By Mark Bern, CPA CFA
I know that Coca Cola (KO) is the dominant global leader in the soft drink space. I know that Warren Buffett has made Coke a core holding of Berkshire Hathaway and that his holdings continue to increase. I really like KO as a dividend play. But I prefer to drink Pepsi (PE) and I also like Lays chips. I have also noted that another analyst with an independent research company for which I have a great deal of respect rates Pepsi a better buy than Coke. So I thought it might be worthwhile to compare the two.
Most of my analysis is based on history and trends, but I also look into the qualitative aspect as well as I can determine if there are advantages that could translate into higher growth rates for one company over another. I think it is worth pointing out that these two companies, while having similarities, also have some stark differences. Coke is a pure play on beverages while Pepsi has three distinct product lines including snacks (Frito-Lay) and Quaker Foods to add to the beverages business. Coke derives over 70% of its business from outside the U.S. Pepsi receives 27% of sales from outside North America (I didn’t find a break out of Canadian sales which are fairly significant).
The companies compete head-to-head in the beverage business especially in the mature North American market and both have aggressive expansion plans for their overseas operations. Carbonated drink sales in North America are falling slightly for both companies while their non-carbonated drink products continue to increase sales. Coke actually picked up a little market share in the latest quarter overall in North America, but that is not where the future profit growth will come from for either company. Both companies are building platforms from which to grow their foreign sales over the coming decade.
Coke’s recent purchase of Coca Cola Enterprises, North America (CCNEA) has provided the company with more control over distribution and customer relations in this segment. The company plans to use this to its advantage in competition for market share.
Near term concerns for both companies include input-cost inflation and currency exchange translations. Coke has more exposure in both of these areas and its CCENA unit had very little commodity-price hedges in place at the time of acquisition and because it derives a greater proportion of its business from overseas markets. As the U.S. dollar rises relative to other major currencies (which it is tending to do lately, especially against the euro) those foreign profits will be adjusted lower to allow for the foreign exchange rate fluctuations. Pepsi will also be adversely impacted by these issues, but not as heavily.
On the brighter side Coke expects to reap an additional $150 million in cost savings from the CCENA acquisition in the current fiscal year. Both companies expect strong volume growth from foreign operations. The snack food business holds excellent expansion opportunities for Pepsi in both the short and long term as developing countries are just beginning to enjoy salty snacks. Pepsi is also growing its healthy snack offerings to meet the rising demand in North America. The company plans to expand its sales of healthier offerings to 30% of its snack sales over the next decade from the current 22% level.
Now let’s look at the numbers. Pepsi’s Return on Equity is slightly higher at 29.5% compared to 28%. Coke’s debt to equity level is significantly lower at about 36.4% compared to Pepsi’s 86%. The industry average is 81%, so Pepsi’s debt level doesn’t worry me much. The higher ROE figure tends to make me believe that they are managing their debt fairly efficiently.
Coke has the higher profit margin at about 18.8% compared to only about 10.4% for Pepsi while the industry average is 14.4%. Again the discrepancy is to be expected because of Pepsi's greater diversity of products and the lower margins produced by the food side compared to beverages. The estimated book value per share is almost identical at 15.0 and 14.6 for Pepsi and Coke, respectively. Earnings per share have grown consistently for both companies with the exception of a small one-year drop for each company during the great recession. Current year expectations are for a slightly higher rise for Pepsi (11.3%) compared to Coke (10.9%). Cash flows continue to grow nicely for each company, remaining consistently in the low double-digit area for both (Coke’s cash flow will grow slightly less than 10% in 2011, but I’ll give them a pass due to the large acquisition and related one-time expenses).
Now we are about to delve into the meat of the analysis, looking at sales and dividend growth. I like dividends and increasing sales combined with stable or improving profit margins generally lead to rising dividends, the cornerstone of long-term investing. Pepsi currently offers the better yield of 3.3% compared to Coke’s 2.8%. Pepsi also has the lower payout ratio at 45% compared to 50% for Coke (both are based upon estimated full year EPS and current dividend information). That would tend to indicate that Pepsi has a little more flexibility in increasing dividends going forward and is likely to be able to maintain the higher dividend yield unless its stock price rises more rapidly.
Sales for Coke have increased dramatically in 2011 compared to 2010, rising an estimated 32.7%, while rising by 13.3% in the previous year. Pepsi’s sales have increased a more modest 14.5% in 2011 over 2010, having grown by 33.8% in the previous year. Isn’t it amazing what a large acquisition can do to sales growth?
Going forward, I believe that both companies will continue to grow at about the same pace. However, I believe that Coke’s acquisition of the bottling unit will tend to decrease margins slightly from its historical average of about 22%, down to about 21%. I think that Pepsi will be able to maintain its margins near its historic level of around 11.5%. At first blush this would still seem to favor Coke. But Pepsi is actually a larger company (by total sales) and with a slightly higher growth in sales everything pretty much evens out up to this point.
So, which one would I chose to own and why? I don’t believe that Coke deserves a P/E ratio premium to Pepsi based upon my analysis. At current valuations, Pepsi is cheaper with a P/E ratio of 14.1 compared to its historic average P/E of 20. Coke’s average historic P/E is 21, but that does not reflect the slightly lower margins I perceive going forward which would put the two even, bringing Coke’s expected long-term P/E down to 20. As the global economy heals and growth returns, the P/E ratios will revert to that 20 level giving Pepsi a little more multiple expansion potential than Coke. In five years I expect Pepsi to sport a share price of about $122.50 while Coke should reach about $117.50. Including dividends, I get total return expectations of 20.5% for Pepsi and 17% for Coke.
I don’t think an investor could go wrong on either company over the long term, but at today’s prices I think I’ll say, “Pepsi, please!”
For an opposing view please see an article by another author here.
I like his analysis and he makes some good points in favor of Coke. We disagree on future growth prospect slightly, and that makes up much of the difference in our opinions.