Saturday, 11 January 2014

1997-Coca Cola's Advanced Accounting Theory

You remember the old election-night parley. The anxious party boss demands, "How many votes did we get in the fourth ward?" Comes the crony’s reassuring reply: "How many votes do we need?"
Such sweet corruption has largely faded from politics but not from corporate America. Substitute, "profits" for "votes," and you could be a chief financial officer assuring his boss he will bet him the bottom line he needs.

Unlike stealing the vote, managing the numbers is merely a theft against perceptions, for it masks the reality of shifting trends with the illusion of smoothness. There is one other difference. Politicians practice their art under cover; earnings managers do their doctoring in daylight.

Witness Coca-Cola Co., which all but promises Wall Street that earnings per share will grow 18% to 20% a year and-one way or another-delivers. So much faith does the Street put in Coca-Cola’s magic that Roy Burry, a veteran analyst at Oppenheimer, recently wrote that Coke has "absolute control over near-term results," referring to its profits through the end of 1998. The drinks have yet to be pursed; the economic and climatic conditions that will affect results cannot be known, but the numbers would seem to be in the bag.

Coca-Cola is as good a company as it exists, and one with no seeming need to manage results. It has 48% of the world soft-drink market, and it is still adding share. Give the folks in Atlanta time, and even water may come in contour bottles.

But its growth does not come evenly, nor is there any reason to expect that it should. One year, Mexico is depressed; the next, Coca-Cola nabs the dominant bottler (and long-time Pepsi franchisee) in Venezuela. But Coca-Cola, like some others, has struck an implicit bargain with Wall Street: It pretends that its profit growth is smooth, and the Street pretends not to notice that it isn’t.

In the first quarter of 1997, Coca-Cola earned 40 cents a share, putting it on target to increase its full-year net by its customary 18%. However, the quarter concluded an eight-cent gain from selling its stake in Coca-Cola & Schweppes Beverages, one of its biggest nonanchor bottlers.

Coca-Cola, which booked similar gains on bottlers last year, is adamant that Wall Street treat such profits as part of its normal earnings stream. It made a point of discussing its investments in its annual and first-quarter reports. Gains from sales, it said, "are an integral part of the soft-drink business."
But are they? Coca-Cola, to its credit, long ago realized that selling concentrate is a far better business that bottling soda. The latter requires lots of capital, while Coca-Cola’s business enjoys high margins, heady growth and vast potential. That’s why its stock trades at 42 times earnings.

Coca-Cola periodically invests in weaker bottlers, shores them up and sells out at a profit-and such sales will undoubtedly recur. Nancy Ford, manager of investor relations, rejects the notion that Coca-Cola does so to manage its numbers. As she notes, the strategic impact of its investments is crucial. "Our bottlers are absolutely critical to our success," she says, meaning critical to the strong distribution that allows it to streamroll the competition.

But not even Coca-Cola can sell the same bottler twice, and it is dubious that such profits from disinvesting will rise at the same rate as soda sales in Beijing. "That doesn’t get valued like selling a case of Coke," says Pat McConnell, accounting analyst at Bear Stearns. "In a sense, it’s a discontinued operation."

The profits are real, but to treat the appreciation on long-held assets as occurring in a single year is an accounting fiction. Coke analysts mostly look the other way, but uneasily.

"It’s controversial," says Salomon Brothers analyst Jennifer Solomon, who includes the gain. "It’s an issue we have been struggling with." Mr. Burry, more bluntly, says, "Of course [the gain] is nonrecurring." But if Coca-Cola can deliver such feats each year, his report suggest, who cares? Last year, Coca-Cola earned $1.40 a share, up and impeccably on-target 19%. But that included large extraordinary and nonoperating items, which contributed roughly 11 cents.

In Coca-Cola’s view, the unusual items merely replaced normal profits that were "lost" when it decided to curtain concentrate shipments to certain bottlers. "They encouraged analysts to think of the unusual gains as income that replaced concentrate income it otherwise would have recognized," says Marc Cohen of Goldman Sachs.

But the curtailment cleared the decks for Coca-Cola to sell more concentrate-and book it-in future quarters. Knocking out the nonoperating items, Mr. Cohen derives a figure for Coca-Cola’s "underlying profits," which advanced in1996 by only 11%. In effect, Coca-Cola masked a (for it) sorely disappointing year.

This year is stronger, but a good case can be made that Coca-Cola’s continuing profits are growing at a midteens rate, not higher. Probably, the strong dollar is catching up with it; perhaps there are other trends bubbling in the business that smoothing the bottom line obscures.

The difference of a few percentage points a year is small, but investors in high-multiple stocks must telescope projected earnings far, far into the future, magnifying the effect of even small differentials. They may be surprised to discover that Coca-Cola has been marketing its stock as aggressively as its drink.

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