Coca-Cola's Secret Accounting Formula
from Summer 2000
by Peter Keating
For many years, Coca-Cola kept two secret formulas hidden in its hometown of Atlanta. One still lies inside the vault at SunTrust Banks at 303 Peachtree Street Northeast: the legendary recipe for Coca-Cola the beverage. The second was stashed across town at 1 Coca-Cola Plaza. There, in the top left-hand drawer of his desk on the 25th floor, former CEO Roberto Goizueta guarded a sheet of paper bearing the recipe for Coca-Cola the business.
Its key element: Coke, which essentially markets its brand name and makes soda goop, would transform its relationship with the companies that infuse the concentrate with carbonated water, bottle the stuff, and sell it. By gathering many bottlers into a few big affiliates in which Coke would retain just less than a majority stake, Coke could call these entities independent but still hold plenty of power over them. The plan became known as "the 49% solution."
This way of doing business propelled Coca-Cola`s products around the world and created terrific wealth for its shareholders. It elevated Goizueta to mythical status and put Douglas Ivester on track to succeed him.
Ultimately, however, the plan backfired. Coke`s returns were so fantastic that few bothered to notice that the company had founded its business model on a legal loophole, reported troubling details incompletely, and used financial legerdemain to sustain its results. When Coke ran out of accounting tricks, its earnings hit a wall and its stock price imploded-ultimately costing shareholders more than $100 billion and 5,200 people their jobs. In one sense, the Coca-Cola saga is a detective story, because so many of its details are hidden on balance sheets and income statements. But it`s not a whodunit, because the identities of those who allowed capital to be misallocated, then destroyed, are clear: the management, the auditors, and-especially-the corporate boards at Coca-Cola and its bottlers.
Fifteen years ago, two men with very different backgrounds but a shared gospel teamed up to match Coca-Cola`s financial power to its brand name. Roberto Goizueta, a Cuban-born chemical engineer who had climbed through Coke`s ranks for 40 years before becoming chairman and CEO in 1981, was a leading disciple of shareholder return. "The curse of all curses is the revenue line," he once said. Goizueta obsessed about Coke`s stock price, not its top line.
Doug Ivester shared that passion. The son of a Georgia factory foreman, Ivester was an accountant for Ernst & Whinney who jumped to Coca-Cola, one of his clients, in 1979. His signal skill was analyzing complex problems and developing solutions that increased returns, and by the mid-`80s Ivester was Coke`s CFO.
Under Goizueta and Ivester, Coca-Cola began acquiring the outfits that pipe Coke beverages into bottles and cans. Bottling is a capital-intensive, low-margin business, and, over time, the bottlers had been uneven performers. Coke`s chiefs were able to absorb bottlers into the network Coke already owned, consolidate the operations, and make them more efficient. Then, in 1986, Coke spun off its group of bottlers and took it public-but kept 49% of the stock in the new entity, Coca-Cola Enterprises (CCE).
In one swift move, Goizueta and Ivester swept the bottlers` debt off Coke`s books-while keeping enough equity in the new company to exert massive influence on it. At the same time, they focused Coke even more purely on selling concentrate-a business that generates high returns and piles of cash without needing much capital investment. Over the next decade, Coke repeated its buy-and-bundle strategy across the world, consolidating regional firms into eight "anchor" bottlers while charging aggressively into international markets. The strategy unlocked astonishing value-from 1980 to 1997, Coke`s profits jumped 876% and its stock price soared more than 6,300%.
Throughout this time, Coke benefited from favorable economic developments-and from troubles at PepsiCo, which pursued an opposite strategy of maintaining ownership of its bottlers and investing heavily in restaurant businesses. Even after Goizueta died of cancer in October 1997, investors remained confident. "Ivester Glides Smoothly to the Helm at Coca-Cola," read one headline in the Atlanta Journal & Constitution. And why not? In the previous quarter, Coke`s profits had climbed 24.8%.
During this period of Coke`s greatest success, not many investors cared that Coke could squeeze its supposedly independent bottlers almost at will. Example: Coke has regularly raised the price of concentrate, knowing that bottlers will pony up for the basic ingredients of their products. In addition, Coke has unloaded billions of dollars of non-cash-producing assets onto the balance sheets of CCE and its siblings since 1986.
Coke moves in and out of equity stakes in its bottlers, often selling whole territories to its anchor bottlers. Coke sold its Belgian and French operations to CCE in 1996, for example; the following year, it sold CCE three more bottlers for at least $1.6 billion. Because bottlers are acquiring the right to distribute Coca-Cola products in these deals, Coke charges them more for these networks than the physical value of the facilities involved-staggeringly more. Bottlers book this excess amount of their purchase over the net asset value of the plants they acquire as "franchise rights," essentially goodwill. They amortize these franchise rights, typically over 40-year periods, which directly depresses earnings. They carry the franchise rights on their balance sheets as "noncurrent assets," a practice that, over time, has helped drive their return on assets below their cost of capital. And they often go deeper into debt to acquire more franchise rights.
