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The Coke System: How It Works And How It Is Changing - Part I

The term Coke System is oftentimes used to refer to the network of companies involved in Coke's soft drinks value chain.

In this article, I will try to delve a little deeper into the workings of the system, its recent history and current dynamics.

The latest change in Coke's system surfaced last week, when the North American refranchising effort witnessed an unexpected development.

The Coke System is a term oftentimes used to describe the network of companies engaged in Coca-Cola's value chain. But what is it exactly? How does it work? And how is it currently evolving? Obviously, at the very core of it sits the Coca-Cola Company (NYSE:KO), which controls the most attractive part of the soft drinks value chain it created: the syrup business. The core of Coke's operations consists of manufacturing syrup concentrates, which are sold to bottling partners. The more than 250 Coca-Cola bottlers present in the Coke system add water, carbonation and packaging to turn it into a consumer product. In marketing terms, the Coca-Cola Company is responsible for creating pull at the consumer level, while the bottlers are responsible for the push part of product marketing, which basically means having the right beverages sit on the right shelves at the right time. The old Coke adage "within an arm's reach of desire" neatly sums up this relationship, with the company responsible for creating desire and the bottlers responsible for making sure the product is within an arm's reach. In its essence the Coca-Cola Company is, therefore, primarily a marketing machine whose foremost job it is to create consumer demand. The messy part of its beverage chain - the bottling and distribution of its drinks, which requires high capital investments and offers lower margins - has historically been left in the hands of other companies.

Rise of the Anchor Bottler

Beginning in the 1980s, Coca-Cola's management sought to change the relation it had with its bottling partners in order to extract more value from the chain. At that time, its bottling system was almost a century old and seriously ill-equipped for modern economic times. The most important problem was the fact that there were so many bottlers, many of them very small, and that a lot of inefficiency and waste had crept into the system. Coke's reasoning was that it would be far better to have a few large and financially strong bottling partners, instead of many small and inefficient ones. The idea was that larger bottlers could be run better through attracting better management, could achieve economies of scale, would have access to better financing terms and could be monitored more closely (because there would be fewer). In other words, the company wanted things changed, and the means by which this was achieved was through the anchor-bottler system.

During the leadership of its legendary CEO, Roberto Goizueta, The Coca-Cola Company actively sought to buy, merge and restructure virtually any Coca-Cola bottler it could get its hands on. When the changes it had sought were completed, the bottler was usually sold off, either to another bottler or through a public offering. Coke usually kept a minority equity interest in order to assert its influence. However, by maintaining a stake lower than 50%, the company would be under no accounting obligation to consolidate the bottler's balance sheet into its own reported numbers, thereby keeping the usually elevated levels of bottler debt off its books. Because the company generally succeeded in improving the scale and efficiency of its bottling investments, there was usually an attractive capital return as a result of this process as well. The proceeds from bottler sell-offs were often used to start another bottler consolidation process, were used for share buybacks or they were invested in expanding the syrup business overseas; during the 1980s and 1990s, these equity proceeds often provided very meaningful additional income to the Coca-Cola Company.

Bottler Agreements

An important risk to the Coke bottlers is that they can get squeezed between Coke's concentrate prices and the prices they can charge the consumer at retail. In the 1990s, there was a period when that actually happened, and which led to a revolt amongst the company's bottlers. Because Coke relies to such a large degree on its bottler partners as a route to market, it is really important for the company to keep relations with the bottlers healthy. This means the economics of the Coke...