The Real Thing

After a rough second half in 1997, Coca-Cola seems to have regained its touch. And CFO James Chestnut insists Coke will keep it. Here's how.

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Ever since it shed financial control of its soft-drink bottling operations in 1986 to focus on marketing, The Coca-Cola Co. has served as the corporate poster child for focusing on core competencies. No surprise, then, that Coke’s stock has far outpaced the market during the past 11 years, returning an average of 31 percent annually through last March 31, compared with 17 percent for the S&P 500.

Coke’s James E. Chestnut has had a lot to do with that performance. Before his appointment as CFO in July 1994 (which followed a nine-month stint as controller), the 48-year-old, Scottish-born and -educated Chestnut was finance chief of Coke’s operations in Japan for almost five years. During Chestnut’s tenure there, Coke Japan became the company’s single most profitable market, according to analysts. A 26-year veteran of the company, Chestnut started out as a financial analyst in its London office. He is now considered a potential heir to chairman and CEO M. Douglas Ivester.

Why would a CFO–even one as talented and as committed to Coke as Chestnut obviously is–figure so prominently in a company that does little but sell syrup to bottlers in return for fees that go to advertising? There are at least two reasons. For one, Chestnut is probably as involved in marketing as any CFO today, responsible as he is for an information system that gathers so much data from its far-flung operations and processes it so quickly that headquarters can update the company’s overall operating performance twice a month. Chestnut is currently upgrading the system, hoping to make that capability available to finance chiefs within each of the 200 countries in which Coke does business.

The move dovetails with a shift in Coke’s marketing strategy, from one focused on the sweeping ad campaigns favored by departing marketing chief Sergio Zyman to one stressing local efforts under Charles Frenette, who headed Coke’s operations in southern Africa before his appointment as Zyman’s successor.

Another reason Chestnut figures prominently: Coke is more vertically integrated than its financial structure would suggest. That’s because it retains significant influence, if not absolute control, over certain key bottlers (“anchor bottlers,” in Coke’s parlance), through large minority stakes and ample board representation.

With the bottlers’ less profitable assets off Coke’s own balance sheet, Coke’s operating margins and returns on equity are much higher than they would otherwise be. Thanks to its artful exploitation of U.S. accounting standards for the results of unconsolidated subsidiaries, Coke has managed to have its financial cake and eat it, too, as CFO demonstrated at length last year (“Off Again, On Again,” July 1997). In this sense, Coke’s bottling strategy amounts to a formula far more complex than that for Coke’s product, and the formula’s financial component is Chestnut’s to oversee.

In fact, investors began to question that formula around the same time that our 1997 article appeared, as operating profit fell and one-time gains from the sale of equity interests in bottlers accounted for a rising proportion of total profit. With the latter raising concerns about the quality of Coke’s earnings, the stock fell 26 percent from mid-June to late October, from around $72 to $55.

The shortfall in operating profit was chiefly the result of currency weakness in Asia, as sales earned in Japanese yen, Thai bhat, and Indonesian rupia, among others, lost value when translated into stronger dollars. As a result, Coke’s revenues last year rose by a meager 1 percent. And, clearly, the sudden death of longtime CEO Roberto Goizueta last October didn’t help matters, although Ivester, COO and president at the time and a former CFO, had long been seen as Goizueta’s heir apparent.

Since last fall, however, Coke’s stock has rebounded, and is now trading near its 52-week high of 813/8, as investors expect improved case volumes to result in faster earnings growth. Whether that expectation proves correct, of course, remains to be seen. Some 80 percent of Coke’s earnings are derived overseas, leaving some analysts to worry that a strong dollar will continue to inhibit growth. And despite Asia’s persistent weakness and potential turmoil, Coke recently announced plans to open its 27th plant in China.

In an interview with CFO senior editor Ronald Fink at Coke’s Atlanta headquarters, Chestnut denied that foreign currency gyrations pose a serious risk, disputed the contention that Coke’s sale of equity interests in bottlers is designed to make up for declining operating profits, and insisted that Coke’s long-term outlook remains bright.

