The Coca-Cola Company’s example shows that through the efforts of an enlightened CEO and a strong board of directors the Share Price Game can be stopped.
Executives of Coca-Cola, playing a relatively simple form of the Game, in conformance with GAAP, helped to increase the price of the stock from around $20 per share in 1994 to a high of more than $86 in mid-1998. Coke manufactures and markets the syrup for the company’s beverages under the Coca-Cola brand name. This activity is not capital intensive. Coke’s bottling operations combine the syrup with carbonated water and deliver the product—both very capital intensive, low-margin aspects of the business. To enhance earnings, the company began in 1986 to bundle up its bottling operations and spin them off. Coca-Cola Enterprises was the first and the largest of these operations. Coke retained 49 percent ownership, but claimed that the company did not control the bottling operations, which meant that under GAAP they would not be part of consolidated financial results. But in practice, the bottlers were effectively single-supplier captives of Coke, and Coke directors dominated the boards. In fact, Doug Ivester, before becoming CEO of Coca-Cola, was chairman of Coca-Cola Enterprises, and approximately half of that company’s board had close ties to Coke.
Coke loaded up the bottlers with its debt, and charged higher prices for its syrup, which raised Coke’s margins while depressing the bottlers’ margins. The company also “sold” distribution rights, generating income for Coke and goodwill for the bottlers. Coke guided its investors to look at its earnings growth and lack of risk. When asked about its “investment” in Coca-Cola Enterprises, Coke urged investors to look at “cash operating profit,” a fancy name for earnings before interest, taxes, depreciation and amortization (EBITDA), because interest, depreciation, and amortization were very significant in these capital intensive, highly leveraged, goodwill-burdened businesses. The result was that growth in Coca-Cola Enterprises was similar to sales growth.
Generally, when a company plays the Share Price Game, some hard-to-predict, external event leads to the Game being revealed. In Coke’s case, it was an unforeseen contamination scare and recall, international antitrust investigations, and a discrimination lawsuit. Only in the face of this bad news did investors and analysts look at the obvious. After all, the Game had been working well up to then. When the truth was revealed, Coke’s stock price fell more than 50 percent. Doug Ivester, who by then had become CEO, received a $120 million exit package in December 1999.
Douglas Daft took over as CEO in early 2000. Investors trusted he would end the Game until early on he promised them continuous 15 percent earnings growth. With that, the stock slid back into the low $40s bottom, and hovered between $40 and $60 per share for the next three years. Smart investors will not fall for the same story too many times.
The lesson took hold. More recently Daft has been on the leading edge of good governance with encouragement from his board and in particular from Warren Buffett. Coke was one of the first companies to announce that options would be expensed going forward, and it later announced that it would no longer give quarterly earnings guidance.
The Coca-Cola case is reminiscent of what happened at Enron. Both Coca-Cola and Enron boosted profits by using nonconsolidated entities that they controlled as a practical matter. Not only did they put lower-margin or losing activities in these entities, they also further inflated profits by charging them for goods and services. These off-balance-sheet entities accepted the charges because of the control the companies exerted. In addition both Coca-Cola and Enron reported lower financial leverage risk by loading these nonconsolidated entities with debt.
There are, however, major differences between the two. Coca-Cola has a fundamentally sound business model, and management has run the business well, avoiding large mistakes. Enron’s business model was flawed, and Enron management made a lot of bad investments. Enron held debt and interest expense in nonconsolidated special purpose entities while recognizing income at the Enron level. But Enron went much farther than Coca-Cola by obfuscating the existence and purpose of their off-balance-sheet subsidiaries. Coke did not try to hide the existence of its subsidiaries, but relied instead on trying to redefine growth in them and took the position that Coke did not control them.
In some instances where earnings manufacture has surfaced in very good companies, investors by and large have ignored it. Perhaps these were one-off events that did not indicate a pattern of behavior, or perhaps the company and its management succeeded in quickly allaying investor concerns. The lesson investors should take away from such an example, however, is clear. If they want to minimize their risk and sell their stock before possible price declines, they should watch diligently for warning signs of earnings manufacture and act accordingly.