Kofola Československo a.s (KOFOL.PR)

Coca Cola and Pepsi dominate pretty much every soft drinks market in the world. There are only a handful of companies that have managed to successfully compete with these two behemoths in their local markets. This is interesting area of the market to examine because, if a drink can outsell some of the best brands of all time, it’s almost a virtual certainty it has some form of moat. One example is AG Barr’s Irn Bru, an orange concoction that is the no.1 soft drink in Scotland (and no. 3 in UK). Another is Inca Kola which has the largest market share in the Peru, (but even Peru’s national soda is part-owned by Coca Cola through a JV with Corporación Lindley S.A.). One you probably have never heard of is Kofola.

Czechoslovak Communist Coke

Communist Kofola

Communist Kofola from the 1960s

Despite being originally developed in the early 1960s by the Czechoslovak communist state as an answer to Western soft drinks, Kofola is actually one of the leading cola brands in the Czech Republic and Slovakia today. Crucially it dominates the high margin HoReCa segment (particularly in Slovakia), where Kofola Draught (“Čepovaná”) is served on tap in bars and restaurants from Brno to Bratislava.

It seems that the common competitive advantage for these types of brands is their ability to form part of a region’s cultural identity, something a worldwide brand like Coke can never achieve. The Kofola brand is firmly ingrained in the cultures of Czechia and Slovakia. While Kofola fell out of favour in the early 1990s following the Velvet Revolution, the Samaras family successfully revived the brand in the 2000s with a relentless nostalgia-fuelled marketing strategy.

Today Kofola is one of the top domestic companies and consistently ranks as the no.2 Czech brand in Ogilvy & Mather’s annual brand survey, second only to Škoda. Almost all Czechs and Slovaks that I spoke to said they would choose Kofola over Coke. One reminisced about a famous Christmas advert they run every year (https://www.youtube.com/watch?v=AVGYFysIVDQ), the Czech/Slovak equivalent of Coca Cola’s Holidays are Coming ad campaign.

For many, the taste of Kofola as a child is one of the rare positive memories from cold war era Czechoslovakia. The CEO of Stock Spirits Group recently stated that its Czech herbal liqueur brand Black Fox was specifically tailored to taste like Kofola in order to compete with Jägermeister. Why? Because taste profiles are generally shaped by what we drink in our childhoods, and young Czechs drink Kofola.  Of course, this type of moat is not repeatable elsewhere. Outside of the Czechoslovak markets, Kofola is just caffeinated sugar water. But within Czechia and Slovakia, no competitor can ever hope to replicate Kofola’s unique cultural status.

Kofola-1

Modern Čepovaná Kofola

Mixed Record of Kofola Management

So Kofola is clearly a fantastic regional brand. But the record of Kofola Československo a.s. as a company is a little more mixed. On the whole, the company has been hugely successful. Since CEO Janis Samaras and his father purchased the Kofola brand in 2002, sales of Kofola have grown around 8% annually from 500m CZK to around 1,900m CZK today. However most of this growth occurred in the first 6 years, and sales growth in recent years has been very modest (2%). Kofola developed Rajec from scratch and turned it into the most popular bottled water brand in Slovakia. They’ve made some intelligent acquisitions such as Vinea, another communist era soft drink that is very popular in Slovakia. They also acquired the top water brand in Slovenia, Radenska.

There have been successful operational initiatives too. Kofola introduced a direct distribution model in the Slovak HoReCA segment in 2009 which resulted in Kofola becoming the market leader and taking huge amounts of market share from Coca Cola HBC. They are clearly very successful at branding and marketing, even while typically under-spending their competitors on advertising expenses. They are on-trend with developments in the beverage industry by expanding into healthier and more fashionable products (juices, teas, cider, coffee, salad bars) and the upcoming acquisition of Ondrášovka will dramatically increase their share of the Czech water market.

Despite these successes, there are quite a few negatives about Kofola, particularly in relation to capital allocation. They made a disastrous unforced error by merging with Hoop Polska in 2008. While the Czechoslovak business chugged along nicely (see below), the expansion into Poland destroyed value and incinerated capital. Thankfully they moved their listing from Warsaw to Prague, their Polish PE partners exited, and nearly all of the Polish business was sold off (at a bargain basement price of €13m or 350m CZK). In addition to Poland, Kofola also had a failed expansion into Hungary that was ultimately abandoned in 2008. The latest expansion into the former Yugoslavic countries is a bit more promising, particularly Slovenia where the group acquired a market leading brand. However Kofola is off to a somewhat slow start in Croatia.

While some acquisitions have been a good fit (and their upcoming acquisition of Ondrášovka might be a game-changer for their retail offering), management are not great capital allocators. Tellingly, return on capital gets no mention in Kofola’s annual reports or presentations. Return on capital does not seem to be a feature of management compensation. In 2017, management spent almost 500m CZK on a tender offer to buy back 5% of its shares at 440 CZK per share. However the purpose of the tender was not to create shareholder value, but rather to provide a liquidity event for Polish PE firm Enterprise Investors. Then when Enterprise tried to fully exit through 2 accelerated book building processes, they were only able to tap investors for 270 CZK and 255 CZK (around where the stock trades at today). Yet Kofola has not repurchased shares ever since, even with shares currently trading 40% below the 2017 tender price.

