In an earlier article here, I presented a bearish outlook for the iconic brands Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP). Since publishing the article, the two companies have meaningfully underperformed the Dow Jones by around 350 bps and 550 bps, respectively. I reiterate my reserved outlook on the short-term while adding that both firms are strong defensive plays in the long-term. A multiples analysis, complemented with DCF modeling, shows value creation challenges within the next three years.
From a multiples perspective, Coca-Cola is the cheaper of the two. It trades at a respective 12.4x and 16.3x past and forward earnings while PepsiCo trades at a respective 16.2x and 14.1x past and forward earnings. Between these two is Dr. Pepper (NYSE:DPS), which trades at 15.4x past earnings and offers the highest dividend yield at 3.4%, followed by PepsiCo at 3.2%. With their low dividend yields of around 0.6, all of the companies are relatively safe from a double dip. Currently only Coca-Cola is rated a "strong buy" while the others are rated a "hold."
There is a strong buy-and-hold case that could be made for the leading non-alcoholic beverage company. On the third quarter earnings call, Coca-Cola's CEO, Muhtar Kent, noted success within a challenging business context:
"We delivered performance results in line with or ahead of our long-term growth targets, making this the sixth consecutive quarter we have either met or exceeded our long-term growth targets.
We continue to advance our global momentum from a position of real strength, realizing growth across every one of our five geographic operating groups. For both the quarter and year-to-date, we once more gained global volume and value share in nonalcoholic ready-to-drink beverages. Our Global Sparkling Beverage portfolio keeps growing, up 4% for the quarter and 5% year-to-date. This growth was driven by brand Coca-Cola, which was up 3% in both the quarter and year-to-date.
And earlier this month, Interbrand ranked Coke-Cola as the world's most valuable brand for the 12th consecutive year. Our Global Still Beverage portfolio is also performing well, up 9% for both the quarter and year-to-date. Importantly, we achieved these balanced quality results together with our system bottling partners during a time of ongoing global market volatility, which is a testament to our clear and focused vision, our strong brands and our solid execution."
In December, the company purchased a half interest in the Saudi Arabian Aujan Industries for $480M. Aujan Industries is the leading juice business in the region with stakes in Egypt, Iran and United Arab Emirates. While Coca-Cola has been praised for its strong international exposures (only one-fifth of business is domestic), activity has been lacking in the Middle East. PepsiCo has a more than 60% share in Saudi Arabia; accordingly, Coca-Cola has made a step in the right direction to secure global dominance. I am also attracted to the top-line growth in Latin America and China, as well as the divesting of bottling operations in areas such as Germany. With that said, I am more reserved on the recent restructuring of the licensing contract with Nestle SA (OTCPK:NSRGY). The new terms suggest that Coca-Cola is scaling back and wants to focus on strategic local geographies - a less aggressive strategy that is a turn off to growth investors.
Consensus estimates for Coca-Cola's EPS are that it will grow by 9.7% to $3.83 in 2011 and then by 7.6% and 10.4% more in the following two years. Assuming a multiple of 15.4x and a conservative 2012 EPS of $3.86 - 6.3% below consensus - the stock would decline by 12%. Modeling an earnings CAGR of 9.2% over the next three years and discounting back at a WACC of 9% implies roughly the same value. Accordingly, I would recommend holding out in the short-term.
Ditto for Pepsi, which has substantial leverage. Net debt stands at $23.3B, or 23.1% of market value. During the third quarter, the company showcased its strength in the snack business. Global snack volumes grew by 8% while the largest segment therein, Frito-Lay North America, delivered 6% operating profit growth from pricing actions. In my view, shareholders are to greatly benefit from a beverage-snack business split that will allow greater capital allocation based on growth preference. Finally, the partnership with Tngyi-Asahi is attractive in terms of penetrating China.
Consensus estimates for PepsiCo's EPS are that it will grow by 6.3% to $4.39 and then by 4.1% and 7.9% more in the following two years. Assuming a multiple of 16x and a conservative 2012 EPS of $4.49, the rough intrinsic value of the stock is $71.84, implying 11.2% upside. Modeling a CAGR of 6.1% over the next three years and discounting back at a WACC of 9% implies, however, that the company is at fair value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.