Cola Wars: Revisiting a Coke and Pepsi Pairs Trade

Includes: DPS, KO, PEP
by: Bennington Investment Ideas

On October 31, 2010, I published an article reviewing a possible pairs trade between Coca-Cola Co. (NYSE:KO) and PepsiCo Inc. (NYSE:PEP). The primariy conclusion of that article was that there was limited opportunity for a pairs trade between the two stocks. KO showed the stronger operating cash flow growth (7% versus 1% from 2007-2009) despite having a similar valuation ratio to PEP.

At that time, KO had a total enterprise value of $141.8 billion compared with PEP's $121.4 billion. These values have not changed much since then. With a $65.87 share price, PEP's total enterprise has increases slightly to $122.8 billion. KO now has an enterprise value $145.9 with a share price of $62.77. KO has shown slightly more appreciation than PEP. This appreciation is driven by slight appreciation in the share price.

Table 1: Recent Stock Performance

Ticker 10/29/2010 Price 1/21/2011 Price % Change Dividend Total Return
KO $61.32 $62.77 2.4% $0.44 3.1%
PEP $65.30 $65.87 0.9% $0.48 1.6%
DPS $36.59 $35.18 -3.9% $0.25 -3.2%
SPY $118.49 $128.37 8.3% $0.653 8.9%

My article suggested that KO would be the better long candidate, which implies that PEP is the offsetting short. Excluding transaction costs, this pairs trade would have worked. However, both stocks substantially underperformed the S&P 500 as tracked by the SPDR S&P 500 Trust, (NYSEARCA:SPY). I also included a quick look at Dr. Pepper Snapple Group, Inc. (NYSE:DPS). While it has shown a recent underperformance to KO and PEP over the last 52 week period it had higher returns 28.6% to 15.7% for KO and 9.1% for PEP and 14.9% for SPY.

Without question, DPS is the smaller rival to KO and PEP with only a $10.3 billion total enterprise value and much lower valuation metrics, which correspond to its lower margins, return on equity, and return on assets.

Table 2: Financial Metrics

KO 13.7x 16.0x 29.2% 29.2% 11.6%
PEP 11.1x 15.0x 17.0% 36.3% 10.7%
DPS 8.8x 6.1x 17.4% 18.7% 6.9%

While a pairs trade probably still does not make sense between KO and PEP, DPS could be a potential long based upon its valuation. This would require additional in depth research to assess its competitive position, growth prospects, and to complete a valuation model to determine if it is truly undervalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.