The Coca-Cola Company - [Business Breakdowns, EP.136]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Zach Buss, an investor at Irenic Capital. And today, we are breaking down the Coca -Cola Company. Coke began in 1886 and now offers a wide -ranging portfolio, including its namesake, Coca -Cola, but including sparkling water, sports drinks, coffee, teas, and juices. The company's beverage products are made available to consumers throughout the world through the company's carefully constructed network of independent bottling partners, distributors, wholesalers, and retailers.

1:21On May 8, 1886, Dr. John Pemberton brought this perfected syrup to Jacobs Pharmacy in downtown Atlanta, where the first glass of Coca -Cola was poured for five cents a glass. Today, more than 1 .9 billion servings per day of Coca -Cola are served worldwide. To break down Coca -Cola, I'm joined by Freddie Late, founder and managing partner at Latitude Investment Management. We cover the business of Coca -Cola and how its bottling network is imperative to its capital life business model. We discuss recent acquisitions like Costa Coffee and Body Armor, capital allocation, and the Coca -Cola company's expansion beyond its flagship brands and products.

2:02Today, the business is focused on its strategy as a total beverage company, leveraging its distribution, marketing, and production capabilities to streamline its portfolio from 400 to 200 brands. with Legacy Cope representing just 50 % of their offering. Now, please enjoy this conversation on the Coca -Cola Company. All right, Freddie, thank you for joining us to break down the Coca -Cola Company. Last time you joined us, you put on an absolute clinic on AutoZone. I hope we can live up to that. I think to start, despite the fact that this business is internationally recognized and appreciated.

2:42I don't think people actually understand the actual business model to the extent that they should. Maybe just start out with size and scope and how we should think about the business. Great to be with you guys again. Everyone knows Coca -Cola. It's one of the most well -recognized brands in the world. What we'll get into today is they have a very different business model. And they've basically created this model by accident and then deliberately over the last 50 to 100 years. That's resulted in them being, depending on how you calculate it, by far and away the largest consumer stable company in the world with the single most valuable consumer brand and the largest amount of operating profit out of any of the companies that we look at.

3:21And to give you a sense of the scope, they have 26 individual billion dollar brands within the business. While Coca -Cola is still the dominant brand by a long way, they do have a number of other businesses that in their own right could constitute a decent business. They astoundingly sell 2 .2 billion servings of their drinks every day. And they sell in all but two countries in the world, which I think are Cuba and North Korea. So the reach of this business and the scale and the brand recognition is the culmination in a kind of nearly 150 years work. And there's a huge amount to go for. People think of it as a very mature category.

3:58They think of it as X growth, but actually it's carried on growing unit volumes pretty much consistently at around 3 % for the last 50, 60 years. And there's plenty of reasons for that. So I think there's a lot to unpack in durability of the growth within the business, as well as the competitive advantages. And I think the scope of the business is just unparalleled. And when you look at the competitors, they're paling in insignificance and actually losing value share to the Coke system. So it is one that's worth anyone who's clicked on the link to listen to the whole story, because there's been a lot of change in the last 20 years.

4:32And the last five, 10 years of financials do not do justice to the value creation that the business has delivered. So I think that's really the key bit we'll unpick today is despite earnings growth being anemic and the reordering of the business and lots of restructuring costs, how have they genuinely demonstrated value creation and what are the next 10 or 20 years look like? And so maybe to kind of set the stage, there are other very prominent beverage businesses that operate globally, Pepsi Corporation, Monster Energy, Keurig Dr. Pepper, it can go for a while. What is it that kind of differentiates this business from a size perspective?

5:13How much bigger is it than its peer set? When you calculate the Coca -Cola company's revenues, it misses the point slightly. So the way the business is constructed in the way they call the system, they have basically outsourced the bottling and ultimate distribution of their beverages. Pepsi has done this to a degree too, so it's very dark pepper in a small way. But this franchising of the bottling and distribution assets results somewhat confusion because we have to talk about either system sales or Coca -Cola Company, which is really a franchise revenue. But if you look at system sales, which is the comparable number to Pepsi or other businesses.

