Intelligent Quant: 3 Reasons Why PepsiCo/Primo Water Is An Interesting Long/Short Story

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Includes: PEP, PRMW
by: Nelson Nguyen, CFA

Summary

Market-neutral trade: Going long PepsiCo at the same time shorting Primo Water.

Going long PEP: Current price as of 2/8/17 is $105.69. Average fair value estimate is $134.81. Magic Formula numbers are ROC of 60.05% and earnings yield of 5.64%.

Shorting PRMW: Current price as of 2/8/17 is $15.11. Average fair value estimate is $7.33. Magic Formula numbers are ROC of 21.11% and earnings yield of 2.22%.

Estimated return is 5.99% or 4.21% yield over and above five-year U.S. Treasuries.

Intelligent Quant is an investment methodology that uses principles from old school value investing by Benjamin Graham and quantitative methods like Ed Thorp (or Quantitative Value Investing approach). In this article, I write about a potential money-making market neutral trade that consists of going long PepsiCo, Inc. (NYSE:PEP) at the same time shorting Primo Water Corporation (NASDAQ:PRMW). There are three primary reasons why I believe this is a high probability market neutral trade. The first reason is the Miracle Formula 2.0 fundamental factors, which are based on Joel Greenblatt's Magic Formula. Second, the valuations and margin of safety imply that going long PEP and shorting PRMW is a good market neutral trade for the non-alcoholic beverage industry. Finally, the short-term market sentiment indicators seem to support my investment thesis. Before we get into the three points, let me tell you more about the background of these two companies.

Companies

PepsiCo, Inc. is an American multinational food, snack and beverage corporation headquartered in Purchase, New York. PEP has interests in the manufacturing, marketing and distribution of grain-based snack foods, beverages and other products. Primo Water Corporation is a provider of multi-gallon purified bottled water, self-service refill water and water dispensers. Although this is not a perfect market neutral trade, given PEP and PRMW are in the non-alcoholic beverage industry, I paired them together in this Long/Short story.

Reason 1: Miracle Formula 2.0

My thesis is that you can create alpha (or excess return above the market return) by performing a market neutral trade going long Group 1 Magic Formula ranked stocks at the same time shorting Group 10 Magic Formula stocks in the same industry/sector with companies that have no M&A news. By going long the undervalued quality stock using the classic Magic Formula (the Group 1 stocks), you can find stocks that are heading to the heavens. By shorting the Anti-Magic Formula (the Group 10 stocks), you will likely find companies that will trade down to earth. Combining the long and short for no M&A stocks, you have the Miracle Formula 2.0 for market neutral investing. This is heaven on earth.

Let's continue with an example of how Miracle Formula Investing works with PEP and PRMW.

Comparing the two Magic Formula Investing factors, we find that PEP is more undervalued and has a better quality than PRMW.

PEP

PRMW

ROC: EBIT/(Net Working Capital + Net Fixed Assets)

60.05%

21.11%

Earnings yield: EBIT/Enterprise Value

5.64%

2.22%

M&A News

No

No

Because PEP ranks higher for both quality and value than PRMW, the former is a better buy than the latter.

Reason 2: Valuations & Margin of Safety

Morningstar and Value Line Valuations

Like an important medical decision, you always want a second opinion. I recommend using Morningstar and Value Line to double check your investment decisions.

According to Morningstar, PEP has a Fair Value Estimate of $106.00 implying a 0.29% margin of safety. Unfortunately, Morningstar does not give a valuation of PRMW at this time. However, a quick check of Value Line shows it does have a Target Price Range for both stocks.

PEP

PRMW

Value Line Target Price Range Low

120.00

11.00

Value Line Target Price Range High

145.00

19.00

Value Line Target Price Range Average

132.50

15.00

Current Price

105.69

15.11

Margin of Safety

25.37%

-0.73%

Based on Value Line's average Target Price Range for the next 3-5 years, it implies that the compound average growth rates (CAGR) for PEP and PRMW are 5.81% and -0.18%, respectively. This means you are projected to make a spread of 5.99% (5.81% - -0.18% = 5.81% + 0.18%) if you go long PEP and short PRMW. Given the five-year U.S. Treasury Yield is about 1.78%, you can make a 4.21% yield over and above Treasuries. This is huge. The measuring stick for market neutral trading is how much return can you make above risk-free rates.

Relative valuations

Price-to-earnings valuation

The current PE multiple for the industry is 24.40. If we multiply it with earnings, we come up with a fair value estimate. For PEP, taking the one-year forward EPS estimate of $4.67 times 24.40 gives us a fair value estimate of $113.95. For PRMW taking one-year forward EPS estimate of $0.30 times 24.40 gives us a fair value estimate of $7.32. Earnings estimates are based on average Wall Street analyst estimates found at Morningstar.

