What Is Coke's Real ROE?
MARKET PLACE
Coca-Cola Under Fire Over Spinoff
August 4, 1998
By MELODY PETERSEN
The Coca-Cola money machine has whirred along for
years, producing extraordinary profits for
investors.
What helped set it in motion was management's decision
in the late 1980s to remove the capital-intensive
bottling factories from the company's books and place
them in a separate company. The maneuver has proved so
successful that archrival Pepsico Inc., a perennial
also-ran, recently announced that it, too, would
consider spinning off its bottling unit.
But a growing chorus of financial analysts and
accountants are trying to strip the gears of Coca-Cola
Co. They say that Coca-Cola and its giant bottling
company, Coca-Cola Enterprises, are essentially one
business and should consolidate their financial
statements, an argument not lost on the United States'
accounting rule makers.
A consolidation would immediately cut hundreds of
millions of dollars from Coca-Cola's earnings, the
analysts say. And Coca-Cola would be forced to reclaim
billions of dollars of debt that now resides with
Coca-Cola Enterprises.
"The numbers look wonderful," said Albert Meyer, an
accountant and investment analyst, about Coca-Cola's
financial reporting system. "It is almost too good to
be true."
To him and others, the system is not the real thing.
"It is pretty fake, actually," he said in a recent
interview.
Accounting rules leave some room for interpretation,
and Coca-Cola has not been forced to consolidate
accounting, because it owns less than 50 percent of the
bottling company.
But the Financial Accounting Standards Board, which
sets the nation's accounting rules, has long been
concerned that some companies, among them Coca-Cola,
may be skirting the spirit of the rules.
So it is now discussing a new rule that would force
companies with very close ties to consolidate even when
there is a minority ownership -- a rule that would
apparently force Coca-Cola's hand. Though the board
moves very slowly, a proposal is scheduled for release
late this year.
The Securities and Exchange Commission could -- on its
own -- require Coca-Cola to consolidate. Officials
there said that they looked at corporate relationships
as well as stock ownership in determining control, but
that they could not comment on Coca-Cola's accounting
in particular.
In select cases, they have forced companies to
consolidate their financial statements after finding
that one company clearly controlled many parts of
another's business.
Without a doubt, the fates of Coca-Cola and its big
bottler are inextricably linked. Coca-Cola recorded
$18.9 billion in worldwide sales last year, compared
with $11.3 billion for Coca-Cola Enterprises, which
accounts for much of domestic Coca-Cola sales.
But the global giant has a market value of $203
billion, dwarfing the $13 billion market value of
Coca-Cola Enterprises. That divergence reflects a
decade of superior returns for investors in Coca-Cola
and a heavy debt burden at Coca-Cola Enterprises.
Critics of the current accounting practices say that
Coca-Cola can, to some degree, bolster its bottom line
through sales to the bottling company, over which it
has much control.
Coca-Cola sells billions of dollars of soft-drink
concentrate each year to Coca-Cola Enterprises. It has
also sold entire operations, including three bottlers
last year for at least $1.6 billion, to Coca-Cola
Enterprises. Such sales could not generate profits if
the accounting books were consolidated.
Coca-Cola stands behind its accounting. Randal
Donaldson, a company spokesman, said that the company
was "absolutely in accordance" with all accounting
rules. Federal securities regulators were informed of
the accounting system in 1986, when Coca-Cola
Enterprises became a separate company, Donaldson said,
and they did not object.
The two companies are independent, he continued,
pointing out that Coca-Cola Co. has a minority stake,
now 44 percent, in the bottler. Because Coca-Cola does
not control the bottler, it does not have the option of
consolidating financial statements, he added.
"This is an old worn-out point of view, totally without
merit," said Laura Asman, spokeswoman for Coca-Cola
Enterprises, "and our company's performance for our
share owners speaks for itself."
Meyer and Dwight Owsen, a doctoral student at the
University of Portsmouth in Britain, have recently
written papers criticizing Coca-Cola's accounting.
They compare the approach with one used by many
companies during the Depression. During those hard
times, a parent company and related entities would sell
items to one another to inflate revenues and raise the
parent company's stock price. Those abuses led to
changes in accounting rules, intended to eliminate any
profit on sales between closely related companies.
"One can't transact business with itself," said Meyer,
an investment analyst with Martin Capital Management in
Elkhart, Ind., and a former accounting professor who
turned the spotlight on the Foundation for New Era
Philanthropy in Philadelphia, which was found to be a
financial fraud. "It is not real. If you consolidate,
then everything collapses."
To Meyer and Owsen, the issue of independence rests
heavily on the composition of the board of directors.
They say the board of Coca-Cola Enterprises is
controlled by people with strong ties to Coca-Cola.
To Coca-Cola's credit, the makeup of the board has
changed recently. Until late last year, Douglas
Ivester, then Coca-Cola's president, was chairman of
the bottling company. He stepped down after being
promoted to chairman and chief executive of Coca-Cola
Co. Neville Isdell, a senior vice president of
Coca-Cola, also stepped down, in February.
But the board still includes two former senior
Coca-Cola executives and Joseph Gladden Jr.,
Coca-Cola's general counsel.
In addition, there are others with a large financial
stake in Coca-Cola: Howard Buffett, the son of Warren
Buffett and a director of Berkshire Hathaway,
Coca-Cola's largest stockholder, and two directors of
Sun Trust Banks, Coca-Cola's second-largest
stockholder.
