Using DuPont Analysis to Compare Coke and Pepsi

Includes: KO, PEP
by: Bennington Investment Ideas

I previously wrote an article on The Coca-Cola Company (NYSE: KO) and PepsiCo, Inc. (NYSE: PEP), and a commenter rightly pointed out that PEP is more of a snack company than a beverage company and questioned the viability of making comparisons between the two companies.

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 (NYSE: 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

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 profitbility 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 my version of this analysis will gloss over the impact of discontinued operations and minority interest. While these items have some impact to both companies, they are not material.

The first step of completing the analysis is to pull some basic financial data for both companies as listed below. All figures are in $ millions:

Basic Financial Data PEP
Data 2008 2009 2010
Revenue 43,251 43,232 57,838
EBIT 7,350 8,476 9,135
Interest Expense 329 397 903
Tax Expense 1,879 2,100 1,894
Net Income 5,142 5,946 6,320
Assets 35,994 39,848 68,153
Equity 12,203 16,908 21,273

Source: Yahoo!Finance

Basic Financial Data KO
Data 2008 2009 2010
Revenue 31,944 30,990 35,119
EBIT 7,877 9,301 14,976
Interest Expense 438 355 733
Tax Expense 1,632 2,040 2,384
Net Income 5,807 6,824 11,809
Assets 40,519 48,671 72,921
Equity 20,472 24,799 31,003

Source: Yahoo!Finance

This data can then be converted into the ROE breakdown to see what differences there are between the two companies.

ROE breakdown for PEP and KO
Lever PEP 2009 PEP 2010 KO 2009 KO 2010
Asset Turnover 1.14x 1.07x 0.69x 0.58x
Profitability 19.6% 15.8% 30.0% 42.6%
Interest Burden 95.3% 90.1% 96.2% 95.1%
Tax Efficiency 74.0% 77.0% 77.2% 83.3%
Leverage 2.61x 2.83x 1.97x 2.18x
Implied ROE 41.1% 33.2% 30.5% 42.5%
Calculated ROE 40.9% 33.1% 30.1% 42.3%

Source: Calculcated from financial data.

The first observation is that the Calculated ROE and the Implied ROE are different numbers, but not significantly different. The largest variation was .4% for KO in 2009. This is driven by not adjusting my factors for minority interest. The next observation is that KO tends to be a little more tax efficient than PEP, especially in 2010. The interest burdens between the two companies also do not explain the difference in ROE.

The key factors are Asset Turnover, where PEP shows substantially higher turnover, Leverage , where PEP is also higher, and then profitability, where KO is substantially superior. At this level, it seems that they run very different businesses. For example, for every $1 of equity PEP produces over $3 of revenue, while KO only produces $1.26. That is a substantial difference. KO then offsets that through superior profitability, as noted by the EBIT/Revenue ratio. In 2010, KO had almost 3x the margin that PEP had. So there are some clear differences which warrant a deeper investigation. I pulled segment information for both PEP and KO and focused on Asset Turnover and Profitability. Leverage was not available at a segment level.

PEP Segment Turnover and Profitability
Segment Business Focus Asset Turnover Profitability*
Frito-Lay North America Snacks 2.12x 26.5%
Quaker Foods North America Snacks 1.87x 31.0%
Latin America Foods Snacks 1.66x 15.9%
PepsiCo Americas Beverages Beverages 1.04x 13.6%
Europe Mix 0.83x 11.0%
Asia Middle East & Africa Mix 1.24x 11.2%
PepsiCo Inc. Mix 1.07x 14.4%

Source: PepsiCo, Inc. 2010 10-K filing.
*Profitability is Operating Income/Net revenue. This is different from the ratio used for the overall company.

KO Segment Turnover and Profitability
Segment Business Focus Asset Turnover Profitability*
Eurasia & Africa Beverages 1.67x 40.4%
Europe Beverages 1.69x 67.3%
Latin America Beverages 1.52x 62.0%
North America Beverages 0.51x 13.6%
Pacific Beverages 2.66x 41.4%
Bottling Investments Beverages 0.56x 2.8%
The Coca-Cola Co. Beverages 0.58x 24.1%

Source: The Coca-Cola Company 2010 10-K filing.
*Profitability is Operating Income/Net revenue. It should be noted that corporate costs are embedded in the total Profitability factor but not allocated to the individual segments. Corporate assets are also excluded from the segments for Asset Turnover.

It is also important to realize that PEP is more vertically integrated than KO. PEP shows much higher turnover and profitability in its snack divisions. KO shows extremely high profitability in its international divisions. KO asset turnover is heavily weighted down by the North America segment, and around 20% of the company's assets are associated with the corporate segment. KO's superior profitability is driven more by its lack of vertical integration overseas.

When comparing the two companies, it is important to recognize that they have different business focuses and even within competing areas, and use different business strategies.

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

Additional disclosure: 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.