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Back to Part VI

By Mark Bern, CPA CFA

If you are new to the series and would like to start at the beginning, just follow this link to "The Dividend Investors' Guide to Successful Investing." In the initial article I provide an description of my selection process and explanations of all the metrics I use.

There are five major trends going on within the beverages industry of which we should be aware. I'll start with the bad, move to the ugly and end with the good. First, input costs are high and still rising. This will continue to cut into margins during the short term. This is relatively temporary and could reverse by 2013. Key ingredients, by and large, are agricultural in nature, meaning that farmers can increase acreage to produce more when prices are high enough. That has always happened in the past and this time will be no different. Although, I don't expect farm production to increase so much as to create a large overhang of inventory so as to cause prices to crater. The increases are more likely to be adequate to lower prices somewhat, but subdued enough to hold prices at very profitable levels. This will simply halt the current trend and create a slightly more favorable cost environment for beverage companies in coming years. Farmers are learning, too.

The second trend primarily concerns developed country populations. Health-conscious people in the developed world are beginning a trend of consuming less soda. Overall volumes of soda sales are decreasing, especially in the U.S. and Europe. I expect European volumes to be hardest hit as the continent sinks deeper into recession this year. I also expect the health-conscious trend to continue for some time, thus market share shifts will determine whether any of the soda companies can eke out volume increases in developed markets in the future. But there are three other trends that will help to counteract this trend in terms of overall volume sales by company.

Larger companies in the industry, such as Coke (NYSE:KO) and Pepsi (NYSE:PEP) are increasing advertising budgets in an attempt to increase market share at the expense of competitors. Private label bottlers are most likely to feel most of the brunt of these efforts. Shifts in market share will be gradual, at one to two percentage point swings in a year, but large enough to offset some of the volumes lost to the health-conscious trend for those who come out on top. It is most likely that the primary beneficiaries of this trend will be those with the deepest pockets.

A second trend being deployed by some companies in the industry is to offer more products that appeal to the health-conscience. Bottled water, water derivatives, and juice drinks are gaining more space of grocery shelves and becoming more readily available in various dining venues. I expect that this trend will continue in the developed countries to offset overall industry volume losses in soda sales. When we combine these last three trends we find that, at least in developed countries, population trends and demographics will play a greater role.

The last major trend I see is a very positive one. There is a wide disparity in soda consumption per capita between developed nations and emerging countries. The trend toward increased soda consumption per capita in developing countries has begun and will continue for the next couple of decades, at least, in my opinion. Consumption of bottled beverages overall will also follow this trend as more consumers in the emerging economies have more disposable income and the sheer number of new consumers, people who climb above the subsistence income levels for the first time is staggering. Hundreds of millions of people on the planet never had the money to taste a Coke before, but that is changing rapidly and on a scale never before seen in history. Penetration into these new markets will be the key to increasing sales volumes and profits in the future and there are several companies in the industry that are well positioned to take full advantage of this and all of the trends mentioned here.

I have three companies from the beverages industry that have made my master list: Coca-Cola, PepsiCo, and Molson-Coors (NYSE:TAP). I'll start with the two obvious picks, Coke and Pepsi.

Have you noticed that KO stock is down only 5.7 percent and PEP is down 5.4 percent from their respective 52-week highs while the S&P 500 is off about 9.7 percent from its high? That is how quality companies' stocks react to economic adversity. Yes, these stocks fall, too, but not by nearly as much. Earnings don't drop as much either. I always contend that there is relationship between earnings and stock price in the long term that cannot be ignored.

Both of these companies have increased their respective marketing budget and are attempting to build brand loyalties while clawing back market share from private label competitors. Both companies have expanded healthy product offerings with water and juices and PEP is taking similar steps in the snack business. Both are penetrating and expanding operations in emerging markets where potential growth is the greatest. Both are making all the right moves.

I have always liked PEP a little better because I always felt that the snack business gave management another avenue of entry into developing countries. The company has leveraged this advantage well. However, KO, under the management of Muhtar Kent, has been making a lot of good moves, as well. Currently, I think KO offers a slightly better value in terms of growth, while PEP still has the edge for income-oriented investors.