In the mid-`90s, Coke continued charging top dollar for franchise rights even as the bottlers began to sweat under the strains of bottling and distribution. From 1995 to 1998, CCE`s operating income climbed 86%, from $468 million to $869 million. But its capital expenditures tripled, to $1.6 billion. Its interest costs more than doubled, to $701 million, and so did its depreciation expenses, to $725 million. And all the while, it continued to plow money-more than $8 billion-into Coke for franchise rights.
As Coke buys and sells properties, its stakes in the bottlers fluctuate, always remaining below 50%. At the end of 1999, for example, it held 40% of CCE. Yet the terms of the concentrate sales and the franchise rights deals suggest that Coke exerts powerful control over its anchor bottlers. So do a series of other stipulations: CCE cannot sell bottling plants without Coke`s permission. It must meet once a year to discuss marketing efforts with Coke. And if any outsider acquires a stake greater than 10% in CCE, Coke can pull out of its bottling contracts with CCE.
If Coke admitted that it controls the bottlers, it would be required to consolidate its financial statements with theirs. And that would mean it could not profit by raising prices to the bottlers or dumping questionable assets on them-at the end of each quarter, their balance sheets would be combined. Coke, however, has always insisted that, because it owns less than a majority of voting shares in the anchor bottlers, it is entitled to treat them as separate entities. Therefore, Coke uses equity accounting, which allows it simply to book the value of its investments in the bottlers on its balance sheet and report its share of the bottlers` earnings. Further, equity accounting permits the gains from Coke`s sales to its bottlers to go straight to its bottom line. By 1997, those profits hit $639 million, equal to 12.8% of Coke`s earnings per share.
Ultimately, the cumulative effect of the structure Coke imposed on the bottlers was like something out of Twins, the movie where Arnold Schwarzenegger got all the good DNA and Danny DeVito, the bad. By 1999, after more than a dozen years of deals with Coke, CCE was carrying $14.6 billion in noncurrent assets-predominantly franchise rights-which accounted for fully 64% of all of its assets. Excluding nonrecurring items, CCE`s return on assets dwindled to a DeVitoish 0.6%, while Coke kept its own return on assets above 16%. CCE had 1.1% net margins in 1999, Coke 16.4%. CCE`s return on equity was 4.7%, Coke`s 35.7%. (PepsiCo, by comparison, had 9.5% margins and a 28.3% return on equity-sort of what Coke and CCE would look like if they were combined.)
Why did CCE`s board stand for this? A possible clue: While CCE`s returns were declining, its leverage rising, and its cash flying out the window to Coke, its board of directors substantially overlapped Coke`s. Before he was promoted to CEO of Coca-Cola, for example, Ivester was chairman of CCE. CCE`s board is still full of members connected to Coke. The current roster includes Joseph Gladden Jr., Coke`s general counsel; James Chestnut, executive vice president for operations support at Coke; Claus Halle, an international consultant for Coke; Howard Buffett, son of Warren and a director of Berkshire Hathaway, Coke`s largest shareholder; L. Phillip Humann, chairman and CEO of SunTrust Banks, Coke`s second-largest shareholder; Scott Probasco Jr., a director at SunTrust; and Robert Keller, a retired former director of Coca-Cola Bottling (a bottler bought by CCE in 1997), who owns more than 400,000 shares of Coke and about 27,000 of CCE. That`s seven of CCE`s 14 directors with official ties to or heavy investments in Coke.
Accounting standards are ambiguous when it comes to cases such as Coke`s. "The rules say that if you control more than 50% of a company, you have to consolidate financial statements, but they don`t say that if you control less than 50%, you don`t have to consolidate," according to Ron Bossio, senior project manager for consolidations at the Financial Accounting Standards Board (FASB).
Coke strongly maintains that its transactions with CCE and other bottlers have been conducted at arm`s length and at fair prices, and that the company is "absolutely in accordance" with all accounting regulations. Coke notes that it apprised federal authorities of its methods in 1986 and that they did not protest. It says that when the CCE board votes on transactions that can affect Coca-Cola, Coke employees on the CCE board abstain.
"This is an old, worn-out point of view, totally without merit," said CCE spokeswoman Laura Asman when asked whether a lack of independence should force the bottler to consolidate its financial statements with Coke. "And our company`s performance for our shareowners speaks for itself." That was in 1998, before CCE went on a skid that more than halved its stock price. In 2000, CCE referred questions about consolidation to Coca-Cola.
As the `90s wore on, Coke was in a tightening bind. The company had successfully focused investors on its earnings growth. But sapping the bottlers to pump growth was threatening to hurt Coke itself. After all, Coke relied on the bottlers for production and distribution. It was a major equity investor in many of the bottlers. Moreover, if the bottlers became truly unhealthy, that might attract regulatory attention to their deals with Coke. And so Coke and its affiliates embarked on a series of maneuvers that might maintain a picture of financial health without rupturing the essence of their relationship.