If nothing else, investors–along with CFOs of companies out to emulate Coke’s success–ought to be reassured by Chestnut’s own gifts, which include a razor-sharp intellect, a clearly strategic conception of finance, and a wry sense of humor.

What was it like dealing with the investment community when Goizueta passed away and Ivester took over?

Roberto was such an integral part of the company. For him to go–and to go so suddenly–was, from a personal standpoint, very upsetting.

When it comes to the corporation, the fact is that for many years–certainly since the early 1980s–the company has focused on one very clear mission: to maximize shareholder value over time. Everything flows from that. Certainly, Roberto laid out [that mission] when he was CEO. But Doug Ivester was an important part of his team for all those years.

What the company stands for hasn’t changed as a result of Roberto’s passing away. It’s a successful formula, and there’s no reason the format should change.

Roberto was very close to many Wall Street analysts. I think people were upset personally, but no one was upset about the company, because everyone was very clear about what that was.

Does the change in marketing have anything to do with a different perspective in the CEO spot?

No. Sergio [Zyman] has decided to move on for his [own] reasons. But he’ll probably continue to have a pretty close relationship with The Coca-Cola Co.

From my standpoint, he’s been a great person to work with in terms of improving our worldwide capabilities relative to the value that comes from marketing.

People talk about marketing as something that has to get done. What we’ve been able to do is focus on what you actually get from marketing. How do you measure that? How do you measure performance on the basis of investment and different types of investment?

How do you measure it?

Essentially, The Coca-Cola Co. is a brand company. We are fortunate that we are married to some top brands. It’s our responsibility to continue to build and develop them. So at its very core, from a strategic standpoint, The Coca-Cola Co. is a brand owner. We make our earnings based on manufacturing a concentrate that we then sell to bottlers around the world.

The bottler takes that and adds sugared water, basically. But the bottler also invests in a huge infrastructure from a physical standpoint, in terms of organization and distribution and that sort of thing.

Our job is to understand the consumer and to invest in marketing in order to increase our brand equity. So if you think about our core business, we don’t really have a great deal of capital investment.

With the new plant in China, the bottler is the one making the capital investment, right?

Yes, but whenever you read about new bottling plants being opened in places like India, China, or Russia, in many cases, those are actually plants that we’re building. As the brand owner, we have an obligation to keep looking for expansion opportunities around the world.

But from a financial point of view, doesn’t the fact that the bottlers’ assets are not on your balance sheet limit your exposure to the risks in those markets?

What I’m saying is: When it comes to areas in which there has to be new investment, you’ll find that very often The Coca-Cola Co. is the investor. Take China. In the early days, we were the investor there. These days  we’ve rolled our investment into an equity position in bottling. In India, we’re investing in a great deal of sites. We’re purchasing bottlers. At what point do you decide it’s time for the bottler to take over that investment responsibility?
It’s based on an assessment of the health of the worldwide system, ensuring that route to market is as strong as it can be. So, for instance, when the Berlin Wall came down, we invested in East Germany. We went in very fast. No bottler could move as quickly as we could. We had the capital resources and the people resources, and we had the speed to go in and build that infrastructure. When that business had achieved stability and success, we saw the opportunity to merge an East German bottler with three bottlers in the southern part of Germany to form the base of a new anchor bottler.

You saw an opportunity, developed it, and then, at a certain point, you could step away.

Because to the bottlers, we’re a brand owner, not bottlers. But in a practical sense, we’re always bottlers, because we have to keep that system strong. To keep it strong, we’re always going into ownership positions, doing what we have to do, and then coming out of ownership positions, normally by folding those interests into an equity stake.

This strategy has come under some criticism from a quality-of-earnings perspective, because of the one-time gains that arise from it. To what degree do you use that strategy as a way of managing earnings? And to the extent that investors are focusing less on earnings and more on cash flow these days, won’t such a strategy become less effective?

