We previously wrote about why we at Saibus Research preferred the taste of Coca-Cola (KO) for our portfolios instead of Pepsi (PEP). The only problem we have with investing in those companies is that everyone is well-acquainted with the fantastic business models for the soft drink makers. This is especially so as the companies have diversified out of America into foreign markets and diversified out of sodas and into juices and water. Because of that, we expect that returns on these companies will only slightly exceed the market return. We believe that as good as the beverage companies are in terms of free cash flows and returning cash through dividends and share repurchases, we believe that both these companies are fairly valued and investors should wait for a lower price to get in to these companies.
We won't pretend that Coca-Cola is immune from the effects of the European debt crisis and the slowing emerging market growth. The most obvious impact to Coca-Cola's top and bottom line is negative currency impact when foreign results are translated back into US dollars due to the negative impact that a strong dollar has on multinational corporate results. Because of the soft US dollar, the fast growth in foreign markets and the volatile range-bound US stock market, Coca-Cola and Pepsi were able to generate total returns to common stockholders well in excess of the S&P 500 from the end of December 1999 to the present. Pepsi had outperformed Coca-Cola because it was at a much more reasonable price to earnings ratio around 1999 (27 for PEP versus 60 for Coca-Cola). In our previous report, we noted that Coca-Cola has soundly outperformed Pepsi since Indra Nooyi became CEO, mainly on the strength of its EPS growth outperforming Pepsi's. We don't expect that these companies will be able to substantially outperform the S&P 500 again during the next 12+ years.
While Coca-Cola saw headwinds to its growth, it was able to manage a 1% growth in its reported EPS for Q2 2012 versus Q2 2011. The company had a 0.4% decline in its reported net income but a 1.4% reduction in its shares outstanding. Revenue increased by 3% and the company benefited from lower non-recurring operating charges and positive operating leverage. Recurring operating expenses increased by 2% versus 3% for revenue, which offset a 5% increase in cost of goods sold. This resulted in a 4% increase in year-over-year operating income. On a Non-GAAP basis which excludes the impact of ostensibly non-recurring charges and changes in income from transaction gains and losses, the company posted $1.22 in Q2 2012 EPS, which was a 4% increase from the prior year's comparable quarter and which beat the consensus estimate by 3 cents.
Recent performance highlights for the company include the following:
- Global volume grew by 4% for the quarter and 5% year to date, on the strength of 5% international volume growth more than offsetting 1% volume growth from North America
- Q2 operating income grew by 4% reported basis and 7% constant currency.
- Operating income saw a 3% headwind to growth due to negative effects of the strong US dollar. This was due to the US being the "cleanest dirty shirt" in the market.
- Key drivers of volume growth were the BRICs: India (20%), Russia (9%), China (7%) and Brazil (6%). These countries helped offset a 5% volume decline in Europe
- As we expected, volume growth from non-carbonated beverages (9%) outperformed sodas and other traditional soft drinks (2%)
Highlights from the fast-growing non-carbonated beverages product line include the following:
- Tea Volume grew by 13% due to growth in key brands such as G old Peak and Honest Tea in North America, Ayataka green tea in Japan and Fuze Tea, which was launched in Latin America during the quarter.
- Packaged Water grew by 10%, based on strong growth from Dasani and its Glaceau water brands. We are amazed that Dasani is getting good growth even though we hardly ever see it on sale and its sale price is more expensive that the regular price of the store brand water.
- POWERADE grew by double-digits during the quarter and this marks the third consecutive quarter in which POWERADE has led the North America sports drink category in absolute unit case volume growth. We prefer POWERADE to Pepsi's Gatorade because of the My Coke Rewards program, which gives us rewards for drinking POWERADE and other Coca-Cola products.
The company continues to return cash to shareholders. Earlier in the year, the company increased its dividend per share by 8.5% and repurchased $1.6B in stock net of employee stock program issuance. On July 10th, Coca-Cola announced it will be splitting its stock two-for-one effective July 27th. Coca-Cola is targeting $2.5B-$3B in net repurchases during year. As of the first half of 2012, Coca-Cola's net share repurchase represents ~51% of its year-to-date free cash flows. We expect that this ratio will decline during the rest of the year as Coca-Cola's cash collection cycle is season and collects more cash relative to income in quarters Q2-Q4 versus the first quarter of a fiscal year.
In conclusion, we believe that both companies are fairly valued. We like the fact that the companies generate above average dividend yields relative to the S&P 500 and both firms have a greater ability to create "homemade dividends" through stock repurchase programs. In the 25 days since we first wrote about Coca-Cola and Pepsi, Coca-Cola's total return exceeded Pepsi's, though we are not expecting to project a trend based on a 25 day period. Other than that, we believe the companies are fairly valued relative to the consensus long-term growth rates both companies are expected to achieve. Coca-Cola has a trailing PE of 19.1 and a consensus LTG of 8.7%. Pepsi has a trailing PE of 17.2 and a consensus LTG of 4.3%. We think investors may want to sell their shares in the beverage makers and reenter for lower prices to reenter into their positions, especially if in tax-advantaged investment accounts. We also mentioned that if Pepsi was replace Indra Nooyi as CEO with someone who knows what they are doing, we would certainly take a position in Pepsi. The reason why we would take a position in Pepsi is that we believe that company would be waking up from its recent record of somnolent performance and this was manifest itself in a potential improvement in its sales and revenue growth post-Nooyi. Coca-Cola reported its earnings last Tuesday, we will see what happens Wednesday July 25th when Pepsi reports.
Additional disclosure: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.