Warren Buffett, via Berkshire Hathaway, initiated a 6.3% stake in Coca-Cola (NYSE:KO) in late 1988 and early 1989 (increased in 1994 to 7.8%, and grew over the years to its current level – about 8.8% due to share repurchases). Buffett would later tell Forbes magazine that a key reason for building the stake was that the stock, at the time, didn’t reflect the all but guaranteed growth that was set to occur in the company’s international business over the coming decades. We’ve seen this play out over that time period (the per capita consumption figures presented each year in the company’s annual report is a thing of beauty and one with plenty of legs in the coming years), but rarely hear about the original investment; this article will focus on the valuation of Coca-Cola common stock when Berkshire Hathaway made its original purchases, using the 1988 annual report and other public information available at that time.

In the ten years to year end 1988, here are the operating results for the Coca-Cola Company:

Year 1979 1980 1981 1982 1983 Revenue $3.895B $4.640B $4.836B $4.760B $5.056B EBIT $644M $680M $720M $773M $828M EBIT Margin 16.5% 14.7% 14.9% 16.2% 16.4% Net Income $420M $422M $482M $512M $559M Net Margin 10.8% 9.1% 10.0% 10.8% 11.1% Shares Out 372M 372M 372M 390M 408M Diluted EPS $1.13 $1.14 $1.30 $1.31 $1.37 ROA 16.3% 14.4% 14.8% 13.5% 12.8% ROE 23.0% 21.1% 22.2% 20.3% 19.6%

Year 1984 1985 1986 1987 1988 Revenue $5.442B $5.879B $6.977B $7.658B $8.338B EBIT $849M $807M $897M $1.324B $1.598B EBIT Margin 15.6% 13.7% 12.9% 17.3% 19.2% Net Income $629M $722M $934M $916M $1.038B Net Margin 11.6% 12.3% 13.4% 12.0% 12.4% Shares Out 396M 393M 387M 377M 365M Diluted EPS $1.59 $1.84 $2.41 $2.43 $2.84 ROA 12.9% 12.5% 13.3% 11.3% 12.9% ROE 22.2% 25.3% 29.1% 27.5% 33.3%

It’s quick to see what piqued Buffett’s interest. KO generates a sustainable and attractive mid-teens return on assets, in addition to a solid 25% to 30% return on equity with limited use of leverage (ROE was below 20% - and just barely - in only two of the fifteen years up to 1988). Even while paying sizable dividends to shareholders, the company successfully reinvested in the business – resulting in EPS growth north of 11% in the period presented. Along with the operating figures, we have the following balance sheet data for year-end 1988:

Cash & Equivalents $1.23B Total Debt $760M Total Assets $7.45B Total Capital $5.47B Common Shareholder Equity $3.05B

As we think about the company’s competitive position, here are some key statements from the 1988 annual report (namely the shareholders letter, written by CEO Roberto Goizueta and COO Don Keough) that provide some insight into the company’s standing in the industry and what they see for the years ahead:

“In 1988, more than 200 billion servings of our soft drinks were sold worldwide. No other company sold even half as much.”

“On a competitive basis, our position as the world's only truly global soft drink company grew stronger. Our market share of the world's flavored, carbonated soft drink sales, excluding China and the Soviet Union, climbed to nearly 45% - an all-time high - reflecting the talent, diligence and dedication of our Company associates and the people of our worldwide system.”

“On a per-share basis in 1988, our aggressive share repurchase program heightened profit growth for the individual shareholder, as net income per common share climbed 17 percent to $2.85. We are planning for continued growth in your equity.”

“Across the world, the news media cover and report the introduction of a new taste for Coke, and then the birth of Coca-Cola classic, not as business stories, but as stories of social significance. Insert any other trademark, and these stories lose their credibility. In the context of Coca-Cola, however, they are unsurprisingly familiar. Everyone knows people who are this passionate about Coca-Cola. These stories, however, are merely examples of a broader, worldwide reality that can easily be taken for granted: Coca-Cola has become such a pervasive component of the environment that its absence can be far more noteworthy than its presence.”

