Pepsi (NYSE:PEP) is the second largest beverage company in the world, with annual sales of ~$60 billion and owns world famous brands like Quaker Oats, Tropicana and Frito-Lay. The company, along with Coca Cola (NYSE:KO), dominates the global beverages market. Pepsi also has huge snack foods divisions which are growing faster than the overall business. However, Pepsi's performance in the recent past has not been good, and its margins have been falling. The stock has underperformed global consumer goods peers like Coca Cola and Johnson & Johnson (NYSE:JNJ). Pepsi has tried to jump start growth through acquisitions, but that has increased its debt load. While Pepsi remains one of the top consumer goods companies in the world, the current stock price is a bit too high for our liking. We would switch to other consumer goods stocks which have better prospects.
Why we would sell Pepsi now
- Health Issues - Pepsi faces issues with the sales of its sugary, fatty snacks and beverages. Obesity has become one of the major problems for US and there is already growing awareness to take urgent action against this issue. Pepsi is the largest seller of sugary, carbonated drinks and fatty snacks in the US, and faces a tough regulatory future.
- Debt - The company's Net Debt at ~$22 billion is quite high compared to other consumer goods companies. The company's net debt has increased by more than ~30% in the last couple of years. Though Pepsi does not face any liquidity or dividend risk from its current debt load, the growing debt is a concern.
- Developed Markets Slowdown - Developed region like USA, Japan and Europe are experiencing a GDP slowdown which is badly affecting most consumer goods players. Though Pepsi is well diversified in terms of geography, the company still gets a majority of revenues from the developed markets. While record low interest rates have led to market exuberance, the overall economy still remains mired in slow growth.
- Competition is growing from new entrants- Pepsi and Coca Cola form a duopoly that dominates the global soda market. However, Pepsi is facing threats from entry of new players into this market which threaten its fat margins. Sodastream (NASDAQ:SODA) has already made impressive gains by selling "at-home" sodamakers. Other companies might also enter the market seeing the success SODA in the soda market.
- Operating Margin has decreased - While the company's gross margins have stagnated in the 50-52% range, operating margin has decreased from ~18% in 2007 to ~14% now. The ROIC has seen a sharper decline falling to ~11% in the last 12 months, from an average of ~25% in the last decade.
- Earnings growth is not inspiring - Pepsi's beverage division earnings growth is slowing down and the snacks division growth is not large enough to offset this slowdown in the growth. The earnings growth estimate at ~4% is not large enough in our view to justify the current valuation. We don't see any major growth catalysts for the company given its large size.
- Valuation is not Cheap - Pepsi is trading more or less in line with its competitors with trailing P/E and P/S multiple of 19x and 1.7x respectively. The revenue and EPS growth in the last 3 years are above the industry average due to numerous acquisitions in emerging markets. The company has a total market capitalization of ~$112 billion with revenues of ~$60 billion. The company's operating and net margins are inferior compared to the industry average at 12% and 9% respectively.
- Poor Stock Performance - Pepsi has performed quite poorly compared to the broader stock market and its main competitor Coca-Cola. The company has given a ~3.5% return compared to ~24% for KO and ~14% for S&P 500. Over the last year, Pepsi has performed in line with S&P 500 giving a return of ~13%.
- Growing Dividends - Consumer goods companies, which have global sales footprint with formidable brand and high margins, are the current stock market flavor. The Heinz buyout at a 20% premium shows that investors are willing to pay top dollars for companies with stable cash flows and having a decent dividend yield. Pepsi gives a dividend yield of ~3% and has been growing its dividends consistently. The payout ratio at ~50% is also not too high given the stability of cash flows till now.
- Emerging Market Strengths - Pepsi has a big presence in most of the big emerging markets such as Russia, Brazil, and India etc. The company has been aggressively expanding into emerging markets through acquisitions of both beverage and snack food companies.
- Relatively Recession proof Industry - The beverage and foods industry is one of the most recession insulated industries. Though earnings and growth will slow down due to an economic decline, Pepsi's revenues won't be hit as hard as an industrial goods company such as General Electric (NYSE:GE). Consumer goods companies have managed to maintain their margins by passing on the commodity price increase to customers.
- Brand Recall - Pepsi and Coca Cola have one of the best brand recalls in the world; thanks to their massive sales and marketing spend. Pepsi brands such as Quaker Oats and others are household names which are trusted implicitly by customers for good quality.
Pepsi's stock is more than adequately reflecting the company's strength i.e. a global franchise with strong stable cash flows. The company has performed poorly compared to its main competitors and other big consumer goods companies in the past 5 years. Its earnings prospects are also not great, and we think it faces structural long term issues, as America comes to deal with its obesity epidemic. While Pepsi has a good track record of growing dividends, debt has increased considerably in the past few years along with the payout ratio. We do not think that the dividends will be cut, but it will be difficult to grow dividends due to lower earnings growth as well as the interest burden. We think Pepsi stock is a bit overvalued and investors should consider selling the stock to buy other companies with better prospects.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.