Billionaire Peltz Is Gulping Down This Soda Stock

| About: PepsiCo Inc. (PEP)
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By Matt Doiron

As part of our work researching and implementing investment strategies, we maintain a database of quarterly 13F filings from hundreds of hedge funds and other notable investors. We've found that the most popular small-cap stocks among hedge funds earn an average excess return of 18 percentage points per year (learn more about our small cap strategy) and our own portfolio based on this finding outperformed the S&P 500 by 33 percentage points in the last 11 months.

One of the billionaire hedge fund managers we track is Nelson Peltz of Trian Partners. In the first quarter of 2013, Trian was a big buyer of PepsiCo (NYSE:PEP), the soft drink and packaged foods company. Peltz has said he plans to push for the company to buy Mondelez (NASDAQ:MDLZ), a packaged foods company recently formed from the breakup of Kraft Foods; he had also taken a position in that stock between January and March (see more of Peltz's stock picks). An alternative, in his mind, would be for PepsiCo to separate its soft drink business from the rest of the company. Reports indicate that Pepsi management is negative at least on the prospect of buying Mondelez.

PepsiCo's revenue increased slightly last quarter compared to the second quarter of 2012, but with COGS and SGA both decreasing the company delivered a significant increase in earnings (offsetting what had been a weak first quarter of the year, to the point that net income was up 18% year to date). The primary source of these higher margins was the Asia, Middle, East, and Africa segment although the beverage business improved as well. The company generated about $3 billion in cash flow from operations in the first half of the year. A little more than half that figure was paid out in dividends- the stock features an annual yield of 2.7%- with most of the remaining cash used to buy back shares.

At its current valuation the stock trades at 20 times its trailing earnings, suggesting that the market is pricing in some sort of value creating deal or substantial EPS growth for the next several years- even though continuing to grow profits through wider margins is likely not sustainable. In addition to the moderate dividend yield, Pepsico's beta is only 0.3 and so it is a prospective stock for defensive investors. In addition to Trian's interest, billionaire Ken Fisher's Fisher Asset Management had reported a position of 8.3 million shares of PepsiCo in its own 13F (find Fisher's favorite stocks).

Mondelez and Kraft Foods Group (KRFT) are priced at similar levels to PepsiCo, with trailing P/Es in the 19-21 range. Mondelez, similar to Pepsi, has not been experiencing much growth on the top line but the company is seeing high growth in pretax income from continuing operations. Wall Street analysts do not expect much future growth at the company, and seem fairly cautious of predicting high EPS growth at PepsiCo and Kraft Foods as well. Kraft, which is more focused on North American operations following the breakup, saw higher margins in the second quarter of 2013 versus a year earlier with the result being a 40% increase in earnings. As a player in a more mature market, it pays a somewhat higher dividend yield than these other two peers at 3.5%.

Of course, because of its beverage business we can also compare PepsiCo to Coca-Cola (NYSE:KO) and Dr. Pepper Snapple (NYSE:DPS). Coca-Cola carries trailing and forward P/Es of 21 and 18, respectively, so it is priced about in line with Pepsi as well. However, its margins have not been as strong and as a result recent reports show small declines in both sales and net income. With a beta of 0.2 and an annual yield close to 3%, Coca-Cola is another favorite of defensive investors. Dr. Pepper Snapple is the cheapest of PepsiCo's peers, at a trailing P/E of only 16. It is even less exposed to the overall economy than these other companies, with a beta of 0 in statistical terms. However, it has actually seen its margins weaken over the last year with earnings falling over 10% on flat revenue.

A spinout of PepsiCo's soft drinks business would have some potential to improve operations if it enabled management to become more focused; synergies would be possibly in the event of a Mondelez deal, though there would be integration risks as well. However, as it stands Pepsi is a questionable value opportunity given its high earnings multiples and flat revenue (which likely indicates low EPS growth in the long term) and we'd recommend avoiding it unless an investor is specifically looking for defensive stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article is written by Insider Monkey's writer, Matt Doiron, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.