Let's take a look at how Coke stacks up by the metrics.

KO

Industry Average

Grade

Dividend Yield

2.8%

2.6%

Pass

Debt-to-Capital Ratio

31.0%

38.7%

Pass

Payout Ratio

50.0%

36.0%

Neutral

5-Yr Average Annual Dividend Increase

8.7%

N/A

Pass

Free Cash Flow Per Share

$0.57

N/A

Pass

Profit Margin

18.8%

9.2%

Pass

5-Yr Average Annual Growth in EPS

10.2%

13.0%

Neutral

5-Yr Average Annual Growth in Rev. / Share

14.7%

14.5%

Pass

Return on Total Capital

19.0%

12.5%

Pass

S&P Credit Rating

A+

N/A

Pass

Are there any surprises? Two categories could have been rated fails and would often be reason to keep a company off my list, but in this case I am making an exception. The reason is simple. Coke has maintained a payout ratio near 50 percent for as long as I can remember. It has not affected the growth of the company or its superior record of dividend increases. Secondly, the 10.2 percent average annual increase in EPS, while falling short of the industry average is still a very respectable number and Coke appears better positioned to continue its EPS increases than most of its peers. Thus, I think both categories really deserve to be rated as neutral rather than fail.

Now, let's take a look at Pepsi's report card.

PEP

Industry Average

Grade

Dividend Yield

3.2%

2.6%

Pass

Debt-to-Capital Ratio

48.0%

38.7%

Neutral

Payout Ratio

45.0%

36.0%

Neutral

5-Yr Average Annual Dividend Increase

11.4%

N/A

Pass

Free Cash Flow Per Share

-$0.37

N/A

Fail

Profit Margin

10.3%

9.2%

Pass

5-Yr Average Annual Growth in EPS

7.5%

13.0%

Neutral

5-Yr Average Annual Growth in Rev. / Share

14.7%

14.5%

Pass

Return on Total Capital

17.0%

12.5%

Pass

S&P Credit Rating

A

N/A

Pass

Admittedly, the three neutral grades would have been fails with a company with lesser management a lower level of consistency. The debt-to-capital ratio is still within a range of being manageable; especially when I consider that much of the debt was recently assumed in the acquisition of the two bottling companies early in 2010. The company plans to pay down debt and I believe management will stick to its word here. The acquisitions give PEP more control over the direct relationships with customers and that should result in positive results from cooperative efforts.

For many years PEP maintained a dividend payout ratio more in line with the industry average. In 2008, the company aggressively increased its dividend in the face of economic collapse, helping to prop up share price. This act was a demonstration of Pepsi's strong financial position and was, in my opinion, designed to send a message to shareholders that the company was well-positioned to ride out the coming storm. As a shareholder, I appreciated that message. I also appreciated the higher dividends. However, I do believe that dividend increases will be slightly lower (about 1 percent per year) than increases in EPS as the company brings the ratio back down gradually. Thus, I feel confident that management is managing its dividend policy and I am comfortable with giving this category a neutral rating.

The one failing grade I gave the company was for having a negative cash flow. The amount per share is small and I do realize that much of the debt coming due will be refinanced. But I don't expect the company to generate free cash flow (the way I measure it) for the next two years. This could sink a lesser company in terms of making my list, but PEP is such a consistent performer that I decided to keep it on the list while keeping an eye on this category to make sure the company makes progress.

Finally, you may be wondering how I could score the five-year average EPS growth a neutral when it is so far below the industry average. The answer is that this is not just a beverage company; it is also a snack (or food processing) company. I expect this category to be a blend of the two industries, with the food processing (6.3 percent average growth) portion lowering the beverage rate. If the rate had fallen below the rate of the food processing industry I would concede that there would be a problem. But, that not being the case, I am comfortable with the 7.5 percent rate of growth for a company that is well-positioned to continuing growing at a good clip.

Now let's look at Molson-Coors, the fifth largest brewer in the world, and how I rate the company with my metrics.