Quality Hidden in the Numbers

Kofola’s recent financial figures understate its business quality. The main reason for this has been the disastrous performance of Hoop Polska. Kofola’s Polish business had no real brand value and was also involved in the lower quality private label end of the beverage business. Furthermore, Kofola had to impair the intangible value of its Polish assets over the last 5 years which has substantially reduced its reported earnings figures. Meanwhile Kofola continued to perform very well in the Czechoslovak markets. The table below shows how well the Czechoslovak business performed compared to the consolidated group results. The Czechoslovak figures are far more relevant now because those markets will account for the vast majority of sales going forward.

CZSK v Group

Kofola also seems to be aggressively depreciating its fixed assets. For the past 8 years, depreciation has consistently been in excess of capex.  Also, Kofola generally tends to have negative working capital (or “float” as Buffett-disciples like to call it), meaning that its customers are essentially a free source of funding for the company. So Kofola’s free cash flow record has been far better than reported earnings.

Kofola has been typically able to earn 15-20% pre-tax returns on tangible capital employed over the last 8 years (depending on how you adjust for normalised capex), which is pretty good for a beverage company that does not outsource its production and bottling. However it should be noted that AG Barr, another national champion which doesn’t outsource production, consistently earns 30%+ returns on tangible capital (and it does not have a negative working capital cycle like Kofola). There is clearly some room for improvement here.  I do think returns on tangible capital are likely to improve as the company is now more focused on its core Czechoslovak markets and the Ondrášovka acquisition is likely to bring about further economies of scale.

Attractive Valuation

The TTM valuation figures for Kofola up to Q3 2019 are as follows:

Valuations

You can buy this unique, under-followed, non-cyclical company with irreplaceable, local-moat beverage brands for a 10% TTM FCF yield. This goes down to ~8% if you throw in the extra capex they will incur on reconstructing their headquarters over the next 2 years. On a relative basis, Kofola is significantly cheaper than Coca Cola, Pepsico, Nichols, or Fevertree. However Kofola is inferior to all of these beverage companies and therefore should trade at a relative discount to them because it does not outsource its production, has a poor track record capital allocation, and probably has lower growth prospects. However Kofola does trade at a significant relative discount to more appropriate comps like AG Barr and Britvic (30-50% discount depending on what valuation metrics you use). So it’s clearly cheap on a relative basis.

It’s not a stretch to foresee 5% growth from here (i.e. the growth rate in CZSK segment since 2012) and a 10-15% annual return going forward. And you’re sitting on a 5.2% dividend yield. I think this is an attractive investment at this price, but not necessarily a screaming buy yet. However, the share price has continually dropped since it listed in Prague, partly due to the low price achieved by Enterprise Investors in 2018. I can see from a Czech stock forum that local retail investors are getting spooked by the price declines and are becoming very bearish, so the price could get very attractive in the near future.

The biggest risk here is probably further bad acquisitions by Kofola. Their capital allocation track record is clearly mixed. There’s no clear focus on returns on capital employed. We don’t have the full details on the Ondrášovka acquisition, but they will probably pay 10x EBITDA (~1bn CZK) and increase net debt/EBITDA to 3. However, I’m actually quite positive on this acquisition as it will put them into 2nd position the in Czech retail water market, there will be clear operational synergies, and they can leverage off their strong HoReCa business. Management has ear-marked Serbia and Bosnia as further expansion opportunities. I wouldn’t be particularly confident that management can execute in those markets. The more they focus on Czechia and Slovakia the better.

There are also general industry risks. The Czechoslovak beverage market is consolidating between 3 big players: KMV (Mattoni), Coca Cola HBC, and Kofola. KMV recently bought the license for the Pepsi brands. Kofola is acquiring Ondrášovka. There are lots of bolt-on acquisitions going on. Consolidation is clearly a good thing for Kofola, however there is increasing competition particularly from KMV. Kofola is the smallest competitor in terms of worldwide revenue. Apparently KMV are now installing Pepsi fridges and vending machines for free at hotels/bars/cafes. They are also offering Pepsi products at huge discounts in order to increase the share of their leading water brands in the HoReCa market (Kofola’s strongest segment). KMV even own a minority stake in Kofola (I think around 100,000 shares), the purpose of which seems to be to act as a general nuisance to Kofola management. Other risks are higher sugar prices going forward, bad population demographics, the introduction of sugar taxes, and the general trend away from soft drinks to healthier alternatives.

Conclusion

There is clearly a lot to like about Kofola at 260 CZK. It’s a somewhat mature but quality company with defensive, reliable cash flows from a strong moat business. Its quality is not obviously captured in its past financial record because of the Hoop Polska disaster. However the Polish business is now sold off and Kofola’s business is now mostly in its core Czechoslovak markets. Also, lots of data sources (including Kofola’s own financial statements) don’t account for the 5% of the shares that are actually treasury shares, further obscuring Kofola’s underlying value. Its stock price has been crushed since listing in Prague and may eventually become an obvious buy. Watch this space.

I do not currently own a position in KOFOL, but may initiate one in the near future. None of the above is investment advice. Do your own research.

Note: I switched off comments on this post, so shoot me an email at streetsofvalue@gmail.com if you want to discuss Kofola with me.

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