Why I Think Coke And PepsiCo Have Bright Futures

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 |  Includes: KO, PEP
by: Income Surfer

Every now and then I come across a stock or a sector that everybody "knows" is in decline. The company (or group of companies) faces such a dramatic shift in customer trends or regulatory pressures, that its future is no longer in doubt... everyone "knows" it's headed for bankruptcy.

My investing experience has taught me that often "everybody" is wrong. I'm not saying that I am some kind of clairvoyant, but I am saying that investors have a very expensive habit of agreeing with the consensus and making poor decisions. Two huge examples of this were the run-ups to the dot com bubble, and more recently, the real estate collapse. These were not isolated incidents, however. History is full of examples of investors being overly optimistic (or pessimistic) about a particular investment… and that investment working out very poorly for them.

"When everybody is thinking alike, then somebody is not thinking" ~ General Patton

As you probably noticed from some of my recent articles, I really enjoy picking through beaten down and under appreciated companies. Sometimes the consensus outlook for a particular company or sector is just too bearish. The reader comments on investment articles about cola companies are beginning to become way too bearish, in my opinion. To be fair, the aforementioned comments generally fall into two groups. The first group are long time Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP) investors, who have profited immensely from these companies over the past decades. The second group are investors who fear the dual threats of flat (cola) sales volumes in North America and the increased government regulation of junk food.

CDC Tobacco Use1

Graph courtesy of CNN.com

I believe, however, that cola companies will continue to grow their profits and dividends. As precedence for my statement, I offer up the tobacco industry (40 years ago). As you can see from the graph above, the per capita consumption of cigarettes (represented by the black line) peaked in the U.S. during the mid 1960s. Therefore, it would be reasonable to assume that the profits and general prospects for U.S. big tobacco companies would have stagnated or declined since then. Instead, the share prices of big American tobacco companies have climbed dramatically over the last few decades.

As a proxy for the industry, I have included Altria's share chart below. Even though Altria (NYSE:MO) has owned other businesses beside tobacco, you can look at many of the industry's biggest players and see largely the same pattern. Additionally, the dividends paid out by many of these companies have increased enormously over the years.

Altria Stock Chart

Altria's Share Price- Courtesy of Yahoo Finance

So how did these tobacco companies continue to thrive in the face of such enormous headwinds? The companies had four features on their side. First, the tobacco companies had strong brands and an addictive product. While colas aren't nearly as addictive as nicotine, consumers tend to be extremely loyal to a particular flavor and brand. This helps the companies maintain market share and command higher prices, which we'll discuss below.

Secondly, both tobacco and cola companies tend to have very low cap-ex (capital expenditure) requirements. Cap-ex is essentially the money that a company needs to reinvest in itself, in order to maintain its business. Cap-ex often include items like the replacement and maintenance of manufacturing plants, transportation vehicles, and other equipment. This feature is important during times of high inflation. The less money that needs to be spent replacing expensive equipment, the more money the company can return to shareholders in the form of dividends and share buybacks.

Third, both tobacco and cola companies tend to have resilient pricing power. Two reasons the companies possess pricing power is because both cola and tobacco products are affordable luxuries, meaning that they are affordable to most consumers. While a new car or house can cost months (or years) of a typical consumer's income, a carton of cigarettes or a case of cola is comparatively cheap. Additionally, consumers tend to be very loyal to their brands. Some people smoke the same brand of cigarettes their whole lives. The same goes for cola products. I don't know many people that drink both Coke and Pepsi. People are creatures of habit. We like what we like and we're slow to change.

Finally, while Tobacco sales volumes were declining in the U.S. in the 1970s and 1980s, they were being offset by sales growth in (less developed) foreign countries. Someone can certainly take issue with exporting a product that isn't medically safe to unsuspecting people, but that isn't the purpose of this article. What I am saying is that sales growth in Asian and Latin American countries was a gold mine for tobacco companies over the last few years. The biggest cola makers have been expanding their presence in underdeveloped foreign markets for many years now. That presence, in these growing countries, should continue in the coming years.

Conclusion

I have been a long-time investor in Coca-Cola and very happy with my investment. As I documented in my most recent Seeking Alpha article, I would like to initiate an investment in PepsiCo when the share price declines. I don't know when that will happen. In the mean time, I will continue to look for investments in companies that feature a strong brand and low cap-ex requirements. In my experience, they make many of the best long-term investments.

Disclosure: I am long KO. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by Yahoo Finance, Morningstar.com and CNNMoney.com