We engage in worthy transactions all the time. That’s been the case for almost 20 years. And as far as I’m concerned, it’ll always be the case because it’s a changing, dynamic world. And as circumstances change, it’s our job to stay on top of the implications of the changing world. To do that, we’ll always be getting into and out of ownership. But we’re doing that to ensure the health of the system, not to have a line of business that is transactions. It’s a very important difference.

That’s what drives the decision?

Yes. So, transactional change will take place whenever it’s the right time for it to take place.

It’s not about meeting or beating estimates?

No, absolutely not. There’s a limit to how you can control the timing of those things, anyway. It would be very difficult, actually, to manage all the transactions, even if we wanted to. You used an expression, “quality of earnings.” Does that mean the market would be more comfortable with us doing fewer transactions, which we just might do?

Good question.

My very strong position is that everything we’re doing on the transactional front is going to increase quality of earnings and the long-term strength of this business. We’re never going to shy away from making structural change simply because it might be more difficult for me to get to the market.

Is your point about the complexity of these transactions sometimes lost on observers who assume that you turn a light switch on and–bang–there’s the one-time gain?

Last year, we were involved in transactions representing equity stakes in bottlers with a total value in excess of $8 billion. We did all of that in-house. We don’t use an outside investment banking capability. As a group, we’re very good at this sort of thing. We know the business.

But you’re saying it’s not that easy. Anyway, back to Asia. Some analysts who take a longer-term point of view say you’re smart to be investing now. How do you assess the risk-reward trade-offs there right now and when you make any new investment?

It really does change your perspective when you genuinely have a long-term view. Also, we have the benefit of a very significant portfolio, a beneficial portfolio. We’re doing this in 200 countries.

The fact that we are doing business in all these countries gives us the capability to look at a Korea or an Indonesia and set it against a background of 198 other countries. So whenever we decide to take a risk in one country, it really is not a great risk. But aren’t you more heavily exposed in some areas than in others? Japan, for instance?
One could ask the same question about the United States.

When you say long term, how far out are you looking?

Coca-Cola is 112 years old. We’re only scratching the surface in terms of potential.

How do you convey that to Wall Street, when it seems that it’s so focused on the short term? Some think that Coke’s growth is slowing, in part because the growth of the Coke brand lags that of some of your other products with brands that don’t have as much power.

For years we’ve said that, over time, increased volume in the 7 to 8 percent range would increase earnings per share in the 15 to 20 percent range. We stick by those statements. Some years we might not get into that range but, over time, we will.

If you look at the character of our worldwide data, we’ve got sizable volume coming from higher per-capita [consumption] markets today, and a growing proportion of volume coming from lower per-capita markets. Obviously, if we’ve got a lower base and a lower per-capita market, we can expect to see higher growth rates over time.

Those lower per capita markets are typically lower-margin markets as well. This is really where the opportunity is. Volume underpins everything we do. We’re going to get 7 or 8 percent over time in volume and 15 to 20 percent over time on EPS. But the volume is the most important one.

We’re seeing strong growth in places like the United States and Mexico, which are higher per capita, so we have all sorts of growth opportunities in those markets as well. But there’s even greater opportunity in [less-developed] territories, where there are 4 billion people under 50 years old. Now the cynic says, “Well, they’re only just scratching out a living. They can’t afford a Coke.” That’s true for some of them. [But] there are a lot of people who can afford a Coke. That’s where we’re investing.

On foreign exchange risk, you’re credited with being as good at hedging as anyone. But there are few opportunities to do that in emerging markets.

There are practically none! But that’s where our portfolio comes into effect. Because in a normal economic cycle, our portfolio works very well for us. Let’s say a company is doing business in one other country. The risk that the company will be running on foreign exchange ranges from 10 to 15 percent over time, based on classic statistical theory.

Do exactly the same analysis for The Coca-Cola Co., [with] its unique profile–200 countries, 60 functional currencies. Instead of plus or minus 10 to 15 percent, the risk is plus or minus 5 to 7 percent. Then we have a very capable trader [to hedge] foreign exchange. So over time, we believe we can limit that downside to no more than 3 percent.

