The Common Mistake With Coke, Pepsi, And Dr. Pepper

Includes: DPS, KO, PEP
by: Tim McAleenan Jr.

When an investor decides not to buy stock in Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), or Dr. Pepper (NYSE:DPS), the reason usually has to do with concerns about volume growth for soda in North America. All three companies have been prone to seeing 2-3% soda volume declines for extended periods of time that occasionally goes on for a year.

There are three problems -- two small, and one big -- with this line of thinking. But they all share one thing in common: focusing on stagnating volume growth over the medium term ignores the presence of countervailing factors that offset soda volume growth in North America and allow the shareholders to experience continued wealth creation with each passing year, which is partially manifested in a growing dividend that regularly puts more and more money in the pockets of their shareowners over time.

First of all, an undue focus on soda consumption ignores the fact that soda does not represent the entirety of the company's profits. Coca-Cola also has a widely diversified portfolio of non-soda offerings, such as Dasani Water, Vitaminwater, Powerade, Minute Maid orange juice, and so on. In the case of Pepsi, there are the huge Frito-Lay and Quaker Oats divisions that are isolated from the trends in the North American soda market. In the case of Dr. Pepper, the non-soda offerings are more limited, to products such as Deja Blue Water, Country Time Lemonade, Snapple teas and juice drinks, Mott's apple and fruit juices, and mixer brands such as Rose's and Margaritaville.

Secondly, your investment in these companies aren't contained by the North American markets. In the case of Coca-Cola, over 59% of its net sales occur outside the United States. When you size up the full global scope of Coca-Cola's operations (that is, count everything), then you will see that volume growth is averaging over 2% increases annually. That share of Coca-Cola that you purchase counts the entire world, so why exclude its non-US operations when performing your own calculations?

Pepsi tells a similar story; the snack portfolio will soon be generating more than half of Pepsi's total annual revenue, and the volume of all of its product divisions is growing in a fashion similar to Coca-Cola's, hovering around the 2% range. When you add up all the operations, both Coca-Cola and Pepsi are growing.

As for Dr. Pepper, it is growing volume somewhere 2.5% annually when you count all product offerings, slightly above Coca-Cola and Pepsi. I find this fact particularly encouraging because Dr. Pepper has devoted a large chunk of its advertising dollars to its ten-calorie drink campaign, and this is allowing Dr. Pepper to capture the modest part of the market that wants to give up 250-300 calorie drinks but doesn't want to give up regular soda consumption, either. The one concern with Dr. Pepper, though, is that it does not own most of its international product rights, which limit expansion outside the United States.

And now, for the last reason (and arguably most important) reason why it is a mistake to place an undue focus on stagnating North American soda volume with these three companies: pricing power. These three companies are able to increase the prices of their goods at a rate far in excess of any declining volume trend, and this is why it is wise to take a hard look at the net profit growth for each of these companies, which tells this part of the company's story that volume figures do not capture.

Over the past five years, net profits at Dr. Pepper have increased 8.5%. At Pepsi, they have increased just shy of 6%. For Coca-Cola, the advances have been at a 9.0% annual clip. Sales, revenue, volume growth -- those figures are only useful over the long run to the extent that they can improve the profits at the companies of our choosing. It is from the profits that we receive dividends, and it is the retained profit that allow a company to grow (and thus attain a higher stock price) without having to take on debt or dilute shareholders via new stock offerings.

Personally, I don't think North American soda volumes will decline 2-3% annually in perpetuity. It will take slight, inevitable modifications to sugar content and total calories to get media outlets and the public focused on a different health bogeyman. But even if soda volumes declined in North America indefinitely, there is still population growth elsewhere that can lead to growth in soda consumption (this would primarily benefit Pepsi and Coca-Cola much more than Dr. Pepper). But most importantly, the pricing power of these three firms is so enormous over the long-run that you could still achieve 8-10% annual growth even if the soda volume stagnation in North America does not reverse itself. And if volume growth in the US, Canada, and Mexico starts to pick up? Then, these companies could deliver total returns in the 10-12% range if purchased at fair value.

Disclosure: I am long KO, DPS. 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.

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