PEP

PRMW

Price-to-Earnings (TTM)

23.20

75.90

Price-to-Earnings (Forward)

20.60

217.40

Price-to-Earnings (Industry Average)

24.40

24.40

EPS

4.59

0.20

EPS Estimate

4.67

0.30

Implied Valuation (TTM)

112.00

4.88

Implied Valuation ((Forward)

113.95

7.32

Implied Valuation (Average TTM & Forward))

112.97

6.10

PEG

3.00

21.60

Price-to-sales valuation

I modified the tradition price-to-sales valuation by adding a premium/discount factor based on net profit margin relative to industry average. I believe this is a better measure of value when you do relative price-to-sales valuation. A company should be worth more if its net margin is better than industry. At the same time, a company should be worth less if it has a lower-than-industry net margin because for every dollar of sales it generates less earnings.

PEP

PRMW

Sales Growth Year over Year

(5.44)

19.40

Sales Growth 3 Year Average

(1.26)

11.54

Sales Growth 5 Year Average

1.74

23.27

Price-to-Sales

2.50

3.40

Price-to-Sales (Industry Average)

2.90

2.90

Sales per Share

42.82

4.96

Net Margin (Industry)

2.8%

2.8%

Net Margin

10.7%

4.3%

Premium/Discount

3.84

1.55

Implied Valuation (P/S)

476.27

22.31

Price-to-book valuation

The current PB multiple for the industry is 7.20. If we multiply it with Book Value per Share (BVPS) of $8.76, we come up with a fair value estimate of $63.07 for PEP. If we multiply the PB industry multiple with BVPS of $1.26, we come up with a fair value estimate of $9.07 for PRMW. The following is a summary of my analysis:

PEP

PRMW

Price-to-Book

12.10

12.10

Price-to-Book (Industry Average)

7.20

7.20

Book Value per Share

8.76

1.26

Implied Valuation (P/B)

63.07

9.07

Book value valuations are more appropriate if the company may go out of business and you want to determine how much the company is dead than alive.

Combined PE (TTM & Forward), PS and PB fair values

Using the TTM and Forward PE, PS and PB valuations, you come up with an average estimate for PEP and PRMW. Combined fair value estimate for PEP is $217.44. Combined fair value estimate for PRMW is $12.49.

Enterprise multiple

The enterprise multiple is a ratio used to determine the value of a company. It looks at a firm as a potential acquirer would, because it takes debt into account (an item which other multiples like the P/E ratio do not include). The enterprise multiple based on EBITDA is calculated as: enterprise value/EBITDA. The enterprise multiple based on EBIT is calculated as: enterprise value/EBIT.

Enterprise value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

PEP

PRMW

Industry Enterprise Multiple (EBIT)

19.61

19.61

Industry Enterprise Multiple (EBITDA)

15.94

15.94

EBIT

9,738.00

6.00

EBITDA

12,121.00

16.00

Preferred Equity

(148.00)

-

Debt

35,606.00

19.00

Minority Interest

116.00

-

Cash & Investments

14,780.00

2.00

Shares Outstanding

1,445.00

27.00

Implied Valuation (EBIT)

117.76

3.73

Implied Valuation (EBITDA)

119.32

8.82

Discounted Cash Flow model

Investopedia defines Discounted Cash Flow (DCF) as follows:

"A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one."

Using Guru Focus' DCF calculator, I come up with the following valuations:

PEP

PRMW

EPS

4.56

0.20

Growth rate next 10 years

7.50%

5.00%

Terminal growth rate

4.00%

4.00%

Years of terminal growth

10.00

10.00

Discount rate

7.38%

4.06%

Tangible book value

(10.53)

0.97

Growth value

45.88

2.10

Terminal value

38.84

2.18

Implied Valuation (DCF)

84.72

4.28

Reverse Discounted Cash Flow model

DCF is great, but it can have a wide range of answers based on underlining assumption. Therefore, garbage in garbage out. What the Reverse DCF attempts to do in order to improve from the reputation of standard DCF is to eliminate the need to forecast. Instead of starting with free cash flow and then projecting into the future, the purpose of the Reverse DCF is to calculate what growth rate the market is applying to the current stock price. In other words, by working backwards, you can see whether the implied growth rate by the market is higher or lower than what the company is able to achieve. Reverse DCF is a great tool to test our behavioral financial bias and see when the market is likely to misprice a stock.

