Coke And Pepsi: Applying DuPont Analysis

Apr.28.14 | About: PepsiCo Inc. (PEP)

Summary

KO and PEP are two leading dividend stocks with strong track records.

DuPont analysis can be used to create insights into how companies perform and the drivers of their ROE.

This analysis suggests that PEP might be the better investment going forward.

The Coca-Cola Company (KO) and PepsiCo Inc. (PEP) are two iconic American brands and corporate behemoths based largely on their ability to sell sugar water. In 2013, KO tallied $46.9 billion in revenue while PEP, with the added benefit of its snack business, rang up $66.4 billion in sales.

Introduction to DuPont Analysis

Using DuPont Analysis is one way to dig a little further into the companies to see what similarities (or differences) there might be. DuPont Analysis is a view of breaking down Return on Equity (ROE) into factors that can be further analyzed. These factors are commonly a profitability measure, a turnover measure, and a leverage measure. DuPont Analysis was created by E. I. du Pont de Nemours and Company (DD) in the 1920s. For this analysis, I looked at a 5 factor analysis:

DuPont Analysis Factors

Factor Calculation
Asset Turnover Revenue/ Average Assets
Profitability EBIT/ Revenue
Interest Burden (EBIT - Interest Expense)/EBIT
Tax Efficiency 1 - Tax Expense/(EBIT - Interest Expense)
Leverage Average Assets/Average Equity
Click to enlarge

More simplified versions of the DuPont Analysis will treat the middle three factors as a single profitability factor that looks at Net Income to Revenue. However, companies have become more focused on tax reporting, and this increases the overall complexity. While leverage is calculated in the Asset to Equity ratio, the cost of the leverage is lost in the profitability margin. Possibly one company has obtained lower cost debt than another, and that financial engineering is different from how it runs its day to day operations.

It should also be noted that the values for tax expense are book accounting values, and not the same as the ones reported to the IRS, which are tax accounting values. It should also be noted that one should make adjustments for minority interests which has some impact on these results - hence the difference in the implied and calculated ROEs.

Applying DuPont to KO and PEP

Using basic financial data from Yahoo!Finance and 10-Ks for both KO and PEP, I assembled the following ROE breakdowns. The first table shows the financial data used for KO.

KO Basic Financial Data ($ Millions)
Financial data 2008 2009 2010 2011 2012 2013
Revenue 31,944 30,990 35,119 46,542 48,017 46,854
EBIT 7,877 9,301 14,976 11,875 12,206 11,940
Interest 438 355 733 417 397 463
Tax Expense 1,632 2,040 2,384 2,812 2,723 2,851
Net Income 5,807 6,824 11,809 8,584 9,019 8,584
Assets 40,519 48,671 72,921 79,974 86,174 90,055
Equity of Shareholders 20,472 24,799 31,003 31,635 32,790 33,173
Click to enlarge

Source: Yahoo!Finance, SEC 10-Ks

The next table shows KO ROE breakdown over the past 5 years.

KO DuPont Analysis ROE Breakdown
Lever 2009 2010 2011 2012 2013
Asset Turnover 0.69x 0.58x 0.61x 0.58x 0.53x
Profitability 30.0% 42.6% 25.5% 25.4% 25.5%
Interest Burden 96.2% 95.1% 96.5% 96.7% 96.1%
Tax Efficiency 77.2% 83.3% 75.5% 76.9% 75.2%
Leverage 1.97x 2.18x 2.44x 2.58x 2.67x
Implied ROE 30.5% 42.5% 27.6% 28.2% 26.2%
Calculated ROE 30.1% 42.3% 27.4% 28.0% 26.0%
Click to enlarge

Source: Author Calculations

The first observation is that asset turnover and profitability are declining. These are offset by increasing leverage. The hit to profitability in 2011 was a result of KO's acquisition of the North American bottling operations of Coca-Cola Enterprises Inc. (CCE) in 2010. This also attributed to a greater share of assets. KO relies upon other bottling operations outside of North America. Tax efficiency and interest burden remain similar over time.

The next table shows the basic financial information for PEP.

