving mining market – Fitch”
Are both related to Jim’s (And anybody here) holdings of BHP and FMG.
So, off topic, Yes. Relavant? absolutly.
If I post it, it’s because Jim has talked about it or owns stocks related to it.
That being said, what I am hearing (From most) is that they would rather not see “off topic” posts from me. I will keep that in mind. I will consider that the several hours a day that Usually don’t post anything that Jim hasn’t talked about previously.
For instance
The above “Greece Now, U.K. Next as Scots Ready for Pound Plunge (Update2)”
Is directly related to something that Jim posted some time ago, where he mentioned that once people got around to “talking about the UK debt problem, it wasn’t a big jump to talking about the US debt problem. “ And when and if THAT happens we were looking at problems a lot bigger then Greece.
The above “Harvard’s Rogoff Gives Legs to China Crash Talk: William Pesek” (This was posted simply because we are seeing more and more talk along these lines lately, and seems like a good idea to be aware of them, as they hold a kernel of truth.
And
The above “Beijing is trying to control explosive bank lending growth that has set off concerns about asset price bubbles and the creation of a fresh crop of bad debt.”
Are directly related to the Jims post “8 reasons for investors to worry” Particularly, worry #2
The above “Monday Market Monitor – Iron Ore WEEK 08 – Frenzied buying” and
“Commodity price speculation is driving mining market – Fitch”
Are both related to Jim’s (And anybody here) holdings of BHP and FMG, both of which mine Iron Ore.
Off topic, Yes. Relevant ? absolutely. However, I will consider that the several hours a day of research that I do, may only be relevant to me, and that I should not be concerned with sharing it, because on balance, it seems to bother most of the folks here… And my attempts to help fill in the blanks, with that research, is not appreciated, which I can understand.
That being said, I think it would be nice if we saw a bit more collaboration here, and I for one, would welcome seeing more posters using their heads and helping to “fill in the blanks”.
Jim does a hell of a lot for us, it’s nice to give back a bit as well.
I would really like to hear more peoples opinion on the Pepsi / Coke topic. Thanks for all the great info Jim.
Jim… I agree with your skepticism of PEP (and KO). Then again, I’ve been off pop for over 3 years and only buy the occassional Gatoade. Health trends seem to be moving away from them. As well as environmental issues with bottled water.
Rum & Coke for me.
jim , your thoughts on a forum in your new space for off topic forums? like when you were at msn? it is wonderful to hear from everyone, but on topic comments keep folks focused to the column at hand. thanks.
>Ed: “Too bad there’s no inverse ETF for the Pound.”
Last week you should have bought puts or sold calls in FXB. If you like to gamble, there’s still time.
>Re DJ: “How about staying even remotely on topic?”
I personally don’t mind as long as the ‘topic’ is somewhere within the bounds of Jim’s portfolios. The last thing we want is for Jim to have to edit the comments. If I’m not interested in some of the interesting things that DJ digs up, they’re not hard to scan past… Uncharacteristically inarticulate was the William Pesek piece on Bloomberg, which sounded like Turkey Lurkey had just conferred with Henny Penny. Maybe he (Pesek) should start predicting earthquakes – in which a lack of detail is taken for granted. OF COURSE there is reversion to the mean at some point. The question is ‘what mean and when?’ Duh.
Agreed. I have to sift passed your posts every single day. There are more appropriate forums, IMO.
DJ…just had to post something? How about staying even remotely on topic?
“Commodity price speculation is driving mining market – Fitch”
Can you say “duh”
http://steelguru.com/news/raw_material_news/MTM0ODIx/Commodity_price_speculation_is_driving_mining_market_-_Fitch.html
Another off topic:
“Monday Market Monitor – Iron Ore WEEK 08 – Frenzied buying”
http://steelguru.com/news/raw_material.html
And we already know this:
“Beijing is trying to control explosive bank lending growth that has set off concerns about asset price bubbles and the creation of a fresh crop of bad debt.”