5:50The business is twice the size of Pepsi in terms of operating income. And PepsiCo, over 50 % of that operating income comes from snacks and salty treats. Of the beverages, it's four times the scale of its nearest competitor. The other major competitors, those drinks brands contained within Nestle or Unilever, Kerry Dr. Pepper is 50 % a competitor and then 50 % coffee, which is slightly different. but they pale in insignificance, a tenth of the size. The system sales are nearly 150 billion. That's the kind of wholesale sales through the Coca -Cola company and its bossilers. That's pretty much unsurpassed by any other beverage company, however you cut it.

6:31And so we'll delve into the intricacies of their global network and bottling and distribution system. But I think maybe to help frame it, let's go through the history of the business. I know it's gone through its different evolutions and its go -to -market strategy and brand strategy, but bring us to where we are today. I'll split it into two parts because the history is incredibly long and distinguished. Obviously, it was founded in the late 1800s and they built the business in North America particularly, but actually through the wars, they distributed bottling plants into Europe and began their international expansion 70 years ago.

7:05They grew as the dominant franchise marketing business. They really invented a number of different brand and marketing initiatives. They were the first to come out with the unique bottle shape. They're credited with at least giving the color to Santa Claus, if not creating him in the first instance. They were the first ones to launch a diet product in the 60s called Tab. The business was a very, very successful business all the way through the early years, the first 50 years of last century. It was growing. and then as the sort of post -war period and consumerism really took off, they captured an enormous amount of share.

7:41They bought into Minute Maid and they expanded their beverage offering into juices and they launched Diet Coke in 1982, which was an extraordinary success. They were basically the dominant brand. I believe in 2000, when the long history ends in this story, they were the most valuable brand in the world. Through that period, there were two major concerns for the business. The first one was the Cola Wars, the Pepsi Wars that I grew up with as a child. Basically, Pepsi ran this series of sort of taste the difference, blind tasting. And it turned out that everyone preferred the taste of Pepsi blind.

8:16And this is very important because what Coke tried to do in the 80s was actually reformulate the Coca -Cola formula, the famous secret formula. And when they launched a new one, there was a huge backlash and they had to cancel it nine months later. And it proved a point 40 years ago, but still very important today, which is it doesn't matter that it's the best product, the best cola. It matters that it's Coca -Cola because that marketing message and advertising had done such a powerful thing to live in the psyche of people who consumed it. And so from then on, they focused a lot more on marketing and distribution as opposed to on the product itself.

8:53They haven't launched a huge number of new variants or new products since then. It's been around building up that moat, and they really won those wars in many ways. The second war, which is the most relevant, I think, was this combative nature with their bottlers. And it's a really important part of the system for people to understand that ever since Coke was first founded, other people have been bottling and selling the drink. And as a quirk of an appalling contract signed in the early 1900s, bottlers were able to buy the raw ingredients from Coca -Cola at a fixed price. So as inflation came through and took off, the bottlers were making all the money and Coca -Cola wasn't.

9:32And so they had to go through a strong period of renegotiating all of those contracts. And there's been a lot of tension in the past. There have been periods where the system itself has been creaking. Off -balance heating, the bottling and distribution assets resulted in Coca -Cola getting a bit greedy, trying to charge too much for the raw materials, and lots of lawsuits through the 70s and 80s. That was the problems that we faced as we came into 2000. What's happened since 2000 is a major reorganization of the business. And so Coca -Cola had basically decided that they were going to re -franchise out an enormous number of these bottling plants in the earlier periods.

10:12In order to get them back in shape and to reset the agreements, they brought them all back on balance sheet. And so a huge proportion of those bottling plants were brought back on balance sheet, reinvested in, had new capital stock, better systems. And a major, major piece of this was between 2015, 2017, when they refranchised over 40 % of the bottling assets. And so the story was one of great success for many, many decades. Conflict within the system itself, and then a sort of 10 to 15 year period of sorting that out, which we are now 95 % of the way through. And so that has resulted in a much better management between the two levels of the system, the external bottlers and the Coca -Cola company itself.

