The steep downturn in Coca-Cola Co.'s performance has finally led analysts and other observers to focus on the company's once- ballyhooed financial relationship with its key bottlers, chiefly Coca-Cola Enterprises Inc. (CCE). That should put former Coke CEO Douglas Ivester's failure into proper perspective. As the architect of the bottling system under his predecessor, Robert Goizueta, Ivester's recent ineptitude at the helm--a bean-counting approach to marketing and a tin ear for public relations--pales in comparison with his bottling strategy, which is now returning to haunt Coke.
Despite the new focus on Coke's relationship with CCE and other bottlers, however, many observers still miss the point of this financial engineering. As CFO explained three years ago (see "Off Again, On Again," July 1997), by spinning off a bare majority interest in its bottling operations in 1986 but retaining seats on CCE's board, Coke has managed to have it both ways. The move, known as the "49 percent solution" (for the stake that Coke originally retained in such companies as CCE), got the low-margin bottling assets off Coke's books. It boosted its own returns without giving up control of the business based on those assets--namely, distribution. Accounting purists contend the strategy violated the spirit, if not the letter, of generally accepted accounting principles. GAAP or not, Fortune magazine recently labeled the strategy "brilliant," though flawed in execution.
Fortune has it backward. What was brilliant, insofar as the strategy was designed to boost Coke's earnings, was the execution. But the strategy itself was flawed. "The bottlers never had a chance to make money," says Albert Meyer, an analyst for the Dallas-based investment research firm David Tice & Associates.
To understand why, look more closely at Ivester's financial wizardry. In return for bottling and distributing Coke's soft drinks (and paying one-time franchise fees for the privilege, to the tune of $15 billion, part of which Coke carries on its balance sheet as a deferred credit against its investment in the bottlers), CCE has received annual payments from Coke labeled "marketing support." Because of that designation, investors may believe that these payments are for advertising and other marketing expenditures, although those are already reflected in Coke's own expenses. In reality, the payments compensate the bottlers for their operating costs. Until recently, that didn't bother investors, no doubt because the payments didn't amount to much. In fact, they were more than offset by the amounts Coke received from the bottlers for franchising rights and for interests in smaller bottlers in which Coke had invested but chose to sell to CCE.
Even so, Coke has been able to exploit its bottlers only so much. When Coke's sales slowed during the past few years, CCE's operating profits plummeted, raising investors' hackles. So Coke has stepped up its marketing support. In 1999 and 1998, payments to CCE alone totaled $1.1 billion and $1.2 billion, respectively, compared with a mere $568 million in 1997. In fact, Coke's support has reached the point at which the bottlers no longer subsidize the parent's earnings, but quite the reverse. Add the equity income or losses Coke reports on its bottling investments, its income or losses from sales of interests in those companies, and the income Coke reports from shares the bottlers issue, and you can see that Coke lost a total of $1.2 billion from the bottling system last year, compared with a gain of $373 million in 1997.
Of course, the bottlers are critical to Coke, so Coke cannot afford not to support them. But surely the job of reversing the bottlers' fortunes would be easier if Coke didn't have to satisfy more than one set of shareholders whose interests are not easily aligned. Is the bottlers' reconsolidation in the cards? It might be, if the Financial Accounting Standards Board makes good on its long- standing threat to eliminate the 51 percent threshold for defining one company's control of another. Coke declined to comment for this article.
No question, reconsolidation would raise Coke's apparent cost structure. But Ivester's "49 percent solution" has served only to hide Coke's real costs, and to deepen the hit to its stock price when that fact became painfully apparent. As Meyer puts it, "It was a gimmick bound to fail."