The pricing behavior of individual stocks and the stock market as a whole can be compared to the action of a pendulum. The center point is true intrinsic value, and prices tend to swing both above and below. Investors can count on the market’s manic-depressive behavior to price companies at intrinsic value, sooner or later. And, an investor should never underestimate the ability of the market’s best investors to accurately gauge the intrinsic value of a business, nor the possibility that the business will trade below that value.

In view of the downswing presently underway in the Internet sector, a couple of quotes from our February and April reports are appropriate:

Stock market history teaches us that it is likely that the pendulum swing from overpricing to underpricing will continue until investors (including professionals), who were jumping on the Internet bandwagon without regard for intrinsic value during the second half of last year, have been thoroughly punished for their mistakes. Since the market paints with a broad brush, those of us who bought QUALCOMM before last year’s huge appreciation will suffer some pain, but should end up making even more money when the pendulum swing reverses.

At the same time, in the consumer brand name sector, the pendulum appears to be swinging in the positive direction. Gillette, Coke, Procter & Gamble and other gorgeous consumer businesses suffered 50% price depreciation over the past two years as money moved from them into the faster growing Internet. A soundly based argument can be made that these companies are actually priced under intrinsic value, even in this still high stock market. The recent strength in their stock prices is a budding clue of the likelihood that these stocks will outperform the market averages over the next five years.

However, the past two years have been unusually bitter for Coke. Operating profit from foreign countries declined from 78% of total operating profits to 68%, a big hit for any company to sustain. This occurred because of the severe economic contractions in many foreign economies and the exceptional weakness of foreign currencies from which foreign sales are translated into US dollars. Currencies in countries Coke does business in declined, on average, by 7% per year between 1996 and 1999, reducing both revenue growth and profit growth by about 5% per year. Coca-Cola’s long-term sales growth is driven by per capita consumption growth, which in turn depends on growth in consumer spending. Currency devaluations cause inflation and recessions. Relative to the US, most of the world’s consumers have really suffered over the past two years. When consumers are scared, they don’t buy as much Coke.

Additional problems also took their toll. Bottling problems in Belgium and France required $500 million in public relations expenditures. US volume growth slowed in 1999 after three years of above trend growth. Management succession problems followed the sudden death of the revered Robert Goizueta, who had managed a decade and a half of exceptional growth.

However, Coke never stands still. Coke took advantage of weak economic conditions in developing countries to strengthen its competitive position. For instance, it used the strong dollar to acquire soft drink businesses in regions where currencies were weak (Cadbury Schweppes, Inchcape-Russia, F&N Coca Cola), and invested a lot of capital to make sure its foreign bottling companies were running right. I expect emerging markets to grow from 5% of Coke’s revenue this year to 10% in five years.

Coke is giving its foreign units a new autonomy. These units have not only been given the choice of local action, they have been given the obligation. This will allow the Coca-Cola system to build volumes by producing products that appeal to local tastes in addition to the traditional Coke family of products. For example, African consumers prefer fruit flavors three times as much as US consumers. Brazilian consumers like the taste of Guarana, so Coke has introduced "Kuat", a new soft drink flavored with this berry from the Amazon River area. Local flavors are expected to add 1% to 2% to Coke’s annual volume growth over the next five years. In this manner Coke, which sells one billion beverages per day, seeks to take a much larger share of the 47 billion per day total market.

It is important to understand that the Coca-Cola System consists of the company, Coca-Cola, which sells soft drink concentrate, and the Coca-Cola bottlers, which buy the concentrate from Coca-Cola, bottle it, and distribute it around the world. While the concentrate business is highly profitable, bottling is only marginally profitable. Coke spent the last 10 years restructuring the bottlers, so that its worldwide marketing and advertising expenditures would be more efficiently used. Coke also owns minority positions in a number of its bottlers. This stock is carried on the books at about $3.5 billion less than its actual market value. Coke’s share of their income or losses is accounted for as "equity income".

Coke’s primary objective is to create shareholder value. The financial plan for the next five years to accomplish this is as follows: Volume growth is to recover to the 7 – 8% per year range. Concentrate prices are to increase 2.5% per year, producing 10% revenue growth. The 7% US price increase by Coke early this year is important to Coke, because it allows the bottlers to improve profit margins. Coke’s equity in its bottlers’ losses over the past four years reduced earnings per share growth by about 4% per year. (Pepsi bottlers matched the price increase.)

EPS growth is likely to have a recovery bounce of 20% in the next year, and then settle in around the middle teens. The components of this are: Revenue growth 10%, expense reductions 1-2%, leverage 1%, share repurchase 1 – 2%. Cash flow growth will be even faster, as the period of large capital expenditures and investments in bottlers is over with. This cash will be returned to shareholders through share repurchases.

Coke also took advantage of the bad period to write-down assets, thus reducing depreciation and amortization expense in future periods. Inventories at bottlers are being drawn down in the first half of this year. The international growth of Coke over the past 10 years created a network large enough and strong enough to be allowed more management autonomy. This decentralization has also allowed a 5200 person headcount reduction, which alone will reduce expenses by about $.08 per share.

We believe Coke’s current share price is below the company’s intrinsic value. Coke’s p/e ratio relative to the market is the lowest since 1988. In the past, Coke’s p/e has responded well to acceleration of volume growth and to increases in the rate of return on capital employed. The re-acceleration of Coke’s earnings growth to a rate in the mid-teens is likely to occur in an environment of earnings growth deceleration for the average U.S. company. Comparatively good stock price performance for Coke should be the result.

Steven L. Ré, CFA

May 17, 2000

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above mentioned securities in their own accounts, and may trade them at any time without notice.