Description

Note: A bullish report on COKE was posted last year by LimitedDownside. More information on the company can be found in that report.

Summary: Coca-Cola Bottling Co. Consolidated (Symbol: COKE) is the largest independent Coca-Cola bottler in the U.S. The company has greatly expanded its territory over the past four years. It has been able to acquire these territories with inexpensive debt. The expansion has reduced margins in the short-term, but the new businesses are being integrated with the legacy business and will soon add to COKE’s profits and EBIT margins. This company has excellent margin expansion and earnings growth potential. My 12-month price target of $306 / share implies a return of roughly 50% on the current stock price.

Introduction: COKE has been completely transformed by multiple transactions over the past four years. The company will report 2017 sales of more than $4 billion, more than double the company’s sales in 2014. The expansion phase is largely complete. Although COKE is a $3.1 billion enterprise value company, it is not well-known by investors. There is limited sell-side coverage, the float is small, and there is minimal investor outreach. COKE’s stock price has dropped about 20% over the past few months as Q2 and Q3 earnings were unimpressive. The market reaction was, in my opinion, unwarranted as the growth story remains intact.   

Background

Coca-Cola Bottling Co. Consolidated (COKE) is the largest independent Coca-Cola bottler in the United States. It is based in Charlotte, NC, and operates in the Southeast and Midwest. I will refer to the company as “COKE” throughout this report. COKE produces, sells, and distributes more than 300 brands and flavors of drinks in 16 states. Its products include Coca-Cola Company products, such as Coca-Cola, Diet Coke, Sprite, Barqs, POWERade, Minute Maid, and Dasani. COKE also produces and distributes some non-Coca-Cola products, including Dr. Pepper, Full Throttle, and Monster Energy. COKE’s territories include majority distribution rights in NC, SC, VA, TN, and WV. The total population of COKE’s territories exceeds 50 million. Chairman and CEO J. Frank Harrison III is the great-grandson of the company’s founder. He has served as CEO since 1994.

Refranchising

            The Coca-Cola Company (symbol: KO) has been refranchising its bottling operations over the past few years. In 2010, KO acquired the North American bottling operations of publicly-traded Coca-Cola Enterprises (CCE) for $12.3 billion. CCE had not been performing well and KO thought that it could manage its bottling operations better and cut costs. KO, though, had difficulty with the localized nature of the business. Beverage distribution requires personal relationships with thousands of grocery stores, convenience stores, big box stores, restaurants, etc. The CCE deal did not improve KO’s operating margins and sales volumes were weak. So, less than three years later, KO changed course and announced that it would refranchise its bottling operations. It decided to get away from the capital-intensive bottling and distribution businesses and focus on selling concentrate and other raw ingredients.

The Coca-Cola Company (KO) has greatly transformed its North American business. The company does not actually sell territories. It engages in refranchising deals that include territory swaps and sub-bottling arrangements in which a bottler makes payments in exchange for exclusive territorial rights. COKE has acquired distribution rights and assets (warehouses, trucks, etc.) from KO. The original plan was for KO to refranchise 100% of its North American operations by the end of 2020. In 2016, it greatly accelerated this refranchising plan as it announced its intention to refranchise all its North American operations by the end of 2017. This was excellent news for COKE. KO also announced its intention to sell its 39 North American cold-fill production plants. COKE has acquired the plants the reside in its regions. The result is that COKE fully controls both manufacturing and distribution in its legacy and new territories and can maximize its competitive strengths.

            The refranchising effort has allowed COKE to greatly expand its business. The company has doubled its footprint in the past three years. In 2010, COKE represented approximately 7% of Coca-Cola’s U.S. volumes. Today, COKE represents nearly 20%. Prior to the refranchising, COKE operated in parts of seven states: NC, SC, AL, GA, TN, VA, and WV. Since 2014, COKE has expanded its territories within these states and entered eleven others. Much of the expansion has occurred in the Mid-Atlantic and Upper Midwest. The fact that KO has allowed COKE to acquire such a large region is a testament to KO’s confidence in COKE’s abilities as an operator. KO’s CEO has told investors that its best bottlers were chosen for the re-franchising.