Timeline
The following shows key developments this year:
Feb 24 – China Banking Regulatory Commission orders commercial banks to restrict new lending they provide to local governments’ financing arms to ward off risk of default.
Feb 22 – Chinese banks warned not to lend too aggressively and to verify that their loans are being used for the intended purpose.
Feb 12 – China central bank surprises markets by raising bank reserve requirements 50 basis points, effective Feb 25, its second increase this year. Few traders had expected the move so soon after a low inflation reading for January.
Feb 11 – China consumer inflation unexpectedly slows in January, but brisk lending and a rise in factory-gate prices to keep policymakers alert. Central bank says it will guide monetary measures away from anti-crisis footing but maintain appropriately loose policy.
Feb 3 – A major Chinese bank, Bank of China, raises mortgage rates in one of the first signs of how government credit clampdown could tame turbo-charged growth.
Feb 2 – Reserve Bank of Australia surprises markets by skipping a rate rise, noting tighter policy in China among other factors in its statement. Before the meeting, a rate rise had been almost fully priced into markets.
Feb 1 – China orders banks to ensure excessive credit has not illegally entered the stock or property markets in latest bid to bring pace of lending under control.
Feb 1 – Shanghai stock market closes at lowest in more than three years on fears of more tightening measures.
JANUARY
Jan 30 – PBOC Deputy Governor Zhu Min tells Reuters the central bank is ready to take further steps to ensure rapid loan growth does not destabilize the economy.
Jan 29 – PBOC says it will ensure money and credit growth remain ample in 2010 even though inflation is likely to rise.
Jan 27 – China’s biggest bank ICBC says it has stopped rolling over some loans to slow credit growth as Chairman of China Banking Regulatory Commission instructs banks to ensure even pace of lending over the course of 2010.
Jan 26 – IMF sees no serious risk of a market bubble in China, a senior official tells a news conference.
Jan 21 – China reports that GDP in Q4 2009 rose 10.7 percent over the same year-earlier quarter.
Jan 21- China’s central bank guides up its bill yields for the second time this year, highlighting its determination to fight inflationary pressures after strong Q4 GDP.
Jan 20 – Chinese banking authorities order some major banks to curb lending for the rest of January, intensifying efforts to prevent loan growth from overheating the economy.
Jan 20 – China tells Bank of China, Industrial & Commercial Bank of China, CITIC Bank and China Everbright Bank to increase reserve requirements by 0.5 percentage point.
Jan 19 – China will maintain “reasonable growth” in credit and money supply and stick with proactive policies to boost demand but will also curb speculative property investment and take steps to deal with inflationary expectations, Premier Wen Jiabao says.
Jan 18 – PBOC allows one-year bill yields to rise more than expected, signaling it aims to shift fund drains to longer-term tenors to rein in lending and fight inflation.
Jan 17 – China’s banking regulator urges banks to be cautious on lending this year, ensuring credit is used in the real economy and not for speculation. It also calls on banks to monitor the property sector and make “greater efforts” to control loan risks.
Jan 13 – China renews vow to curb runaway property price rises by increasing the supply of affordable housing and cracking down on speculation.
Jan 12 – China announces a 50-basis-point increase in banks’ required reserves, its strongest step yet toward tightening monetary policy that rocks global financial market because it came earlier than expected.
Jan 12 – PBOC raises yield on 20 billion yuan ($2.9 billion) of 1-year bills, having held it steady for previous 20 auctions; also drains record 200 billion yuan from the financial system via 28-day bond repurchase agreements.
Jan 7 – Central bank surprises by raising auction yield of its three-month bills for the first time since mid-August.
DJ,
Too bad there’s no inverse ETF for the Pound.
Not to be a gloomy guss, but. . .
Harvard’s Rogoff Gives Legs to China Crash Talk: William Pesek
http://www.bloomberg.com/apps/news?pid=20601039&sid=aV4rQ9FFF.WU
Off topic bad news…
Greece Now, U.K. Next as Scots Ready for Pound Plunge (Update2)
http://www.bloomberg.com/apps/news?pid=20601109&sid=aJhONJ3Sdkqw&pos=12