Thursday, November 24, 2011

Coca-Cola vs Alcoa: Full Business Cycle Earnings

From this Barron's interview with Mark Holowesko (formerly at Templeton and now manages over $ 2 billion at Holowesko Partners):

"At Templeton, we looked at earnings over a full business cycle..."

In the interview, Holowesko also says that some tend to look at earnings on a short-term basis. I think that frequently leads to misjudgments of intrinsic value. Sometimes, rather large ones. To gauge whether something is inexpensive, the more conservative approach is to use earnings over a full business cycle to estimate value then compare to the current share price.

So, in many cases (though, of course, not all), it's smart to look at earnings over a longer horizon. With this in mind, lets take a look at the business of Coca-Cola (KO) and Alcoa (AA).

For highly cyclical businesses, earnings need to be viewed over at least a full business cycle. Sometimes that's not even long enough. Consider the earnings of a cyclical business like Alcoa before, during, and right after the financial crisis:

Alcoa Earnings (millions)
2006       2007         2008          2009
2,246      2,562         (76)         (1,151)

Alcoa didn't return to profitability (barely) until 2010 and this year will have earnings that are still down by more than 50% compared to 2006. To make matters worse, its shares outstanding grew by nearly 30%.

The company continues to carry substantial debt.

For a business with mediocre at best economics, and vulnerable earnings during a recession, more modest use of debt is generally a good idea.

For financially sound businesses with very consistent earnings like Coca-Cola earnings do not necessarily need to be looked at over a full business cycle.

Here's an indication why it's far less necessary. In contrast to Alcoa, here's the earnings of Coca-Cola before, during, and right after the financial crisis:

Coca-Cola Earnings (millions)
2006       2007         2008         2009
5,080      5,981        5,807        6,824

Coca-Cola's earnings hardly missed a beat during the crisis. By 2009, Coca-Cola's earnings was 34% higher than 2006 and, of course, is much higher now (nearly $ 8.6 billion). Those earnings seem rather likely to increase, even if not every single year, nicely over time. Most importantly, it'll be accomplished at a high return on capital.

It mostly comes down to whether or not a business can generate attractive return on capital that, give or take, remains persistent going forward.

It comes down to whether or not a business possesses durable advantages.

There's nothing wrong with a little (or even more than a little) cyclicality if the return on capital generated over time, all risks considered, will remain sufficiently attractive.

For Coca-Cola this seems more than likely (even if, considering its sheer size, less so than the past).

For Alcoa, rather less so.

To understand the normalized earning power of many businesses, a single year of earnings is often insufficient. It all comes down to the quality of the business.

A full business cycle probably isn't even a long enough time frame for a business like Alcoa.

For one with persistently high earnings, a durable franchise, and great economics like Coca-Cola, the current year's earnings might work just fine.

Adam

Established a long position in Coca-Cola at much lower than recent prices
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