That accounts for six of the board's 13 members.
Another director is a consultant who has contracts with
both Coca-Cola and the bottler.
Meyer and Owsen suggest that Coca-Cola exerts so much
influence that Coca-Cola Enterprises may be overpaying
it for bottling factories and a myriad of other goods
and services. Coca-Cola's stunning returns, compared
with far weaker profits at Coca-Cola Enterprises, are
evidence that Coca-Cola could be charging too much,
they say.
Other stock market analysts and accountants have
questioned Coca-Cola's accounting after examining its
transactions with the bottling company.
"The open secret on Wall Street, it seems, is that
Enterprises and Coke are one and the same company,
accounting principles to the contrary notwithstanding,"
wrote James Grant, the editor of Grant's Interest Rate
Observer, in a 1996 article. "In essence, the bottling
giant is a kind of receptacle for the everyday business
detritus that would otherwise mar the parent's nearly
perfect financial profile."
In his newsletter last week, Grant pointed to Pepsico's
recent announcement that it would put many of its
bottling operations in a separate company. "Will
Pepsico's announcement prompt an official inquiry into
the accounting arrangements?" Grant asked. "The
government has investigated less worthy subjects."
Already, Moody's Investors Service Inc. and Standard &
Poor's Corp., the two big bond-rating agencies,
consolidate Coca-Cola and Coca-Cola Enterprises when
they analyze the companies' financial statements.
Pepsi has not disclosed how big a stake in its bottling
operations might be sold to the public. Still, it would
probably follow Coca-Cola's model.
In 1986, when Coca-Cola decided to put most of its
North American bottling factories into a separate
company, it sold 51 percent of that company to the
public. It kept just shy of the 50 percent stake
required for independent financial reporting.
The move allowed Coca-Cola to rid its balance sheet of
the expensive bottling factories and those factories'
debt. And it meant that Coca-Cola's earnings would no
longer be lowered by the factories' billions of dollars
of depreciation and interest expense every year.
Since then, Coca-Cola's main duties have consisted of
setting global corporate strategy, planning advertising
campaigns and selling soft-drink syrup to bottlers.
Coca-Cola Enterprises mainly handles production: mixing
the syrup with fizzy water, putting it into bottles and
trucking it to retailers.
Despite the split, Coca-Cola still exerts much
influence over Enterprises. For example, the bottler
cannot sell any bottling operations without Coca-Cola's
consent. And if an outsider buys more than 10 percent
of Coca-Cola Enterprises' stock, Coca-Cola can
terminate its bottling agreements with Enterprises,
which would essentially end the bottler's business.
Descriptions of the business transactions between the
two companies take up several pages in the documents
that Coca-Cola Enterprises must file with regulators.
In 1997, Enterprises bought vehicles and rented office
space from Coca-Cola. And it repaired Coca-Cola's
equipment.
Even goods that Enterprises could buy directly from
outside vendors came from Coca-Cola. For example,
Enterprises bought almost all its sweeteners from
Coca-Cola in 1997.
Enterprises delivers fountain syrup to customers on
Coca-Cola's behalf, and at times, bills and collects
money on those sales, later transferring the money to
Coca-Cola.
Donaldson said that all the transactions were conducted
at arm's length and at fair market prices.
But it is Coca-Cola's sales of billion-dollar bottling
operations to Enterprises that most bothers Meyer and
Owsen. They say that Enterprises and its shareholders
may be paying too much for these factories, and they
point to poor profit margins and the billions of
dollars of intangible assets that accompany the
purchases to support their case.
There is no evidence that these or any other purchases
were done at anything other than market value.
But the underlying issue, according to Meyer and Owsen,
is that Enterprises' board is dominated by people with
strong ties to Coca-Cola.
"They are not going to drive a hard bargain," Meyer
said. "They have a conflict of interest." Any profits
that Coca-Cola earns on these sales -- about $508
million in 1997 -- are "mythical," he said.
Donaldson said that Coca-Cola strongly disagreed with
Meyer's contention that Coca-Cola exerted control over
Enterprises' board.
And he noted that before Coca-Cola sells its interest
in any bottling operation to Enterprises, the price
must be approved by a three-member committee of
Enterprises' board, and those three members cannot be
Coca-Cola executives or former executives.
When it comes to the accounting rule makers, Donaldson
said that the Financial Accounting Standards Board had
been debating the rules for many years without reaching
a conclusion. He pointed to a paper by Dennis
Beresford, former chairman of the accounting board, who
argued that the current rules were satisfactory.
Not all stock analysts argue for consolidation.
Emanuel Goldman, an analyst at Paine Webber in San
Francisco, said Monday that it would be "insane" to
join the two companies' financial statements. He said
that the relationship was like that between most
franchisers and franchisees. And he said that
Enterprises' management clearly had the best interests
of its stockholders at heart because most of their
personal net worth was invested in the company's stock.
At a beverage-industry forum in May, Goldman talked
about how well Enterprises' stock had performed in
recent years even as it acquired additional bottling
operations.
"The more they acquire, the less they make and the
higher the stock goes," Goldman said. "It's the only
stock that I've ever seen like that."
Then again, over the last decade, Coca-Cola Co.'s
return to investors has been even better.
Copyright 1998 The New York Times Company |