10:58And obviously the brand remains as relevant as ever. And actually since the pandemic has been growing in its relevance quite dramatically. And so I think it'd be helpful to just take a sidebar here and talk about why bottling and effectively managing a brand or different businesses. I think from a basic economics perspective, one is obviously more capital -like than the other, but I think it'd be helpful if you kind of set the stage for why you may be a great bottling business and why you may be a great brand building and distribution business and why you may not be both or may not want to be both from like an economics perspective.

11:34So there's the pure economics, as you say, the sort of financial returns are far higher for the Coca -Cola company than they are for their bottlers. Closer to 30 % return on investor capital at the moment and rising quite dramatically versus 10 to 15 for the bottlers around the world. That's one of the key reasons that the business wants to focus on marketing. But the second is really a circle of competence, Art. It's that a local business managed with a long -term, they call them reference shareholders, but normally large family shareholder alongside the Coca -Cola company, and in some cases, public shareholders, these businesses are listed, allows for that local go -to -market knowledge, local innovation around the brands, and a greater understanding of exercise requirements, changes in the retail landscape, changes in regulation, changes in consumer taste, which not only benefits that region itself, so you have a much more acute go -to -market strategy run by the bottling plant in conjunction with the Coca -Cola company, but that information is also fed back.

12:36The model is that the Coca -Cola company still owns around 20 % of most of these bottling assets. They sit on the board, they help direct, but they also take feedback from, which they can give back to the rest of the system. That's where many of their innovations have come from. That's where many of their best practices have come from, learning from the best bottlers in certain regions and then taking that skill set and transferring it elsewhere. So there is clearly an argument from the financial perspective that you can operate a higher return on capital business like the Coca -Cola Company, which is effectively a franchise ownership business that supports those franchisees with an extraordinary amount of marketing.

13:1515 % of Coca -Cola Company sales are spent on marketing support direct for the bottlers, another 10 % in brand advertising. But also to create this innovation that's bubbling up towards the center and then distribute from the center. The other role that the central company plays is adding new beverages to the portfolio and supporting that growth on a local and global basis. It's not purely a split operating company in a property and capital company business. Those models, which have been more prevalent in the last 20 years, interest rates have been falling. They're more of a kind of cost of capital arbitrage.

13:52This one's particularly interesting to us because it actually creates synergistic benefits for the group as a whole. I know a handful of these enterprises on the bottling side are also independently public. I know there's Coca -Cola Femsa. I believe there's the ticker Coke in the US, which is often mistaken for the Coca -Cola company. Do you guys spend time investigating and understanding those businesses in order to inform your view on the Coca -Cola company? There's quite a few that are listed, half a dozen or so. And so you can get pretty helpful bottom -up financials for the other half of the system and to understand how they're operating and where it's going.

14:33So we have looked at a lot of them. Some of them would make interesting investments in their own right as well. The key tension between the bottlers and Coca -Cola over time has been the price that they charge for what they call the concentrate. This syrup that they sell to the bottlers, which they add sugar and fizzy water and create the drinks. And that has tended to be in the sort of low 20s as a percentage of sales for those bottlers. And that creeps up over time as you're more mature. But what we need to believe is that the bottlers are healthy. They're investing back in their businesses and have great capital stock, great investment initiatives and alignment with us as shareholders of Coca -Cola.

15:11So the first thing we assessed was what are the average returns on capital in these businesses? Are they making an adequate return on capital? And are they getting the support they need from Coke? because if they weren't making an adequate return, eventually that would be a cost for us. When you look through it, the average return on capital, and it's quite a widespread, but for the bottling assets is around 10 to 12%. And so that's an ample return. But particularly given that, about 30 % on average of that invested capital calculation is a intangible asset for the fact that they own the right to distribute Coca -Cola.

15:47Now that is obviously a very valuable asset. And in different regions, they calculate it different ways, but it's on their balance sheets as a petrally intangible asset in many cases. So adjusting for that, their kind of cash return on cash invested capital, it's closer to 15 % and in some cases it's higher as 20. So actually, these businesses are doing very well at the current franchise fee and are investing back in their businesses for growth. So that was the first point. They're healthy and they're growing and they're investing back in their businesses. And there may even be room for the Coca -Cola company to charge a little bit more to that concentrate over time.

