Dunkin Donuts Drops Pepsi For Coke - Should You?

| About: PepsiCo Inc. (PEP)
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By Renee O'Farrell

The feud between Coca-cola (KO) and Pepsico (PEP) has been raging since the late 19th Century when pharmacist Caleb Bradham invented Pepsi using a recipe surprisingly similar to Coke's. The two have been battling it out ever since.

Coke has been getting a leg up lately, boosting its already leading position in spite of Pepsi's campaigns directly attacking Coke's most popular mascots (Coke has 42% of the market, while Pepsi is responsible for just 31%). Starwood Hotels (HOT), the company that owns the world's Sheratons, Westins and Four Points by Sheraton, switched to Coke from Pepsi last year.

More recently, Dunkin' Donuts (DNKN) decided to switch teams. Dunkin' Donuts, which had offered Pepsi products in its stores for years, has opted to sign a multi-year agreement with Coke instead. Under terms of the deal, Coke's soft drinks, juices, water and energy drinks will be sold at Dunkin' Donuts and Baskin Robbins stores nationwide. The transition should be complete by August this year.

Pepsi, in contrast, is big into snacks and processed foods. It owns several big brands, including Fritos, Doritos, Aunt Jemima, Quaker, Sun Chips, Ruffles, Lipton, Capn' Crunch, Rice-a-Roni and others. "The North American snack business is Pepsi's most profitable segment, generating 24% of the firm's total revenue in 2011, but 41% of its operating profits," writes the IBTimes. "Pepsi controls around 64% of the U.S. salty snack market, 60% of the market in Brazil, and 46% of the U.K. market."

Emerging markets, like Brazil, are especially important to Pepsi. Roughly 34% of Pepsi's revenue came from emerging markets in 2011, up from just 22% in 2006. With that much at stake, Pepsi is certainly trying to forge stronger ties in emerging economies. So far, the company has invested more than $1.6 billion in China. Earlier this year, Pepsi announced that it had obtained approval (both shareholder and regulatory) to move ahead in a strategic venture with Tingyi, China's biggest maker of packaged foods. The deal is expected to save Pepsi as much as $200 million in operating losses.

However, for as big as it sounds, Pepsi's investments in the Chinese market pale in comparison to Coke's. Coke is expanding aggressively in emerging markets. The company has a plan in place to spend $4 billion over the next three years in China alone and it has already invested more than $2 billion in India (over the last 18 years). Coke plans to spend another $2 billion in India over the coming years.

All in all, it makes for a pretty strong position for Coke. Right now, analysts are estimating that the company's earnings will grow at a rate of 6.17% a year on average over the next five years. At this level of growth and its current trading price of $74 a share with a $2.04 dividend (2.80% yield), Coke is priced at 16.50 times its future earnings, a fair bit lower than its peers' average of 19.39. Coke's revenue growth has outpaced its industry, coming in at 5.2% quarter over quarter versus an average of 4.4% from its peers. Its net operating cash flow has done even better, increasing almost 16%.

However, the company's earnings per share have fallen somewhat and it has a debt to equity ratio which, at 0.90, may not be high per se, but it is higher than its industry's average. At the same time, Coke has a low quick ratio of 0.78, suggesting that covering short term cash needs could be an issue. The company is also priced at a premium to its book value (5.28 vs. 4.69 for its peers) and its cash flow (17.63 vs. 14.70 for its peers).

Of the 350-plus hedge funds we track, 37 had positions in Coke at the end of the fourth quarter. Collectively, these funds held $16.38 billion in the company at the end of December. Included in that number is the massive stake owned by Warren Buffett's Berkshire Hathaway (see Warren Buffett's top stock picks). It was worth roughly $14 billion at the end of 2011. Boykin Curry's Eagle Capital Management and Paul Ruddock and Steve Heinz's Lansdowne Partners also held significant positions in the company at the end of the fourth quarter.

In contrast, Pepsi recently traded at $66.56 a share and pays a $2.06 dividend (3.10% yield). Analysts are predicting greater earnings growth for the company, forecasting its earnings will increase by an average yearly rate of 7.60% over the next five years. This puts Pepsi's forward price to earnings ratio at roughly 15, which is lower than Coke. Pepsi has also enjoyed greater quarter over quarter revenue growth than its rival, after its revenues increased by 11%. The company also has had a greater net operating cash flow increase; at nearly 17%, it beat Coke by roughly a full percentage point. However, Pepsi's quick ratio is just 0.62, meaning that it is even less prepared to meet short-term cash needs. Also, like Coke, it is priced high relative to its book value (Pepsi's price to book value is 5.02, Coke's 5.28).

Overall, Pepsi does marginally better than Coke on a variety of metrics, including the number of hedge funds invested in the company - there were 38 hedge funds invested in Pepsi at the end of the fourth quarter versus Coke's 37. Diamond Hill Capital, Scout Capital Management and Legg Mason Capital Management held significant positions in Pepsi at the end of the fourth quarter.

Of course, there is always a middle ground. Boykin Curry's Eagle Capital Management has a significant stake in both Coke and Pepsi. While its stake in Coke is larger, its position in Pepsi is the largest among the hedge funds we track. I think this is a good strategy but for do-it-yourself investors that are looking to choose only one, I recommend the market leader Coke.

While both companies look good to me (they are both "buys" in my book), I like Coke's aggressive investing strategy and I think that its current numbers are great taking that into consideration. Also, I like that it is keeping its focus solely on drinks. I think that may help the company narrow in more easily on opportunities as well as identify challenges.

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