Coca-Cola Co. (KO
) is one of those companies investors want to believe in. Since 1998, the longtime Wall Street darling has disappointed: Sales of its iconic product stalled, cutting its profits and share price. But investors have been betting on a comeback since January. So on Apr. 16, when the beverage company said bottlers' sales volumes had jumped a surprising 5% and Coke's own earnings--excluding nonrecurring items--had apparently beaten expectations, that's all investors needed. They have bid the stock up nearly 10% since then, vs. a 1.5% drop for the Standard & Poor's 500-stock index. All told, Coke shares are up 22% this year, compared with a 22.5% fall in 2001. Coke Chairman Douglas N. Daft couldn't resist a boast at the company's annual meeting the next day: "Our financial results speak for themselves."
Or do they? It may be reasonable to gloss over Coke's $125 million first-quarter loss due to accounting-rule changes. Or ignore that Coke now stresses "currency-neutral" earnings, factoring out the negative impact of the strong dollar on foreign earnings. (Funny, it never did that a decade ago, when the weak dollar fueled as much as a quarter of its 18% earnings growth.) Still, at a time when U.S. companies face intense scrutiny over the quality of their earnings, Coke's figures--and its comeback--deserve a closer look.
That means investors must increasingly figure in the financial performance of its global network of bottlers, whose fates are intertwined with Coke--even if their balance sheets aren't. The fact is, Coke made its numbers in the 1990s in part by exploiting its bottlers. Now, the company is starting to acknowledge that it's going to have to help them repair the damage to their balance sheets that resulted. And that will likely cut into earnings growth going forward, analysts say.
Coke's finances have long been among the most complicated in Corporate America, because of the company's Byzantine relationship with its 38%-owned affiliate, Coca-Cola Enterprises Inc., the huge bottling company it spun off in 1986, and other members of its global bottling network. Coke doesn't consolidate CCE because it owns less than 50%. And it insists it doesn't control the company. But the bottlers are essentially captive customers for Coke's highly profitable syrup.
For years, under Daft's predecessor, M. Douglas Ivester, Coke pushed bottlers to add production capacity and acquire other bottlers, sometimes bought from Coke at grossly inflated prices. During the 1990s, Coke banked hundreds of millions in profits from buying and reselling assets to its bottlers. The added capacity allowed Coke to boost sales volumes while keeping debt from the capital-intensive, low-margin bottling business off its books. But that strategy saddled bottlers with the debt and razor-thin returns. "CCE still doesn't cover its cost of capital and can't say when it ever will," notes Carlos Laboy, an analyst with Bear, Stearns & Co.
As a result, while Coke enjoys a return on assets of around 18%, CCE's ROA (table) is one-sixth that. Analysts expect CCE in 2002 to earn a mere $404 million on revenues of $16.5 billion--nearly double its profits in 2001. But that still only gives it a return that's roughly half its cost of capital.
What's more, CCE's pretax income for 2002 is expected to include more than $950 million in so-called "marketing support" payments--actually a long-running subsidy--from parent Coke. Daft seemed willing to wind down the payments after taking over in 2000, but he had to reverse course and promise to maintain them through 2009. Daft may have feared, among other things, that such a move would spur credit-rating agencies to downgrade CCE, raising its borrowing costs further. "It's clear that without support from Coca-Cola, CCE would be in deep trouble," says Abe Mastbaum, chief financial officer at American Securities in New York.
To Daft's credit, Coke seems to be playing it straighter than it used to. When Coke booked a small gain--less than 1 cents a share--from the sale of its stake in a Brazilian bottler to Molson Inc. (MLSAF
), Daft didn't try to include the gain as operating profits, as former Chairmen Robert Goizueta and Ivester sometimes did.
In general, bottlers claim that Daft has taken a more enlightened view of the relationship. Daft's vision, they say, seems to be that Coke's interests are ultimately aligned with those of its bottlers. And by keeping them healthy, he can increase business for all. In one welcome move, he slashed annual syrup-price hikes back below 2%, compared with the 7.6% jump that Ivester rammed through in 1999. Daft has also worked with bottlers to help them cut costs and boost productivity by sharing their manufacturing capacity with other Coke bottlers. He is even giving them more freedom to sell some outside brands in which Coke may not get a cut of the profit. "I think [the relationship] has changed dramatically since Doug Daft took the helm," says Lowry F. Kline, chief executive of CCE.
In any case, odds are that regulators would have shaken up that relationship. The Securities & Exchange Commission has begun to look askance at the way Coke and CCE account for the myriad payments between them. In January, CCE disclosed that the SEC had advised it to change how it was booking special payments that Coke makes to help bottlers pay for new vending machines and coolers. The SEC told CCE it should only book those payments as income when the equipment is put into service--not, as had been the case, when the check from Coke arrived.
That forced CCE to alert investors that it had prematurely booked $300 million in income back to 1994. The irony, though, is that as a result of the same SEC order, the bottler can now rebook those payments as earnings between now and 2008 as it places the vending machines in the field. The result: an accounting boost to CCE's net earnings on the order of $70 million to $80 million a year over that period. That, says John Faucher, an analyst with J.P. Morgan Securities Inc., "gives us some pause as to the quality of CCE's reported earnings."
Regulators may not have the last word on the ties between Coke and CCE. Indeed, as soon as next year, the Financial Accounting Standards Board is expected to dive back into a controversial project that could require companies to consolidate their financial statements with those of any other affiliates over which they exert control. If FASB prevails, some analysts think Coke will eventually have to combine its balance sheet with CCE's. "I think they should be consolidated," says J. Edward Ketz, an associate professor of accounting at Pennsylvania State University who has studied Coke's ties with CCE. "Coke has de facto control over CCE."
If Coca-Cola were obliged to do that today, it's not clear what the impact would be. Some analysts say that if Coke had to consolidate CCE's financials, it might only clip Coke's earnings by about 4%. Still, once it assumed its share of CCE's low-yielding assets, Coke's return on invested capital would be slashed by half, to around 15%--a development that, some analysts believe, could cause Coke's stock to tumble. But these same analysts say that all depends on the aggressiveness of the FASB proposal.
Coke Chief Financial Officer Gary P. Fayard says the company did an internal study of an earlier FASB proposal and "our conclusion was that we did not have to consolidate any of those bottlers under those proposed rules. That's going to disappoint a lot of people," he adds. Still, in the post-Enron Corp. world, regulators and investors are becoming a lot more finicky about accounting maneuvers that few people cared about in the '90s. The reality: Coke and CCE are joined at the hip. They both need to sell that cola. For Coke to recapture its earnings fizz, it will have to embrace the bottlers as partners--not just pump them dry, as it has in the past.
By Dean Foust in Atlanta, with David Henry in New York
Get BusinessWeek directly on your desktop with our RSS feeds.
Add BusinessWeek news to your Web site with our headline feed.
Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video.
To subscribe online to BusinessWeek magazine, please click here.
Copyright 2002 , by The McGraw-Hill Companies Inc. All rights reserved.
Printer-Friendly Version
