Berkshire Hathaway 2002 Annual Meeting Audience Question # 19

How to take into account the individual balance sheets of the Coca-Cola bottlers to the Coca-Cola company

Warren Buffett:

OK, we’ll go to number 1. Well, wait a second, is there anybody at number 9? Probably not, now.

Audience Member:

Yes, there is.

Warren Buffett:

OK, good enough. Nine.

Audience Member:

Phil McCaw, from Greenwich, Connecticut.

Could you discuss if and how you take into account the individual balance sheets of the Coca- Cola bottlers to the Coca-Cola Company, and if you view various regulatory control issues as a potential problem for Coca-Cola?

Warren Buffett:

Yeah, well, certain Coca-Cola bottlers became quite leveraged, the ones that were, in general, acquiring companies. Coca-Cola Enterprises certainly became very leveraged over… it started out fairly leveraged, and it became more leveraged in recent times.

And they have a business that’s a solid, steady business, but it’s not one with abnormal profitability. So, it can take leverage, in the sense that it won’t be subject to huge dips, but it also is a business where it’s very tough to increase margins significantly.

So, if most of the money goes to debt service, you know, that is something that you have to take into account when you value the equity.

It’s a fairly capital-intensive business, the bottling business. On average, you’ll probably spend between 5 and 6 percent of revenues on capital expenditures just to stay in the same place.

And in a business that, before depreciation, makes… and interest and taxes… makes maybe 15 cents on the dollar, having 5 or 6 cents on the dollar go to capital expenditures is a pretty healthy percentage of that. That’s true at the Pepsi-Cola bottling company, too.

It’s just the nature of the bottling business. It’s a reason why I like, basically, the syrup business better than the bottling business.

It’s less capital-intensive.

And I think that the bottling business is a perfectly decent business. It isn’t a wonderful business because the… it’s very competitive out there.

I mean, on any given weekend, the big supermarket in town, or the Walmart, or whatever, is going to be featuring one or the other of the colas, and they’re going to… it’s going to be based on price. And you’re going to read ads saying, you know, 12 for something or other, or 6 for something or other.

And it has become something where a lot of people will switch from one to another, based on price, on that weekend. And that makes it a tough business for bottlers. But it’s a decent business.

But it doesn’t, in terms of the Coca-Cola Company, itself, its bottlers are going to do perfectly OK over time. And they’ve got to earn enough money to be able to sustain that kind of capital expenditure and earn a cost of capital.

And if they get in trouble, it’s because, if they pay too much for another bottler, it gets tough to make the math work.

Was there a second question about Coca-Cola then, too?

Audience Member:

Well, I was curious if you concern yourself, when you see FASB-type issues come out about control…

Warren Buffett:

No. Yeah, no, I understand. I’m talking…

Audience Member:

Combining all the balance sheets, type of thing.

Warren Buffett:

Yeah, that really doesn’t make any difference to us. I mean, in the end, the Coca-Cola Company, there’s no question about it in my mind, the Coca-Cola Company needs a successful bottling group in order to prosper as a syrup manufacturer.

But the profitability of bottling will allow that. And the capital requirements at the… at Big Coke, as it’s called… are relatively minor, so most of the money they make can either be used as dividends or share repurchases.

But nobody’s going to run out of money at Coca-Cola, nor are their bottlers, basically, going to run out of money. So, it is not a big balance sheet issue at all. And whether the figures are consolidated or otherwise, the economics are basically the same.

I mean, you have a, you know, there’s not going to be a capital crunch of any kind. It would show different ratios if you consolidated and if you didn’t, but it really wouldn’t change the basic economics any.

Charlie?

Audience Member:

Thank you.

Charlie Munger:

Yeah, I don’t think it changes anything on a basic level. But ideally, in the world, you wouldn’t have capitalization structures that are designed partly for appearance’s sake.

Audience Member:

Thank you.

Warren Buffett:

We… thank you.

We pay a lot of attention to what we regard as the reality of the balance sheets and economic conditions and cash situation, all of that of a business. And sometimes we think accounting reflects reality, and sometimes we don’t.

It’s a good starting point for us always, but I mean, there are companies in the United… there’s at least one company, at least last year, that was using a 12 percent investment return assumption on its pension plan, and there are other companies that use, I think, even below six, certainly six.

And in the end, should we look at the figures the same of one company, particularly if the pension fund’s a big element, that uses 12 and six? No, we look at what it says they’re using.

But, in our minds, we don’t think the company that’s using a 12 percent assumption is likely to do any better with their pension fund than one of the one’s that’s using six. In fact, we might even think the one that’s using six is likely to do better because we might think they’re more realistic about the world.

So, we start with the figures of the companies we look at, but we’ve got our own model in mind as to what they will look like. It’s true of the businesses we own a hundred percent of. Some of them have some debt in them, some of them don’t, partly that situation’s inherited.

In the end, we’ve got the same metrics that apply to them, whether they happen to have some debt on their own particular balance sheet or not, because in the end, we’re not going to be willing to have very much debt at all at Berkshire.

And where it’s placed doesn’t really make any difference because we’re going to pay everything we owe, no matter where it is.

And it’s almost an accident whether company A or company B has a little debt attached to it.

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