16:23So that creates an incredible alignment of interest. And we have that system that's going to be working. We do believe that over time, and you can look at in the more mature markets, Coca -Cola is already able to charge more to that concentrate. So it is likely over time that the average concentrate cost as a percentage of sales may drift up from sort of 21 % to 23%. The other thing that I think is really critical is the concept of alignment. What's happened in the comments I made earlier about the breakdown in the two sides of the system was because Coca -Cola was really running a volume -based system.

16:56And that didn't align to value creation. And so they've moved to something, and there's quite a lot of terms you need to learn if you start analyzing Coca -Cola's annual reports 10Ks, but incidence -based pricing. And all this means is they're looking for value. So if they can sell smaller pack sizes or more convenient pack sizes, that generates higher gross profit dollars, they should be doing that. And that aligns well with the bottlers. So effectively, they're on a revenue share now, which has created far smoother alignment. And that's even enshrined in quite a few of the shareholder agreements that they've struck with these independent bottlers.

17:30So you have better alignment. You have a very healthy bottling system that's reinvesting and generating decent returns for itself while growing. And you can believe that the tension has faded. And so now that we've kind of established the Rand versus Botler dynamics, I want to speak more broadly about how this business grows and why growth has been so consistent. Clearly, they have pricing power over their Botlers in some ways, but I would suggest that the growth of the business has actually been a lot healthier than people perceive given it's not just all price. There's plenty of volume growth in the system, how do they think about driving top line?

18:11When you think about the system as a whole, they refer to things called unit cases, which is just an equivalent of 24 cans of eight ounces. But unit case volumes has grown around 3 % incredibly steadily for the last 10, 20 years. So volume has been coming through. Now, part of that's acquisition, part of that's brand extension, but these are things that they've proven themselves to be able to do. And actually, even Coca -Cola itself is still growing substantially around the world, as well as Diet Coke, not to mention Coke Zero, which is really the darling in the portfolio at the moment, growing 10 % plus per year in terms of volume.

18:47On top of that, over the last 10 to 15 years, while inflation has been quite low, they have averaged around 2 % to 3 % price, roughly inflationary pricing, which I would anticipate remains in the future. So you've ended up achieving a kind of 5 % to 6 % system revenues growth, which is well in excess of the consumer staples peer group and in excess of certainly most of the large ones that we look at that aren't special. It's grown very nicely and will continue to do so. The growth opportunities for the business, again, I mean, people talk about, well, surely it's X growth and can't move on from here.

19:22There's a number of growth opportunities that they're really pressing at the moment. The first one I would say that is slightly overlooked is the fact that there are $26 billion brands, all of which outside maybe Coke, Sprite and Fanta, which are the three most leading brands, all have room to grow. Some are recent additions to the portfolio, Body Armor or Fairlife, relatively recent additions to the portfolio like Innocent Smoothies. But these businesses are growing far faster than the group and adding a lot to the top line. and the business has this phrase that they're trying to become a total beverage company which means entering every category and dominating in the categories where they play and so they've already done very well in juice with the minute maid acquisition years ago they've done very well in water they own vitamin water and glass so they have some reasonably good energy assets they missed a chance to invest in monster and they have a joint venture with monster which has been highly accreted that they didn't get to own monster monster beverages but they do own Powerade.

20:20They have recently bought Body Armor. And they've recently also moved into alcoholic drinks. They're launching cans of Gak and Coke. They've just signed another deal to do Absolute Vodka and Sprite. And they're testing and finding their way in the alcoholic category too. Not to mention Costa Coffee, which was an acquisition a few years ago. UK coffee business, very successful. Sales were up 3x or something like that in the 10 years prior to buying that business. What you end up with is a core business with decent volume growth, a lot of additional potential around the edges, and now a system and a central business that is totally aligned behind the revenue growth management and the value creation of each of those brands in a standalone basis.

