Pepsi Has Procter & Gamble Syndrome

| About: PepsiCo Inc. (PEP)


Procter & Gamble has been a disappointing investment since 2007 due to difficulties in growing revenues.

Since 2011, Pepsi has been showing signs of showing signs of following in Procter & Gamble's footsteps as the blue-chip stock in the doghouse.

This does not mean that Pepsi is a sell, but rather that investors should insist on paying 17x earnings instead of 20x earnings.

A great indicator that a blue-chip stock is running through some tough times is when revenue growth stops. It tells you about the health of the business, because it captures whether a company is able to sell more of its product or raise prices without financing engineering acting as a salve to cover up the bad news (earnings per share can provide false signals of business health if buybacks cover up declining brands or cost-cutting moves cover up stagnant sales growth).

The blue-chip stocks that you should a demand a greater discount for before purchasing are those that struggle to grow revenues. Procter & Gamble (NYSE:PG) shareholders have only made 4% annually since 2008. Why is that? Because P&G made $83.5 billion in revenues back in 2007, and is only going to make an estimated $77 billion this year. An inability to increase both volumes and prices explains why the company has tended to give shareholders 4% returns recently, compared to the 1970-2015 record of 12% annual returns.

Another company that is going through something similar is PepsiCo (NYSE:PEP). For the past 45 years, it has delivered 9.5% annual revenue growth. That impressive figure has translated into substantial returns for shareholders. Over the past 45 years, Pepsi shareholders have received returns of almost 13.5% annually.

Yet, it is important to understand when conditions change. Pepsi's soda division has ceased to deliver revenue growth that matches inflation, and that is putting pressure on the company's snack and breakfast divisions. It is in the early stages of dealing with the same thing that Procter & Gamble has been dealing with for the past eight years - difficulty figuring out how to deliver revenue growth.

Right now, Pepsi and Procter & Gamble share the same dilemma: When they lower prices, the subsequent gains in sales is not enough to compensate for the lowered prices. And when prices are hiked, the pushback in lower sales is not enough to get growth back on track. You can already see this troubling relationship play out in the revenue figures at Pepsi.

Back in 2011, Pepsi generated $66 billion in annual sales. Now? It is expected to generate $65 billion in sales for the 2015 year. Although earnings per share have increased from $3.98 to $4.55 over this four-year time frame, this has been the cost of cost-cutting and share buybacks rather than revenue growth.

Pepsi has tacked on $10 billion in balance sheet debt to retire almost 100 million shares of Pepsi stock, and even though the borrowing costs are low, the current balance sheet is higher than customary for the snack and beverage giant. It now has $31.4 billion in balance sheet debt, and that amounts to 60% of the capital. Pepsi will end up paying $860 million in interest payments alone on the current debt load, and this will weigh a little bit on future profits.

The other consequence is that, as Pepsi's payout ratio has crossed the 60% threshold, the pension funding has gone a bit neglected. It currently has $18 billion in pension requirements, and has $15.6 billion in total funding for the pension.

None of these issues presented are huge demerits for the company when analyzed on an individualized basis, but collectively explain why investors might see many similarities between Pepsi right now and what has been going on at Procter & Gamble over the past eight years.

This article should not be read as encouragement to sell Pepsi shares, but rather, it is my hope that investors recognize how negligible growth in revenues of the company have significantly limited its earnings per share growth (and highlight the unsustainable actions of Pepsi's current efforts at boosting earnings per share).

When you conclude that a blue-chip company is struggling to grow revenues, you should insist on a greater valuation discount before purchasing shares of the company. Pepsi has come down 10%, from $100 to the $90 range in the past year, but that still amounts to a valuation of 20x earnings. That's about Pepsi's historical average.

I would desire another 15% or so discount before buying any shares to reflect the difficulties at the company in growing revenues. That means I would not make a buy order before the stock began trading at a valuation of 17x earnings or cheaper. Based on expected 2015 earnings of $4.55 per share, that would be a target price of $77.

Pepsi, like Procter & Gamble, has been an excellent company to own for very long periods of time. But those periods of investment excellence have always been accompanied by revenue growth. When the conditions became a bit more unfavorable, investors should demand a greater margin of safety before purchasing the stock. Given Pepsi's difficulty in growing revenues since 2011, you should insist on a valuation near 17x earnings before initiating a position in the stock.

Disclosure: I am/we are long PG.

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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