PEP Basic Financial Data ($ Millions)
Financial data 2008 2009 2010 2011 2012 2013
Revenue 43,251 43,232 57,838 66,504 65,492 66,415
EBIT 7,350 8,476 9,135 9,690 9,203 9,802
Interest 329 397 903 856 899 911
Tax Expense 1,879 2,100 1,894 2,372 2,090 2,104
Net Income 5,142 5,946 6,320 6,443 6,178 6,740
Assets 35,994 39,848 68,153 72,882 74,638 77,478
Equity of Shareholders 12,203 16,908 21,273 20,704 22,399 24,389
Click to enlarge

Source: Yahoo!Finance, SEC 10-Ks

One can see similar trends in this financial data.

PEP DuPont Analysis ROE Breakdown
Lever 2009 2010 2011 2012 2013
Asset Turnover 1.14x 1.07x 0.94x 0.89x 0.87x
Profitability 19.6% 15.8% 14.6% 14.1% 14.8%
Interest Burden 95.3% 90.1% 91.2% 90.2% 90.7%
Tax Efficiency 74.0% 77.0% 73.1% 74.8% 76.3%
Leverage 2.61x 2.83x 3.36x 3.42x 3.25x
Implied ROE 41.1% 33.2% 30.8% 28.8% 29.0%
Calculated ROE 40.9% 33.1% 30.7% 28.7% 28.8%
Click to enlarge

Source: Yahoo!Finance, SEC 10-Ks, Author Calculations

This is pretty much the same story as KO. However, PEP has substantially more leverage, asset turnover and substantially lower profitability. Despite the higher leverage figure, PEP's leverage has increased at a slower pace. This is due to a greater portion of integrated production in contrast to KO's outsourced bottling in other parts of the world. PEP has superior turnover when compared to KO and comparable tax efficiency. It does have a higher interest burden as expected with its higher leverage. Its ROE has declined less from its 5 year peak value as well.

Looking Beyond DuPont Analysis

By no stretch of the imagination is DuPont Analysis the only work you should do prior to making an investment decision. The first comment is that operating income and EBIT do not align as well for KO as they do for PEP. KO has several other impacts, including $534 million of interest income and over $1 billion in other income. The $534 million of interest income in 2013 exceeds KO's interest expense of just $463 million. In contrast, PEP had just $97 million of interest income - a fraction of its $911 million of interest expense. This difference is from KO's over $30 billion in cash, short term investments and long term investments. In contrast, PEP has a little over $10 billion in those categories.

Another key consideration about DuPont Analysis is that it offers no perspective on valuation. While high ROEs suggest the potential to sustain higher organic growth, it does not provide much insight as to what you should pay for the company or stock. The following table shows that despite similar ROEs - suggesting the potential for similar growth, KO trades at a higher PE multiple.

PE Multiple Comparison
Dimension KO PEP KO Premium
Price $41.01 $85.25 na
2014 EPS $2.09 $4.54 na
2015 EPS $2.24 $4.89 na
2014 F PE 19.6x 18.8x 4.5%
2015 F PE 18.3x 17.4x 5.0%
EPS growth 14-15 7.2% 7.7% -6.9%
EPS Long term growth 6.7% 7.2% -6.9%
Click to enlarge

Source: Yahoo!Finance, Author calculations

So it appears, from a quick simple look, that KO is somewhat overvalued - paying more for less growth. However, both companies appear to have slightly lower multiples than the broader S&P 500, which makes sense given their lower projected earnings growth.

Some possible explanations would be that KO has a more valuable brand - it does. Forbes values KO's brand at $54.9 billion as the third most valuable brand, while PEP's brand is just $18.1 billion, good for 25th place. Another consideration would be the translation from earnings to cash flow. However, PEP generates almost as much operating cash flow as KO, despite a much lower enterprise value of $151.5 billion to $197.9 billion.

Conclusion

Based on this analysis, I would have to lean towards PEP due to a higher ROE and lower valuation. Furthermore, PEP appears to be able to grow its business without the same incremental asset needs of KO. However, there is substantial space for other considerations and clearly this is not the only analysis that should be done.

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.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.