COKE has long-term agreements with KO. When it expands into a new area, it signs a 10-year comprehensive beverage agreement (CBA). CBAs renew automatically unless cancelled. They give COKE the exclusive rights to distribute beverages in exchange for quarterly sub-bottling payments. They also include the acquisition of certain distribution assets. The typical process is that COKE signs a letter of intent (LOI) for a new territory first and signs a definitive CBA several months later. In February, 2016, for example, COKE signed an LOI with KO to acquire distribution rights in several sections of Ohio. A definitive deal was closed in April, 2017. COKE has also executed exchanges with KO and independent Coca-Cola bottlers. In 2015, for example, COKE signed an agreement with KO to exchange territory that it held in Tennessee for new territory in Kentucky and Indiana. COKE has also purchased manufacturing facilities from KO as it has gained territory. The company now owns approximately 13 manufacturing facilities and 86 warehouses / distribution centers. This is a mixture of owned and leased properties.

COKE recently announced the acquisition of new distribution territories. These deals likely represent the company’s final territory gains as KO announced the completion of its refranchising effort on Oct. 30. In the latest set of deals, COKE acquired new territories in parts of Arkansas, Tennessee, and South Carolina. In exchange, it transferred territories in parts of Alabama, Mississippi, Georgia, Kentucky, and Tennessee. COKE made these deals to acquire territories that integrate better with its existing territories and allow for better economies of scale. The geographic expansion has required significant money, time, and effort. Among other issues, the company has added 10,000 new employees. The end of the expansion means that COKE’s management can now focus on extracting value from new territories.

Image: The Coca-Cola Company has refranchised many of its territories to its nearly 70 independent Coca-Cola bottlers. COKE’s territories are shown in light blue in the map at right.

The Business

            COKE is dependent on the continued success of Coca-Cola and other products. Its portfolio includes more than 300 brands in nine beverage categories. Growth categories for COKE include tea, energy, sparkling, and dairy brands. It is having success with mini-cans and other unusual SKUs. Mini-cans sell well at convenience stores and other locations which have better growth than traditional grocery stores. COKE has more than doubled the number of SKUs over the past few years. The diversity of its brands gives it some margin of safety against weakness in a category or categories. Its Monster business has grown nicely since 2015 when KO invested in Monster and two companies signed a partnership deal. COKE, though, remains dependent on the most popular Coca-Cola brands. Carbonated beverages represent about 70% of its sales. This percentage has been falling as energy products and other still beverages have had better growth. One slight negative with COKE is that more than 80% of its sales are bottle and can sales to retail customers. Its three largest customer accounts are Walmart, Food Lion, and Kroger.

CONA

            COKE is part of a group called CONA Services LLC. “CONA” stands for “Coke One North America”. It was created as part of KO’s refranchising strategy. The group is a collaborative effort among bottlers that have expanded under KO’s refranchising plan. It is owned and governed by eight U.S. bottlers. One of COKE’s execs serves as its current chairman. CONA is developing an IT platform based on bottlers’ best practices. Some of the areas of interest include customer account management, customer care, manufacturing, purchasing, warehouse operations, delivery, finance, and HR. COKE is currently running both its legacy IT system and the beta CONA system. The goal is to migrate the entire company to the CONA system in early-2018 without any disruption to business. COKE is currently incurring some development and implementation costs as CONA is developed. Next year, the completion of CONA should improve margins as costs go away and operations improve.