To measure its operating performance, CCE trumpets a statistic called "cash operating profit" (COP) to investors and analysts. COP is net income with taxes, interest, depreciation, and amortization added back-basically EBITDA (earnings before interest, taxes, depreciation, and amortization) under a livelier name. Since CCE is in the business of acquiring bottling operations, investing in plants, and trucking beverages around, it`s fairly silly to evaluate the company without looking at borrowing costs or depreciation. But COP allows management to report numbers that don`t reflect the huge amortization costs associated with its purchase of billions of dollars in franchise rights from Coke.
In the mid-`90s, Coke started stepping up cash payments to its anchor bottlers for what it calls "support for certain marketing activities" and "infrastructure programs." These payments rapidly became an important component of CCE`s top line; they rose from $398 million in 1995 to $794 million (7% of CCE`s revenues) in 1997.
The annual amounts of Coke`s support for CCE-the only bottler for which Coke fully itemizes support payments in its financial statements-were no coincidence. In 1995, Coke chipped in $343 million in marketing support and $55 million in infrastructure support. Added to the $599 million in cash that CCE generated from other sources, this produced a cash operating profit of $997 million for CCE, or 14.7% of revenues. The following year, Coke`s payments jumped to $568 million-creating a COP of 14.8% of revenues for CCE. And in 1997, Coke donated $794 million in support. CCE`s resulting COP? 14.8% of revenues.
Management`s statistic of choice, therefore, showed CCE growing profits perfectly in line with sales-thanks to precise supplements from Coke.
Curiously, Coke treats at least part of its support payments as deferred expenses even though CCE gobbles them up as immediate income, a fact uncovered by James Grant of Grant`s Interest Rate Observer in 1998. That`s high-fizz accounting-but it lets Coke put off having to dock earnings for its burgeoning transfers to bottlers.
In the third quarter of 1998 CCE went on a stock buyback spree. According to SEC filings, the company repurchased 13.9 million shares at a cost of $403 million-more than it had spent on its own stock over the entire preceding decade.
All these moves seemed designed to prop up prices at CCE and its siblings despite their deteriorating financial condition. In the fall of 1998 that got tougher, as currency plunges hit the bottlers coming and going, depressing revenues and making it harder to service their U.S. debt. At CCE, interest and capital maintenance expenses continued to shoot higher-up 49.8% in 1998-while income from sources besides Coke declined. But Coke showed up with the bail money, contributing a whopping $899 million in marketing support and $324 million in infrastructure support, bringing CCE`s cash operating profit to-you guessed it-the same old 14.8% of revenues.
Soon, however, Coke was hit with so many problems-a racial discrimination lawsuit, international antitrust investigations, a contamination scare and recall, continuing sluggish sales-that it could no longer paper over evidence of the drag its bottlers had become. Coke`s equity investments, which had added $518 million to its earnings in 1997 and $59 million in 1998, produced a loss of $184 million in 1999. And its selling, general, and administrative (SG&A) costs, which include the support payments to bottlers, rose 8.6% to $9 billion-faster than gross profits. To keep CCE`s COP in the target range, Coke`s marketing and infrastructure support to CCE came to $1.1 billion.
"Coke`s management and stock market pundits offer all kinds of excuses for the sudden deterioration in Coke`s prospects," says Albert Meyer, an accountant and analyst at the investment firm David Tice and Associates, who uncovered the pattern of Coke`s supplements to CCE`s COP. "No one seems willing to blame the ever-weakening bottling system." Since Meyer published his first report for Tice, a mutual fund run by the firm has taken short positions in Coca-Cola stock.
In December 1999, Ivester shocked the business world by announcing his retirement; he received an exit package worth $120 million. At the end of the year, CCE CEO Henry Schimberg also retired.
Coke`s new CEO, Douglas Daft, an Australian and 30-year Coke veteran, has already wiped out a fifth of Coke`s workforce and announced an $813 million charge to 1999 earnings for underperforming operations in Eastern Europe and Russia. But Wall Street was unimpressed when Daft set a 15% earnings growth target. Coke shares, which once traded at $86.32, fell below $60 in January, plunged again in March, and recently traded around $50. Meanwhile, CCE warned in May that 2000 earnings may be 30% lower than expected. The company blamed slumping demand and the weakness of the euro; left unmentioned was the fact that interest expenses, largely attributable to those pricey deals with Coke, now devour 90% of CCE`s operating income. Shares in the bottler skidded to around $15, down 57% in the past two years.
The justification for Coke`s relationship with its bottlers-turbocharged earnings growth-has collapsed. It is now clear that investors in and employees of Coca-Cola and its affiliates have been poorly served by corporate boards and regulators that refuse to acknowledge that the companies are part of a unified business.
FASB is considering new rules to cover consolidation-but it has been chewing on that topic for a decade. And even if the rules governing consolidation do change, will it make a difference? "God, I hope so," says FASB`s Bossio. "Otherwise, why do we have audits?"
A good question-and one that should be put to corporate boards that appear to give auditors, not to mention executives with bright ideas, their rubber stamps.
