One of the bigger debates that rages on within the Consumer Staples sector is whether Coca-Cola (KO) or PepsiCo (PEP) is a better investment. The two carbonated and non-carbonated soft drink manufacturing behemoths take up over 70% of the world wide beverage sales and have been solid equity holdings since well before I was born. Raising dividends and consistent earnings might as well be each company’s middle name, but the debate of which one is better still rages on. While both are solid investment ideas, they are still fundamentally different in many ways. Let’s take a closer look at the companies.
One of the most important things to consider when looking at Pepsi & Coke are the beverage trends in the various markets that they serve. A common measure is volume growth, and it is the volume growth in the regions in which they operate that will drive future growth for both firms. If either firm misses an opportunity in an area, it is likely that the other will pounce on the misstep and take advantage.
First, lets take a look at the domestic operating environment. It has been no secret that beverage trends, especially for carbonated soft drinks, have taken a turn for the worse over the past two and a half years as Americans battle with health problems such as diabetes and obesity, of which Pepsi and Coke have shouldered part of the blame due to their unhealthy carbonated drinks. Volume growth in North America for Pepsi has gone from 5% volume growth in 2006 to an estimated -2% growth for 2008. Coke has had similar dismal numbers domestically, going from 0% growth in 2006 to an estimated -1% growth for 2008. Let’s face it, North America is not the place that these companies want to invest much more money into going forward, unless they revamp their product lines, which I will touch on later.
International volume growth has been much stronger for both firms in the past few years. Coke has had consistent growth of 7%, while Pepsi has had consistent growth of 9%. While both have strong international growth, Coke is the firm that is able to benefit the most from strong international beverage growth. With nearly 80% of their sales, compared to Pepsi’s 50%, coming from international sources, Coke has slightly pulled ahead in the race. Coke 1, Pepsi 0 (a little scorecard for the readers.) You might counter by saying the strengthening dollar is going to hurt Coke more going forward. Think again. Coke has already said that they will see gains from their currency hedging for the next quarter and the full year, but Pepsi has said that they will probably have to book a loss in the fourth quarter due to currency hedges that have gone bad. So Coke, with even higher international sales, has not had a problem with currencies, while Pepsi has had a problem. Coke 2, Pepsi 0.
Well, that means that Pepsi has more room to grow internationally and take control over Coke. While this may be true, I think Pepsi is going to find it hard to become a competitor right away in markets that Coke has already had a place in for years. Let’s say that Pepsi does see this international growth; they are going to have another problem. Margins. With almost any staples company, maintaining healthy margins are crucial to success. Pepsi International has the worst margins of all its business segments and is well below the firm’s average. Pepsi’s international operating margins were 13.2% in 2007, while firm wide margins were 18.4%. Compare this to Coke and you will see why they are better. Take a look at a breakdown by international region of their margins:
North America: 22.1%
Latin America: 57.1%
Eurasia & Africa: 36.3%
Firm wide operating margins: 26.1%
Their best margins come from international waters, where the most growth is. Pepsi’s worst margins come from the region where the most growth is. Coke 3, Pepsi 0.
One of the most important things to understand with both Pepsi and Coke is the relationship with their bottlers. These bottling groups, such as Coca-Cola Enterprises (CCE) for Coke and Pepsi Bottling Group (PBG) for Pepsi, are core pieces of both firms’ business model. Maintaining healthy relationships with the bottlers is important because these are the firms that Coke and Pepsi sell their products to and are the companies that actually sell and distribute most of their products. It has been no secret that Pepsi has had much better relations with their bottlers in the past and probably will continue to do so going forward. That being said, Coke, with their newest CEO, has made it a much larger part of corporate strategy to develop stronger relations with their bottlers in an attempt to solidify their business model. I would expect KO to continue to develop positive relations with their bottlers, as they try to rid themselves of some of the problems they have had in the past. But, Pepsi still has the advantage here so Coke 3, Pepsi 1.
Probably the biggest difference between Coke and Pepsi is the range of products that they offer. While Coke only offers soft drinks, Pepsi also offers snacks to the consumer, such as Lays potato chips and Cheetos. Traditionally snacks outperform beverages during economic downturns and if there is one thing that is keeping Pepsi afloat, it is their diverse range of product offerings, which Coke does not have. Some of these products also offer healthy options, such as Quaker oatmeal, which helps Pepsi’s image in the face of the domestic consumer. Coke 3, Pepsi 2.
Productivity for Growth
One of the biggest things that came out of Pepsi’s latest conference call was the fact that they would be cutting costs and saving $1.2 billion over the next 3 years and use the funds to make capital expenditures to revitalize their North American business line and ensure the continued success of their snacks and international business. They also recently announced a $1 billion investment in China, which seems like a response to Coca-Cola’s acquisition of one of the top Chinese beverage producers Huiyan Juice company.
They have also pledged to invest $3 billion in Mexico to increase sales of both beverages and snacks in the area. While these expenditures do limit their ability to acquire firms as they have in the past to further diversify their portfolio, spending money to grow internationally is a positive in my mind. The only thing that bothers me is the margin factor that I mentioned above. If they can improve on this it will be a brilliant move, but we have yet to get any visibility on how pricing will be after these investments. So for now, I will give Pepsi 0.5 points of credit. Coke 3, Pepsi 2.5.
From a valuation standpoint, these companies are currently pretty similar. But when looking at historical data, Coke is at a 20 year low on a P/E basis, while Pepsi has just begun to approach these levels. From a valuation standpoint, Coke seems to be the better choice. The strong margins and solid sales in this economy have helped shelter them from the downturn better than Pepsi. Until Pepsi can make international sales a more significant part of their revenue stream and improve margins (which in my mind indicates better brand recognition and pricing power), I will continue to believe that Coke is the better choice. Either way, both Pepsi and Coke offer great things for investors with consistent earnings and dividend growth. It’s just a matter of which one you like better. For me, it’s Coca-Cola.
Disclosure: The mutual fund that the author is associated with is long KO.