TAP

Industry Average

Grade

Dividend Yield

3.1%

2.6%

Pass

Debt-to-Capital Ratio

19.0%

38.7%

Pass

Payout Ratio

35.0%

36.0%

Pass

5-Yr Average Annual Dividend Increase

14.1%

N/A

Pass

Free Cash Flow Per Share

$0.11

N/A

Pass

Profit Margin

18.0%

9.2%

Pass

5-Yr Average Annual Growth in EPS

10.1%

13.0%

Neutral

5-Yr Average Annual Growth in Rev. / Share

-10.0%

14.5%

Fail

Return on Total Capital

6.5%

12.5%

Fail

S&P Credit Rating

BBB-

N/A

Pass

TAP ended up with two fails, but one is excusable when we look deeper into the reason it exists. Revenue growth dropped off a cliff in 2009 after the company formed a joint venture with SABMiller. Each company contributed assets to the JV and now the JV records the revenues produced by those assets, but the companies continue to record earnings from the JV, thus earnings per share jumped nicely in 2009 over 2008, at precisely the same time that revenues fell. It turned out to be a good trade off and so I excuse this fail grade. Return on capital has remained within an acceptable range and fairly steady since the JV was created and are actually higher, on average, that before the JV. I can accept the one fail because it does not degrade any of the other metrics. Seven passing categories is still a strong showing.

Now, let's take a brief look at a company that didn't quite make the grade. Brown-Forman produces and markets distilled spirits and wines. Major brands include Canadian Mist, Finlandia, Jack Daniels, Korbel, and Southern Comfort. Also, at the current price level, this stock does not hold the promise of high total returns. Let's look at the metrics.

BF.B

Industry Average

Grade

Dividend Yield

1.7%

2.6%

Fail

Debt-to-Capital Ratio

20.0%

38.7%

Pass

Payout Ratio

38.0%

36.0%

Neutral

5-Yr Average Annual Dividend Increase

9.6%

N/A

Pass

Free Cash Flow Per Share

$1.17

N/A

Pass

Profit Margin

19.2%

9.2%

Pass

5-Yr Average Annual Growth in EPS

7.4%

13.0%

Fail

5-Yr Average Annual Growth in Rev. / Share

5.8%

14.5%

Fail

Return on Total Capital

22.0%

12.5%

Pass

S&P Credit Rating

A

N/A

Pass

Three fails are registered. The first one, dividend yield, would not be such a concern except that the company's payout ratio is already above the industry average, the company has maintained the ratio over the years at this level, and so there is very little chance that the yield is likely to grow faster than growth in EPS to give a better yield in the future. The revenue growth is not as high as I would like and is likely to remain sup-par for the industry, as is EPS growth. Those are the categories that are most troubling for me. Just the same, I like the company for its consistency. It's just not able to project the total returns for which I look.

I know that some readers are going to ask about AB InBev (NYSE:BUD) and they should. The company was formed by the combination of InBev and Anheuser-Busch in 2008. Shares were not available in the U.S. until July 2009. The combined company doesn't have enough history for my liking. I prefer at least five years of history. I did not follow InBev previously and I have not taken the time necessary to do so. I will continue to watch the company's progress and expect it to be on the list someday.

Dr. Pepper Snapple (NYSE:DPS) and Diageo (NYSE:DEO) have negative cash flow of $1.28 and $1.31 per share, respectively. DEO has a debt-to-capital ratio of 57 percent which is a bit on the high side and the dividend yield has fallen over the past five years due primarily to currency exchange rates. Both companies have had less than stellar revenue growth at 5.2 percent and 3.1 percent, respectively for DPS and DEO. DPS had a respectable showing in EPS growth but may be facing headwinds as its deeper-pocketed competitors, KO and PEP, use their marketing muscle to go after market share. Both companies offer above average dividend yields and with improvements in other areas could become candidates for the list in the future.

I don't follow Boston Beer (NYSE:SAM), Central European Distribution (NASDAQ:CEDC), Constellation Brands (NYSE:STZ), Cott Corp. (NYSE:COT), or Monster Beverages (NASDAQ:MNST) because the companies do not pay a dividend.

This concludes my assessment of the beverage industry. I hope you will join me in upcoming articles in the series as I next plan to explore the auto parts business. Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

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Source: The Dividend Investors' Guide - Part VII: Beverages, How Much Can The World Swallow?