NPSS

            COKE is part a group called the National Product Supply System (NPSS). This group was created in 2015 when KO decided to sell production facilities to bottlers. NPSS, like CONA, is a group that consists of large Coca-Cola bottlers who have joined forces to make the entire system better. Coca-Cola bottlers benefit from collaboration in several ways. They can, for example, purchase plastics through a single entity to increase their purchasing power. In a statement, KO outlined three goals for NPSS:

• Achieve the lowest optimal manufactured and delivered cost for all bottlers in the Coca-Cola system
• Enable system investment to build sustainable capability and competitive advantage
• Prioritize quality, service and innovation in order to successfully meet and exceed customer and consumer requirements

Acquisitions  

            COKE has disclosed some financials related to expansion activities. The company does not disclose financial considerations when it announces LOIs or definitive agreements. Financials related to the deals are available in some SEC filings. On 7/13/17, COKE filed an 8-K with financial information on its expansion activities in 2016 and the first few months of 2017. This 8-K revealed that COKE paid $396.9 mil. in cash and assumed liabilities for the 2016 expansion territories. Further, it revealed that COKE paid $274.5 mil. in cash and assumed liabilities for the early-2017 expansion territories. The company finances these acquisitions by drawing on its revolving credit facility. It has been reporting interest rates below 2% on this facility. COKE’s long-term debt has increased from $399 mil. at the end of 2013 to $1.1 bil. at the end of Q2 ’17.

COKE discloses some financial information on its acquisitions. The firm reported operating income of $127.9 mil. and net income of $50.1 mil. for 2016. Pro forma for the 2016 and 2017 transactions, COKE would have reported operating income of $198.5 mil. and net income of $91.0 mil. for 2016. These numbers are likely inaccurate because KO can attribute costs as it pleases. Pro forma revenues would have increased from the reported $3.16 bil. in 2016 to $4.25 billion. The release of these financials has made it easier for investors to estimate COKE’s revenues and profit margins.   

For God, Family…and Shareholders?

            COKE is a family-controlled business with some unfortunate corporate governance issues. Three members of the Harrison family sit on its board of directors. There are only 9.4 mil. shares outstanding and nearly half of them have been taken out of the public float. There are two classes of COKE stock, the publicly-traded Class A shares and super-voting Class B shares. Coca-Cola (KO) is the largest shareholder as it holds 34.8% of the outstanding Class A shares. J. Frank Harrison III and his family own 100% of the outstanding Class B shares. This ownership stake gives the Harrison family 86.0% of the total voting power. There has been some controversy related to how the Harrison family spends shareholders’ money.

Some of COKE’s money goes to Harrison’s favored charities. Harrison and other execs are evangelical Christians who bring their faith to the workplace. Harrison serves on the board of the Billy Graham Evangelical Association and has said that God is the true owner of COKE. The first paragraph of the company’s 2016 10-K states that, “Our purpose is to honor God…” In a rarity for a public firm, COKE spends several hundred thousand dollars per year to staff its facilities with chaplains. It also donates money to numerous Christian charities. One of these is a Christian missionary group called With Open Eyes. This group shares an address with COKE’s corporate headquarters. It was founded in 2008 by J. Frank Harrison III and his son, J. Frank Harrison IV. The younger Mr. Harrison died in 2010 while doing missionary work in Kenya. In 2015, COKE announced that it had made a “one-time” charitable contribution of $4 mil. to, “…further the Company’s purpose to serve and impact the lives of others.” While the recipient of this donation was not disclosed, it is no great stretch to suggest that it was With Open Eyes. In an appearance at a 2016 prayer breakfast, Harrison said that he intends to donate 10% of COKE’s profits to charities. The firm’s charitable donations totaled $6.0 mil. in 2015 and $8.4 mil. in 2016.

There are some questionable corporate governance practices at COKE. Harrison and his family own COKE’s corporate headquarters and one of its production facilities. The principal balances of the capital leases on these properties totaled $30.2 million at the beginning of 2017. The company paid $8.3 mil. in rent on these properties in 2016. This means that COKE paid more rent to Harrison in 2016 than it paid in dividends to outside shareholders. Harrison, who owns more than $400 mil. in Class B shares, received more than $11.3 mil. in total compensation in 2016. Most of this compensation consisted of a grant of 40,000 new Class B shares. In past years, Harrison has also received millions of dollars in cash payments to cover taxes on restricted stock grants.    