How much do you worry about brand value?

We’re measuring the profitability of every brand in every country where we do business. It depends on what you mean by “value.”

Do you pay much attention to surveys of brand value?

I think they’re very useful to people who are not familiar with the way we work. They get everything encapsulated in one number. I think that’s useful–not terribly useful for us, because we run the business, but useful in an external sense, because it says, “Here are brands that have significant value, and the numbers are significant.”

There’s a logic that says this company has a market capitalization of, say, $185 billion. That value comes from the brand and from our system–the way we run our business on a worldwide basis–and the long-term potential.

So these survey numbers are not useful to you internally?

Well, internally, value is the ability of something to create earnings. What’s the value of this building? Or, what’s the value of the plant in Puerto Rico? It’s not the cost of the investment, it’s the ability of that [investment] to create value in the long term.

Same with a brand. If we own a brand, its value is in our ability to create earnings from it. But at the end of the day, we’ve got to be able to measure the value and satisfy ourselves that the investment that we’re putting against the brand is actually delivering value and building brand equity. How do you make brand equity? You understand the consumer. You invest in research, you invest in understanding the customer, and you keep all those factors increasing over time.

But U.S. accounting doesn’t really reflect that. Is there a disconnect between what you’re doing and what one would see on the financial statements as a result?

Let me go back to the pieces that integrate value. I’m a great believer in trying to stimulate the right sort of behavior. The important thing is to make sure that we have not only the right structure in place, but also the right people with the right skills, who are motivated to do the right thing.

For many years, this company has done a lot of work on value. What does value mean? How do you create it? What are the drivers? We’ve used EVA [economic value added] for many years, and over the last four or five years, we’ve also been using value-based management as a way of stimulating the right behavior.

We need to make sure that people understand what it takes to create value. A part of that is the traditional income statement. But it doesn’t take into account value in an appropriate way. It doesn’t matter whether your brand has a value of $1 or $100 million. It’s the improvement from one year to the next that’s the important thing. How do you measure value? How do you stimulate people to bring it about?

For our people to make the best decisions, they need to have the facts. There’s no point in having a hunch and making decisions purely based on that hunch. We want people to use their hunches and their good judgment, but on a foundation of facts.

[That creates] the need for a greater information capability. We’ve been doing a fair bit on that in our project Infinity, which we started 18 months ago. We think we’re pretty much ahead of anybody else in pulling information from a worldwide system and using information on a structured, disciplined, and routine basis. But we need to make sure that in a couple of years, we’ll have even better information capabilities. So, we have a group here in Atlanta drawn not only from The Coca-Cola Co. organization, but also from bottlers throughout the world, to work with SAP to build this capability for the future.

Where are you now versus where you’re going?

We have very good routine information–to a certain level–every month. We report twice a month. Then our rolling estimate comes in about a week or 10 days later. The rolling estimate is really a revised review of the budget–month by month for the current year, and quarter by quarter for next year. That’s coming in from every country, every month.

We’re moving to a point at which that level of information is available to local finance managers. Two hundred countries, twice a month, are now preparing information on a variety of systems and platforms and understanding their local marketplace to a certain level of detail.

Infinity will provide these managers with improved skills, so all of that work [will be standardized] in all the different countries. But there will also be more detail and more capability in each operation.

What issue keeps you awake at night?

The critical element in maintaining our growth is continuing to hire high-caliber, high-capability people on a worldwide basis. That’s an area in which we continue to invest a lot. We try to focus not only on the finance area, but across the organization. Our game is to make sure that whenever we invest funds, we’re not doing it frivolously; we’re going into situations where we have the right capabilities and the right people.

What does that take?

A lot of attention. It’s very important, not only from the point of view of making sure you’ve got the right people coming through the organization, but from a cultural standpoint. Probably about a quarter of the finance department in Atlanta are foreign nationals.

What that communicates to the whole finance organization is the need for risk-taking, the need for flexibility, and the need for cultural sensitivity. Careers aren’t built only at corporate headquarters. They have to be built on a worldwide basis.

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