“Perhaps the most direct measurement of the emotional attachment between Coca-Cola and its consumers is to be found in three independent worldwide surveys conducted in 1988 by Landor & Associates. The surveys went well beyond confirming Coca-Cola as the best known and most admired trademark in the world. They quantified the huge gap between Coca-Cola and all other brands: the point spread between Coca-Cola and the second place trademark was greater than the spread between that runner-up and the 10th-ranked trademark. As a national business magazine noted in reporting the U.S. results, ‘Coca-Cola is so powerful it's practically off the charts’”

“Our worldwide system is not a proposal or a promise. It is real, the model to which our competitors can only aspire… And through aggressive, thoughtful investment, it is continuously expanding its ability to place our soft drinks within "an arm's reach of desire'.' In Japan last year, for example, the system added 26,000 new vending machines to the more than 700,000 already in place; in the United States, it added more than 100,000. The system expanded in the Middle East, adding six countries and 16 million consumers.”

“Soft drinks are the fastest- growing beverage in the world, easily outpacing wine, beer, tea, milk and even tap water. We take responsibility for continuing this growth.”

“Evaluated from any perspective and in any locale, The Coca-Cola Company is accelerating, growing profitably, building on the assets, and the advantages, that we alone possess.”

“In many international markets, low per capita consumption rates for soft drinks offer obvious opportunity that is reinforced by demographic trends, economic development and the expanding reach of the mass media. Last year, international per capita consumption of Company products grew 5 percent to more than 51 drinks per year.”

For comparison, per cap consumption of Coca-Cola products in the U.S. was 289 in 1988.

Every quote cited above came from the first 10 to 15 pages of the 1988 annual report. In those few sentences, we find something quite desirable: a company focused on its core business (Columbia Pictures was sold in 1987), one in which it has a commanding lead and with plenty of opportunity for continued global expansion (international share was even higher than global share, at 47%) that is centered on selling a product that is the most admired trademark in the world (the “New Coke” fiasco of 1985 made this quite clear); in addition, the company is focused on “aggressively” repurchasing common stock, a move that will increase owner’s stake in a great business with time – and hopefully avoid value destroying “deworsification.”

Even with all this, the price still needs to be right for attractive returns; here was the share price and market capitalization at year end, in the five years ending Dec. 31, 1988:

Year Average Shares Year End Price Market Cap 1984 396M $20.80 $8.2B 1985 393M $28.15 $11.1B 1986 387M $37.75 $14.6B 1987 377M $38.10 $14.4B 1988 365M $44.60 $16.3B

To put these numbers into content, 10 year average ROA was 13.5%. Using year-end 1988 figures, we come up with the following estimate as a proxy for sustainable earnings power:

Metric 10-Yr Average Current Earnings Power ROA 13.5% $7.45B Roughly $1B

KO had a profitable and growing business - one in which it had a commanding lead and plenty of opportunities for international growth. When plugged into a reverse DCF model (with a discount rate of 10%), the valuation at 1/1/1989 implies growth of 3% in perpetuity – as noted by Buffett, this suggests the market was essentially disregarding the global growth opportunities for Coca-Cola.

Deeper analysis over this period may shed light on expecting mean reversion in ROA to the mid-teens figure reported in the years prior to 1983 (and as we see now, in the years after 1989/1990) - an adjustment that yields marginally higher growth figures to those presented even at a discount rate of 12-15%. With worldwide volumes increasing at a rate of 7% in 1988, the disconnect begins to become apparent.

CONCLUSION

Warren and Charlie concluded that this was grossly pessimistic and made a big bet. Coca-Cola's trademarks and its system were two unique and invaluable assets that would time and again all but assure success in new regions. Looking back, with 20/20 vision, we can see that this has played out nicely for KO: per capita consumption across the globe has more than doubled since 1988, and the company is still a dominant leader in the industry; in addition, India and China recently (2011) reported per capita consumption figures of 12 and 38, respectively - suggesting that there is still plenty of work to do for the boys in Atlanta.

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