Pepsi Is Fairly Valued And Falling Behind Coca-Cola

 |  About: PepsiCo Inc. (PEP), Includes: BRK.A, KO
by: Saibus Research

We believe that although PepsiCo Inc. (NYSE:PEP) has been a poor performing company under the mismanagement of Indra Nooyi, it is still an industry-leading beverage maker. We're displeased that PepsiCo's gains against The Coca-Cola Company (NYSE:KO) under Nooyi's mentor Steven Reinemund have dissipated under her watch. Despite its mediocre performance and recent growth by acquisition strategy, we would not be comfortable shorting Pepsi.

We believe that PepsiCo's dividend and share repurchase program is providing a floor for the shares and we believe that it is merely a fairly valued company that will not repeat its outperformance against the S&P 500 that it enjoyed since the 1980s. We believe that the same paradigm also applies to Coca-Cola too. We also would not be comfortable shorting the beverage makers because both firms are backed by famous investors.

PepsiCo has Ralph Whitworth of Relational Investors LLC and Coca-Cola has had Warren Buffett and Berkshire Hathaway (BRK.A, BRK.B) backing it for nearly 25 years. That doesn't change the fact that the stronger-performing Coca-Cola is expected to grow its earnings by 6.9% long-term, according to Morningstar, versus 4.6% for Pepsi.

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Source: Morningstar Direct

Coca-Cola maintained its lead over Pepsi in the worldwide beverage business. In North America, Coca-Cola's Q3 2012 results were almost a mirror image of Pepsi's, as Coca-Cola grew its beverage volumes by 2%, its revenues by 5%, and its comparable currency operating income by 3%. Pepsi Americas saw its beverage volumes decline by 3%, its revenues decline by 7%, and its constant currency operating income drop by 13%.

The Pepsi Americas Food Division was a better performer than the beverages business in that it grew its volume by 6%, however that was primarily due to acquisitions of Latin American food companies. Even with the 11% volume boost from Latin American food acquisitions, net revenue only grew by 7% and constant currency operating income declined by 1% during the period.

Both companies had mediocre results in Europe during the quarter, but we believe that we will see stability in European operations, going forward. Coca-Cola Europe checked in with a 1% volume increase and declines of 8% for revenue and operating profits. Pepsi Europe had stable volumes for its food products and 1% volume growth for its beverage products.

We were surprised to see that Pepsi Europe was able to generate a 7% constant currency revenue growth and 3% increase in operating profit. We also note that Pepsi Europe is not quite comparable to Coca-Cola Europe because Pepsi Europe includes the former Warsaw Pact nations of Eastern Europe whereas Coca-Cola includes its operations in those countries as part of its Eurasia and Africa division.

PepsiCo Asia, Middle East and Africa saw strong snack volumes growth of 13% and solid beverage volume growth of 15% for its beverages business. Organic net revenue grew by 10% and net reported revenue declined by 17%, due to the refranchising of its Chinese bottling operations. Pepsi's AMEA constant currency operating income grew by 14% in this division, which was greater than the 2% decline by Coca-Cola's Pacific division and 11% in its Eurasia and Africa operations. Coca-Cola Pacific and Eurasia and Africa had comparable beverage volume growth of 3% and 11%, respectively.

We see that Pepsi's overall results continue to have less fizz than Coca-Cola's. Coke grew its overall revenue by 1% in the most recent quarter and 3% year to date, while Pepsi's revenues declined 5% for the quarter and 2% year-to-date. This enabled Coca-Cola to achieve a small, but acceptable level of operating income growth during these periods in comparison to the operating profit declines by Pepsi.

Coca-Cola's EPS grew by 5.4% for the quarter and 4.7% for the year-to-date period in spite of global macroeconomic headwinds, a strong US dollar and the absence in 2012 of a $417M gain in 2011 upon the merger of its Mexican bottling partners. Pepsi faced similar headwinds, but was not able to avoid a 3% decline in EPS for the quarter and 9% on a year-to-date basis. At least both companies have been able to reduce the weighted average outstanding share count by about 1.5% year-over-year during the period.

Despite the fact that Pepsi has 11% more revenue than Coca-Cola, Coca-Cola earned 82% more profits than PepsiCo. Coca-Cola has $12.6B more assets on its balance sheet than Pepsi; however, this is because Coke has ~$21B more cash, securities and equity method investments than PepsiCo. This probably explains why Coca-Cola has $12B more in stockholders equity than Pepsi.

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Source: MRQ Reports for Pepsi and Coca-Cola

Even with Ralph Whitworth's recent investment in Pepsi through Relational Investors LLC, Pepsi is fairly valued thanks to the flight-to-safety by investors in the wake of the European debt crisis and demand for any investment offering an annual yield payout exceeding the low rates paid on T-Bills, bank deposits and even intermediate-term debt.

We think if investors want to invest in the soft-drink industry based on what a famous investor is doing, they should bend it like Warren Buffett of Berkshire Hathaway and invest in Coca-Cola. However, until Pepsi announces a major strategic action (like splitting off the food division) or leadership succession plans, we believe that dividend-seeking investors and investors who mimic what notable investors do should go with Coca-Cola instead of Pepsi.

In conclusion, even if PepsiCo smartens up and replaces Nooyi with someone who knows what they are doing, the company is fairly valued and any special situation or upgrade to management is already embedded in the price of the company. Although Coca-Cola is also fairly valued too, we believe investors who insist on investing in the beverage industry should say to their brokers "Um, yes, I'll have another Coke please".

We think Pepsi stakeholders wish that Indra Nooyi was selected as the President of the World Bank instead of Jim Young Kin of Dartmouth College. Maybe Dartmouth will take her now that it needs to fill Kin's shoes as President. We saw that Thomson Reuters blogger and Seeking Alpha Contributor Felix Salmon got a real tingle in his leg with regards to the prospect of Nooyi going to the World Bank.

We think PepsiCo's board should call up various technocratic non-governmental public welfare organizations to see if those groups would be willing to take Nooyi off PepsiCo's hands. We believe that even while she was successful as Steven Reinemund's understudy, we don't believe that her heart was really into working at PepsiCo. We believe that PepsiCo should call up Wake Forest University and make a trade in which PepsiCo gives WFU Nooyi and Wake Forest sends Steven Reinemund back to PepsiCo.

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Source: Morningstar Direct

Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.