Dividend Investors' Guide: Part III - Beverage Industry 2013 Review

Includes: KO, PEP, TAP
by: Mark Bern, CFA

Back to Part II - Integrated Oil Industry Review

By Mark Bern, CPA CFA

If you are new to the series and would like to start at the beginning, just follow this link to "The Dividend Investors' Guide to Successful Investing." In the initial article I provide a description of my selection process and explanations of all the metrics I use. I am currently in the process of providing annual updates to the original industry articles. The beginning of the review process starts with an article reviewing the Food Processing Industry that can be found here.

In this article, I intend to accomplish two primary goals: to review the beverage industry and the companies that were covered in my original article on this industry. I will publish another article quickly to address my thoughts about inflation and deflation as promised previously. I wanted to include that in this article but it just got too long.

Beverage Industry Update

The original beverage industry review article can be found at this link for a more in depth discussion. First, we will deal with some of the bad news. Input prices for commodities used to make beverage products have experienced some inflation, cutting into margins. Currency exchange rates have had a negative impact on earnings for the industry, as well. Both of these trends are likely to be of a temporary nature. Swings in currency exchange rates swing both ways over time. Trends like this don't last forever and eventually reverse themselves. Then the impact becomes favorable. It all balances out over time. Commodity cost inflation generally trends higher over time, but the current pace has been greater than usual. This, too, shall pass in time.

I have come across quite a bit of material about how the populations of developed countries are becoming more health conscious and that the sugar-based soft drink industry and snack food industry could suffer in a big way. Then I go to Wal-Mart or the mall and just look at all the people. They don't look any healthier to me today than they did a few years ago. As a matter of fact, the average waist size seems to be expanding rather than diminishing. I won't deny that Americans need to get healthier, but on the whole I just am not witnessing the movement. I also haven't noticed a drop in traffic at McDonald's or Burger King!

PepsiCo (NYSE:PEP) is making a move to serve the health conscious consumer market with products from its Quaker Oats division. The results thus far have been disappointing in terms of growth; sales have been relatively flat for Quaker. Here is one example of an interesting article on the movement in developed countries toward healthier food and drink and away from sugar. While I agree that the trend has become evident in recent years, I disagree with the premise that the move will contain growth altogether. Volumes at both Coke and PepsiCo are again rising globally and domestically, albeit at a slower pace than a decade ago. A sluggish global economy is another culprit in the slowing growth mix, which will correct with time. The author of the article does make an interesting assumption that stevia will need to replace sugar. That may come to pass, but it will likely be a much longer process than implied by the article. The process will take a decade or, more likely, much longer, in my humble opinion. In the meantime, growth of beverages using sugar will continue to grow in developing and emerging markets with huge populations while new products without sugar could actually bring back former loyal consumers to a healthier option if the taste is close enough. So, excuse me if I don't get too concerned about the "movement" just yet.

The above mentioned article implies that Coke (NYSE:KO) and Dr. Pepper/Snapple (DNS) will feel the brunt of the effects of healthier choices by consumers while PEP is better positioned for growth with its snack and food units. While I agree with the author that PEP may be a better investment (at the right price), I wouldn't recommend selling KO just yet as I expect the company to continue rewarding shareholders for some years into the future.

Another article on KO that has a more supportive slant relies more on past performance and projects more of the same into the future. I suspect KO will do well in emerging markets around the globe, especially in Asia where it has relatively strong brand recognition already. The argument of increasing dividends is compelling and well worth consideration. I expect, just as this author does, that KO will continue to increase its dividend for many years well into the future.

This article emphasizing the Mexico "FAT' tax on high calorie foods and drinks in addition to the new tax on sugary beverages is one more angle to consider when making assumptions about future growth of the industry. I point this one out specifically because Mexico has an even higher per capita consumption rate of sugary beverages than the U.S. and it will be interesting to see what impact the new laws have on drinking habits south of the border.

Update on PepsiCo

The news for PEP is much the same as it is for the industry with a couple of notable exceptions. First, the company has instituted a cost cutting program to become more efficient that is yielding good savings. Second, I continue to maintain that PEP has more avenues for growth, with its much larger product line spanning both beverages and snack foods, than its peer group in the industry. This diversification also tends to give PEP more ways to enter and create a foothold in new markets, which is very important for future growth in the emerging markets. It also has the potential of providing more stability and, thus, less risk, in my opinion.

The PEP stock price has risen faster than I expected in the last year but the stock, with its current P/E of just under 20, is fairly valued relative to its historical P/E levels. The current price is $84.72 (all quotes in this article are as of the market close on Wednesday, October 10, 2013) compared to $67.00 when I last wrote the industry analysis on June 5, 2012. The share price is up 26.4 percent since then. The dividend was increased from $2.15 per share to $2.27, or 5.6 percent.

The dividend increase from last year is well below the average of 11.4 percent over the previous five years. I am concerned that over the next few years PEP management will be less inclined to maintain dividend increases on par with the growth in earnings. I say this because I believe that management is more likely to focus on reducing debt and continuing its share repurchase program. Dividends will likely continue to rise annually, but just at a slower rate than that to which shareholders have become accustomed. The company is excellent with steady growth prospects going forward and holders of the shares should not get overly concerned as the rate of increase should very well begin to pick up again in a few years. Long-term shareholders will continue to be blessed with above average total returns as my five-year projected share price is $130.

Here is an interesting article of PEP with an evaluation of what price an investor should consider having a reasonable margin of safety.

Update on Coke

KO shares have lagged PEP in the last 17 months and stand currently at $39.62 compared to a split-adjusted $35.05. That represents a gain of 13 percent for these premium shares. The dividend increased from $1.02 (split-adjusted) to $1.12, or 9.8 percent. The share price increase is in line with my expectations while the dividend increase is a little better than shareholders have received on average over the previous five years (8.7%).

Overall unit sales increased by two percent in the latest quarter (YOY), with growth in the Asia-Pacific region leading the way. Continued growth in emerging markets will be the key to success for KO as volumes in developed countries are expected to either fall or stagnate. The company continues to advertise heavily in order to grow market share in mature markets and the results, while not overwhelming, are showing positive results.

I do expect dividend increases for KO to continue to keep pace with share earnings growth in the future, which I believe will be in the high single-digit range. The bottom line should continue to expand around six percent a year with share repurchases reducing the number of shares outstanding by two percent per year or more. That should yield an average EPS increase of eight percent or more on average annually. The shares are slightly over-priced based upon historical P/E levels. Thus, I would wait for a pullback in share price to about $36 or less for a better entry point.

Update on Molson Coors

Molson Coors (NYSE:TAP) shares have been on a tear since I recommended the stock back in June 2013. The current price is $54.83 compared to $38.30 from the original industry article for a gain of 43.2 percent. The dividends have remained flat from last year. I expect the company to continue increasing the dividend but am a little disconcerted by management's lack of action in this area. Another year of the same and the company will fall off of my list.

The company has decent growth prospects for the future despite disappointing demand for beer in North America and much of Europe. Acquisitions, such as StarBev, acquired in mid-2012, should help significantly in this regard as should an increased focus on marketing.

I believe the shares are a bit pricey at the moment based upon historical P/E levels and future growth prospects. Thus, I would recommend that those considering buying these quality shares wait for a better entry point below $50.

This concludes my review of the beverages industry. Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

Disclosure: I am long PEP. 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.