This article is part of a five-article series looking at investing in soft drink companies. Each article will investigate price targets, analyze the company's current and future prospects, and compare it with other companies in the industry. This is the second of five articles. To view our first article featuring Coca-Cola (NYSE:KO), please click here.
Ticker: PepsiCo (NYSE:PEP)
PepsiCo was one of our top picks for 2012, but heading into 2013, we are adjusting to choosing Coca-Cola over PEP. We liked PEP in 2012 for its diversification of product line with snack foods as soft drinks were weak in 2012, but heading into 2013 we are not seeing much upside potential for the company. The issue for soft drink companies right now is that they are seeing declining trends in the popularity of their main beverages. They need diversification into other "flat" drinks like juices, waters, and sports drinks. Additionally, these beverage companies need strong international expansion. This is the reason we like Coca-Cola a lot more than Pepsi. Let's take a closer look at what's going on at PEP.
One of the most troubling aspects of the PEP business is that they are not showing good results in their flat drink market. In the latest quarter, non-carbonated soft drinks saw a 7% decrease in sales, which is not a good sign if trends suggest buyers are moving away from sodas. The company noted that it was due to the company's refusal to lower prices on Gatorade and dropping some juices, but we believe the success of Gatorade and Tropicana is key to PEP's future success. Right now, we see very flat growth for that portion of the company in 2013, which will limit growth in North America. Additionally, soft drink companies are trying to find ways to appeal to health-conscious consumers. KO offers mini sodas and Coca-Cola Zero. PEP has some ideas in the works like a "fat-fighting" soft drink, but it is still to be seen if this will have any lasting impact.
The other main story in the soft drink business is emerging market growth. KO has built up its business in China strongly, but PEP is fighting back. The company opened up a large resource center in the country and is looking to build their business there. The move is expected to help PEP build their market share in China and allow them to have around 70 plants in the country. That development is definitely encouraging, but we have priced in strong growth in emerging markets into our model. The problem remains growth in other areas. The latest quarter shows the issues we are seeing. PepsiCo Americas Beverages saw sales drop around 7% in the latest quarter. Europe dropped 6%, and Asia/Middle East/Africa dropped 21%. The company's core business in America is really the issue. They are struggling at home, and the growth in emerging markets can only make up for this issue. Right now, we do not see nay reason to believe that there will be a drastic expansion in NA due to reasons highlighted above.
One reason to like PEP (yes ... there are some) is that the company does have strong yields above 3% and has nice diversification with foods including Lay's, Cheetos, and Quakers. The snack foods sector provides a nice amount of diversification away from sodas, but it does not give us any major growth potential that we think can drastically increase equity values. Dividends are solid as well, but for a low-growth company with limited upside, they are only attractive to income investors alone.
Right now, the execution of emerging markets, flat drinks, and some intriguing new products is not strong enough on the operating results for the company. They need to show us some strong earnings growth before we believe it will not be flat again in 2013. With the valuations of the company decent at 19 PE and 16 future PE, the stock is not a value performer either. Profitability declined in 2012 as will be discussed below.
Rating: Maintain at Hold
New Price Target
Old Price Target
New Buy/Sell Range
The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.
Here is how to calculate price targets using discounted cash flow analysis:
(all figures in millions)
Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
We see 2013 as continuing to be weak for PepsiCo with profitability levels remaining weak and questions over execution on various segments. Growth should resume in 2014-2016, but we believe the market is appropriately pricing in that growth currently. We have used a 28% tax rate in our model. We continue to see capex increasing due to high competition in the beverage sector. Working capital figures are based on ten-year averages.
Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).
WACC for PEP: 6.00%
PV Factor of WACC
PV of Available Cash Flow
* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.
For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.
Cap Rate for PEP: 4.0%
Available Cash Flow
Divided by Cap Rate
Multiply by 2016 PV Factor
PV of Residual Value
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.
Divide equity value by shares outstanding:
In the end, we have found that PEP is worth around $79, which we believe accurately reflects the company's five-year projections.
Q1 - Q3 2011
Return on Equity
Pepsi's profitability has declined in 2012. A lot of this is due to restructuring the company is undertaking, but it should be noted. They are drastically lagging their competition as well. The company believes the restructuring should help profits moving forward, but we are yet to see them help.
Coke is outperforming PEP with 24% operating margin, 61% gross margin, and 22% ROE. Dr. Pepper Snapple (NYSE:DPS) has operating margins at 18%, gross margins at 58%, and ROE at 24%. Recent comer Monster Beverage (NASDAQ:MNST) offers 28% in operating margin and 52% in gross margin as well as 31% ROE. Cott (NYSE:COT), finally, offers 5% operating margin, 13% gross margin, 8% ROE. As we can see, PEP needs to increase their margins to compete with their competition for investing value.
PepsiCo has decent value. Below 18 is where we look for value plays and below 15 on future PE, so they are near those levels. At the same time, their competition is in the same areas. KO sits with a 20 PE and 17 future PE. MNST operates with a 29 PE and 22 future PE. DPS has a 15 PE and 14 future PE, and COT has a 24 PE and 12 future PE. We need a bit more weakness for PEP to really start to appeal as a value play. At this time, though, we see their valuation as fair given our Hold rating.