21:01They actually cut their brands down from over 500 to 200 a couple of years ago in the spirit of trying to focus on these brands, really build them out individually. So the room for growth in terms of the potential from the underlying brand is very strong. And when you think about the demand side, how much more can we all drink of these sorts of drinks? There's two ways to look at it. If you look at the North American consumption per capita for the last 30 years, the market hasn't really risen much. Coke's been taking share and will probably continue to take share from Pepsi. It outspends Pepsi on a marketing basis, three to one, maybe even four or five to one actually these days if you exclude the snacks.

21:44So it's really dominant against its competitors. Elsewhere, in Latin America, for example, 20 years ago, the consumption per capita was half the level of North America. And as that economy has grown and population has grown, you've seen that rise all the way towards the North American average of 400 servings per year. And so you can see this potential for growth from the rest of the emerging markets and other regions, which at the moment, on average, are around a third of the level of consumption per capita that the Americas are. And so the potential for growth, for moving people into commercial beverage occasion, they call it, but the idea of not just drinking water at home, but buying a drink out for your fridge is very likely over the next 10 to 20 years.

22:29We see the supply side, the brands that are winning and the market share that's being taken. We also see the demand side as economies evolve over the next 10 to 15 years. I must ask, given that just looking at the monster shareholder list. Coca -Cola is the largest holder with almost 20%. Is there a better, more interesting story behind that? Behind the story of why they own 20 %? Yep. And how they kind of missed the opportunity to own more. I think at the time they had an existing brand and they felt the shares were overvalued. I do think it was as simple as that. And they've always been expensive monster.

23:04And look, the success that they've had has been extraordinary. Partially down to the fact that through the ownership stake, they've been given access to the Coke distribution. There is no distribution network like the Coca -Cola distribution network on the planet. And if you manage a drink or invent a brand or come up with a brand and want to push a brand, it's the single best point of access. 30 million customers globally, 50 % rise in the last decade in the number of customer outlets. And don't forget the customers are retail stores or concessions or restaurants. They're not us. We are one step away.

23:38I think it was a sense of valuation risk at the time. I mean, it's interesting you bring up the point because I think some of the most successful companies tend to dominate when it comes to distribution. You think of the likes of Microsoft and Apple and technology and their ability to push things through their system. The Coca -Cola company shares a comparable competitive advantage. What are the other components of this business that you think provide the defensibility that makes it so hard to challenge? A network effect created by the customer touch points ultimately being right in front of the customer at all times.

24:11In the Coca -Cola systems model, that's also managed by local partners who understand those individual customers better than perhaps some global HQ can. And so it's not a one size fits all model, but yet still connected to the same system. So I do think that is the leading advantage that they've created. And they've nurtured it the last 20 years. they've improved it dramatically and invested behind it enormously. The second one, which is a corollary to that really, but it's taken people a while to realize the benefit of this, is the data and the insights and the analytics that you can get. So all of these bottlers are invested in systems similar to SAPs, HANA, or Microsoft Dynamics, and they're getting this real -time data and feedback on consumer changes, consumer behavior, which again, really informs their marketing spend really informs their revenue growth management and their categories in different regions.

25:03And that's just one of the big benefits that comes from it. I think obviously you can't mention Coca -Cola without talking about the brand and the franchise value and the value of nurturing over a very long period of time that brand equity. It's probably one of the most recognized words in the world, certainly one of the most recognized symbols in the world, and it stands the test of time. I think the final one is really just their scale. As I said, they're outspending in terms of as a percentage of their sales, let alone in absolute dollars, the amount they spend on marketing and advertising globally.

25:40And really that's the lifeblood for consumer goods companies. And so building that out has been huge and it's all been led by this dominance in Cola. Their Coca -Cola trademark Coke is such a cash cow and that has enabled them to buy these other businesses, sometimes highly successfully, sometimes lower success. But to build up that kind of distribution network, to build up that brand portfolio and invest behind it, they're generating $10 billion free cash flow at the moment. It'll be 12 quite soon. Extraordinary amount of free cash flow to invest back in the business or obviously pay out its dividends.