Usually during the third quarter of each year I analyze my portfolio’s performance, do a little tweaking and cast about for an underlying strategy for the new year. 2016 was especially difficult due to a couple of mergers wreaking havoc on my portfolio structure as well as the uncertainty caused by the election. The easy fix is to add to my anchor, core and satellite holdings at reasonable price points to get them to their target weightings. This is illustrated by my recent purchases of KMB, CLX and SBUX with more to come. The more difficult issue was identifying potential value plays for an ancillary portion of the portfolio.
I looked for ideas in companies that were beaten down and soon locked in on Coca-Cola. Headwinds abound with sugar taxes,slowing growth and nutritional concerns valid arguments. This is, however, a company undergoing a transformation which is under-reported, ignored, or misunderstood by many. In Sure Dividend’s recent piece, Soda Wars: Coca-Cola vs. PepsiCo, Bob’s well written article has no mention of the 21st Century Beverage Partnership Model. While I personally agree that Pepsi (PEP) is the better investment, the more I uncovered the stronger my belief that there was a hidden opportunity within Coca-Cola (KO). In fact, Timberwolf Equity Research published a series on Seeking Alpha on this topic (Part 1, Part 2, Part 3).
The short version of the Coca-Cola restructuring is a consolidation of the bottlers through buyouts,operational integration and mergers resulting in a smaller, yet stronger, bottling operation with geographic concentration. These are referred to as “anchor bottlers”. A key point in this effort is that once complete, KO retains a significant minority ownership stake in the independent bottlers rather than full ownership of several. There is a twofold benefit in this as 1) KO no longer has to consolidate bottling operations in their earnings – shedding a capital intensive, low growth business (and associated debt); which in turn 2) provides a dividend stream. Per Berkshire Hathaway‘s annual letter (p. 20), their tax rate on dividends is between 7 and 10.5%. I suspect KO’s rate would be similar which is a significant reduction on the standard corporate tax rate. With the restructuring set to complete this year (2017), I suspect KO to begin reaping the benefits starting in 2018. The primary downside being the face of tax reform.
The real question becomes, why then buy the bottlers? To cross this bridge requires a few assumptions:
- The US dollar is at historic highs which is not sustainable,
- The promise of operational efficiencies will be fulfilled, and
- Merger activity continues, further increasing efficiencies
My hypothesis is that if all were to occur the investment would be both interesting and profitable. Worst case scenario (outside a business failure) is a dividend stream that lacks robustness due to currency valuations. My guess is reality resides somewhere in between. What I find interesting is to buy the bottlers is to buy (in many cases) diversification – from snacks (like PEP) to airlines to other bottling brands including liquor.
|Swire Pacific||SWRAY||O/M||Hong Kong
owns 45% Cathay Pacific
|Suntory Bev. & Food||STBFY||M/S||Japan|
|Asahi Group Hold.||ASBRF||M/S||Japan|
My intention is to purchase most of the possibles depending on the relative strength of the US$ as the ex-div date draws closer, with any company not to exceed 1% of the portfolio value. I also plan to add to KO on weakness throughout 2017.
The M&A aspect appears valid as two others (not listed) are being taken over, COFCO’s Coca-Cola assets by SWRAY and CCOJF by COJPF.
Notes: The foreign (non-ADR) stocks may have higher brokerage fees than standard rates. Switzerland tax withheld at 35% unless declared as US treaty prior to payment. Ensure your broker performs this service to attain 15% withholding.
Update 7 May 2018: This strategy was given a ‘back-handed endorsement’ in comments made by Buffett subsequent to the 2018 Berkshire annual meeting as follows:
Coca-Cola … (has) the– the world’s greatest distribution system. So they can push liquids through that. I don’t know whether they could push cream of wheat, you know, or some things through their distribution system. Obviously, a great distribution system is worth an enormous amount. And– and like I say, Coca-Cola has a great one. Coca-Cola incidentally, you know– they’re selling 5% more liquids. They are selling 100 ounces of liquids per capita in the whole world. 7 billion people are drinking their Coca-Cola product. And they’re drinking that at the rate of 100 ounces a year. That’s substantial. Leaves a lotta ounces to go. But they are selling more ounces of liquid– but they’ve got more brands now. But they are selling (more) than they’ve ever sold. And it grows year by year. And it’s growing.
ed. note: KO is the marketing arm and the franchisor. The bottlers are the distribution system (supply chain).