Using Guru Focus' Reverse DCF calculator, I come up with the following valuations:

(Per Guru Focus)

PEP

PRMW

EPS

4.56

0.20

Growth rate next 10 years

7.50%

5.00%

Terminal growth rate

4.00%

4.00%

Years of terminal growth

10.00

10.00

Discount rate

7.38%

4.06%

Revenue Growth Rate 1 year

-1.50%

-6.10%

Revenue Growth Rate 5 year

2.90%

-10.90%

Revenue Growth Rate 10 year

9.50%

0.00%

Reverse DCF Growth Rate

10.63%

22.02%

Analyzing the Reverse DCF growth rates, it appears the market is slightly overvalued for PEP and significantly overvalued for PRMW. PEP may be able to achieve a 10.63% growth rate based on 1-, 5-, and 10-year growth rates. We can see PRMW is not likely to achieve a 22.02% growth rate based on current historical growth rates (based on Guru Focus's growth rates).

(Per Morningstar)

PEP

PRMW

Sales Growth Year over Year

(5.44)

19.40

Sales Growth 3-Year Average

(1.26)

11.54

Sales Growth 5-Year Average

1.74

23.27

However, if we take Morningstar's growth rates found in the PS valuation section, we find PRMW is slightly overvalued and PEP significantly overvalued based on Reverse DCF.

Average fair value estimate and margin of safety

PEP

PRMW

Combined P/E (TTM & Forward), P/S & P/B Valuations

217.44

12.49

Implied Valuation (EBIT)

117.76

3.73

Implied Valuation (EBITDA)

119.32

8.82

Implied Valuation (DCF)

84.72

4.28

Average Fair Value Estimates

134.81

7.33

Current Price as of 2/8/17

105.69

15.11

Margin of Safety

21.60%

-106.15%

Based on the average fair value estimates, we find that PEP is undervalued and has a margin of safety of 21.60%. In contrast, PRMW is considered overvalued and has a margin of safety of -106.15%.

Reason 3: Short Tells

Insider Activity

Thesis: Buying opportunities can be found by looking at when insiders are buying. Checkout this article entitled "When insiders buy, should investors join them?" for why this can be a tell against other investment poker faces.

A check at Morningstar's website, we find that insiders have been buying at PEP since 9/30/2016; there have been more acquisitions by insiders than selling. This is a good sign because we want to Long PEP. Trying to interpret PRMW's insider activity, I see more dispositions than accumulations of the stock. Some key executives for PRMW would exercise options to buy shares and then shortly after sell the shares. It appears that PRMW's insider activity signals bearish tones.

Short Tells

In investment poker, there are three popular market sentiment indicators for a stock's short-term outlook, which are 1) Put-Call Ratio, 2) Short Interest Ratio, and 3) Short Percentage of Float.

PEP

PRMW

SPY

Put-call ratio

2.501

N/A

2.312

Short interest ratio

1.81

2.63

2.22

Short percentage of float

0.55%

1.87%

N/A

Put-call ratio is a technical indicator demonstrating investors' sentiment. The ratio represents a proportion between all the put options and all the call options purchased on any given day. The put-call ratio can be calculated for any individual stock, as well as for any index, or can be aggregated. The ratio may be calculated using the numbers of puts and calls or on a dollar-weighted basis. PRMW does not have a put-call ratio as of 2/8/17 for the Thinkorswim platform. With a put-call ratio of 2.501, PEP is bearish because there are more puts than calls. Comparing this ratio with the market's S&P 500 put call ratio, we find PEP is more bearish than SPY (a barometer for the overall U.S. market).

The short interest ratio or float short for a public company is the ratio of tradable shares being shorted to shares in the market or the float. It is an indirect metric of investor sentiment. When short interest is high, it implies company's investors hope shares will decline in value. Since the short interest for PEP is less than PRMW, PepsiCo is likely to outperform Primo Water on a relative basis.

Short percentage of float is the percentage of shares shorted compared to the float. As of 2/8/17, PEP's short percentage of float is 0.55%. Short percentage of float is the percentage of shares shorted compared to the float. PRMW's short percentage of float is 1.87%. Therefore, PEP is a better buy than PRMW based on short percentage of float analysis.

Conclusion

We analyzed the quality of these two stocks and came up with quality and relative valuations using the Magic Formula. As a result, we found that PEP is a relatively better quality and value compared to PRMW. After analyzing Value Line's Target Price Range, we concluded that PEP has a high probability of outperforming PRMW on a relative basis. We also performed valuations that support our thesis for this Long/Short stock pitch. Insider activity seems to support our thesis that PEP is a good buy and PRMW is either fairly valued or overvalued. Finally, we concluded from the short investment poker tells indicate that PEP has more upside than PRMW. This is the reason why I believe going long PEP and shorting PRMW is a great market neutral trade.

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

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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