Street Estimates

            The only sell-side analyst who follows COKE is Wendy Nicholson at Citi. She has not been bullish as she has rated COKE at “Neutral” since 2013. Nicholson does not publish a price target for COKE because the company does not provide guidance or hold earnings calls. She ignores the reported adjusted numbers and uses her own adjusted numbers. She lowered her 2017 and 2018 estimates after both Q2 and Q3. Nicholson’s 2017 estimates are adjusted EPS of $7.57, revenue of $4.37 bil., adjusted EBITDA of $326 mil., and adjusted EBIT of $162 million. Her 2018 estimates are adjusted EPS of $8.83, revenue of $4.84 bil., adjusted EBITDA of $370 mil., and adjusted EBIT of $188 million. She forecasts adjusted EPS of $1.13 for Q4. Nicholson has not published estimates for 2019 when, I believe, the earnings power of COKE will become more apparent. There is no forecast of margin improvements in her current model.

Q3 Results

            COKE reported subpar Q3 results. The earnings press release quoted COKE’s president as saying, “The third quarter was one of the more challenging quarters we have experienced in several years with softer than expected sales performance in certain channels of trade. The third quarter was also impacted by hurricanes, which resulted in negative product sourcing impacts and a noticeable shift in product mix during September to lower margin case pack water.” Many people in COKE’s main southeast territories stocked up on bottled water in anticipation of hurricanes. COKE also sold bottled water to FEMA. These were low-margin sales. The company also had to pay unusually high rates for transportation in situations in which it uses third-party trucking. Other food and beverage companies that operate in the southeast reported similar problems. COKE’s stock dropped about 10% after the earnings announcement. I think that this drop was an overreaction and has created a buying opportunity.

It will take some time for COKE to see the benefit of its huge business transformation. Its numbers are messy due to the territory acquisitions. While net sales increased 36.9% year-over-year in Q3, operating income fell 9.2% and EPS dropped from $2.48 to $1.86. COKE also reports “comparable” numbers which exclude recent territory acquisitions. The comparable numbers did not look strong in Q3. It is important to note, however, that the comparable base increased by about 25% because it included the 2015 acquisitions. COKE’s expenses are increasing faster than its sales as it takes time to integrate new territories into its system. It will not receive the full benefit of its 2014-17 expansion until 2019 or later. COKE’s CFO has confirmed that acquired territories should have similar margins as the legacy territories. There is no reason, in other words, to think that COKE is acquiring businesses with worse prospects than its legacy business. The firm is experiencing margin compression that should only be temporary.

Balance Sheet / FCF

            COKE will have an opportunity to reduce its debt. Some investors have been concerned that COKE’s debt has nearly tripled its debt to fund its expansion. The firm closed Q3 with $1.17 bil. in long-term debt. It will incur interest expense of more than $40 mil. this year. I believe, however, that COKE’s debt is manageable and has nearly peaked. There will be no need for further borrowing as the expansion is complete. I do not think that COKE has taken on too much debt as its long-term debt is only about 3.0x my estimate of next year’s EBIT. The firm has not been generating FCF over the past few years as capex has gradually increased to around $200 mil. / year. CONA and other expansion-related activities have required unusual capex. Beginning in 2018, however, the expansion will be effectively complete, capex should stabilize, and the company should generate free cash that it can use to pay down debt. I estimate that COKE will generate more than $100 mil. in FCF next year. Much of this FCF should be used for debt reduction. The company may be able to pay down $300 mil. in debt by the end of 2021.

Forecasts

            COKE has an opportunity to greatly increase EBIT and EPS over the next few years. The company’s recent results have been messy due to the massive expansion. The EBIT margins on acquired territories are not much more than 0%. Over time, the company should bring these margins up to normal levels for the business. COKE will be able to improve EBIT margins for the entire business as it implements CONA and benefits from economies of scale. The company could reach EBIT margins in the range of 7.5% - 8.5%. The long-term growth rate for the company is likely in the low single digits. It should reach $5 bil. in revenues by 2021. The gross margin should stabilize in the high-30%s. COKE reports unusual and significant “other income” expenses based on NPV calculations of future sub-bottling payments to KO. While these expenses affect GAAP EPS, they are not cash expenses. A corporate tax cut would provide significant boost to COKE’s net income and EPS as I assume a high tax rate of 38%. Here are my GAAP income statement expectations:

            COKE should expand its margins and grow as the company integrates the new territories. One of the reasons that The Coca-Cola Company (KO) is refranchising its operations is that it has underperformed as a bottler and distributor. COKE has generated 6 - 7% EBIT margins with its legacy territories. The company’s CFO has said that acquired territories have had similar margins. The expansion over the past three years, though, has reduced EBIT margins as the transition takes time. It takes a year or more for COKE to integrate acquired regions into its system. I believe that COKE will optimize the acquired territories and increase EBIT margins to approximately 8.5%. It will likely take three to five years for the new territories to match the performance of legacy territories and for new initiatives to have their full impact. COKE is currently trading at 10.4x my 2020 GAAP EPS estimate.

The Stock

            COKE’s stock price has been volatile. It does not take much for this stock to experience violent up and down moves due to the limited float. COKE has been public since the early-1970s, but, as discussed, has not really managed as a public company. A paltry dividend of $1.00 / year was set in 1994 and has not been changed since. COKE traded around $50 for decades as there was no reason to buy it. The announcement and implementation of KO’s re-franchising strategy, though, increased interest in the stock. It soared from about $70 at the beginning of 2014 to more than $200 in 2015. In 2016, the stock dropped back all the way to $120 as investors worried about the success of the growth plan. This turned out to be a good buying opportunity as the stock subsequently rose to a new all-time high of nearly $250 in July, 2017. I think that the recent pullback to $200 is another buying opportunity.

Valuation

            My price target I based on COKE’s earnings after it optimizes performance in its new territories. By my model, COKE should achieve EBIT of approximately $46 / share in 2021. Discounting this number back three years, I get a value of approximately $34 / share. I believe that a multiple of 9x on this discounted EBIT number is fair, so my 12-month price target on COKE is $306. This target implies a one-year return of roughly 50% on the current stock price. Note that COKE’s current EV of $3.1 bil. is only 0.7x current-year sales.

Some Risks

·         COKE has expanded into new territories in a short period. There is no guarantee that it will be as successful in these new territories as in its legacy regions.

·         COKE has greatly increased in size. It has more employees, production plants, customers, routes, etc., than it has ever had before. There are significant logistical and financial challenges with such a major expansion. COKE’s workforce has more than doubled in the past four years. There is significant execution risk.

·         COKE has introduced many new products and SKUs in the last few years. These products may not be as popular as COKE expects.

·         COKE’s corporate governance is poor. It is a family-controlled company with a history of questionable insider transactions. It is not clear that it is being managed to maximize shareholder returns. There is little that minority shareholders can do about this situation.

·         Many of COKE’s products are unhealthy. COKE could suffer if people choose to consumer beverages with less sugar. These is also a risk that governments may impose taxes to reduce soft drink consumption. COKE does, however, produce and distribute some healthier beverages.

·         COKE is dependent on KO to some extent. KO could take actions that could hurt bottlers’ margins or growth. It could, for example, reduce advertising. For the most part, however, KO wants the bottlers to be successful.

·         COKE has taken on substantial debt to fund its acquisitions.

·         COKE is transitioning to a new IT system. There is a risk of business disruptions or software failures.

·         COKE must fulfill certain requirements under its agreements with KO. It could lose distribution rights if it fails to meet some requirements.

·         Higher gas prices are detrimental to COKE’s margins as employs a large number of trucks for distribution.      

Conclusion

            COKE is in the late stages of a huge transformation. KO’s refranchising strategy has provided a golden opportunity for COKE to expand its territories and benefit from economies of scale. Some investors see a family-controlled company that has taken on a lot of debt to acquire low margin businesses. I see a business that is wrapping up its acquisitions and has a great opportunity for growth and margin expansion. The COKE story is largely unknown due to minimal Street coverage and a limited float. I do not think it will take long for COKE to trade at new all-time highs.

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

margin expansion, growth