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PepsiCo Fails This Critical Test

June 20, 2014 | About:
Vinay Singh

Vinay Singh

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Despite the efforts of First Lady Michelle Obama and New York City Mayor Michael Bloomberg to get kids and adults to lay off the sugary beverages, soda continues to be a solid market for investors, depending on what company you invest in, of course. In the decades-old rivalry between PepsiCo (PEP) and Coca-Cola (KO), Pepsi fails the test on many dimensions, some of which you won’t hear from many people in the industry.

A mixed bag at PepsiCo

One of PepsiCo’s challenges is that it muddies the waters with non-beverage food products, which makes it difficult to do a straight-on comparison to its biggest competitor, Coca-Cola. It was smart to let go of the company that eventually became Yum! Brands, but as long as it continues to hold onto Frito-Lay and Quaker Foods, it will continue to be held back by those diversions.

Some people are lured by its reported EPS growth of almost 20% and dividend increase of nearly 6%, but year-over-year net revenue growth has actually been down by 1%, in spite of strong growth in some of its divisions (especially in overseas markets such as Africa, Asia, and the emerging Middle East regions). Its carbonated beverage division in the U.S., however, has seen basically flat volume of late, whereas even Dr. Pepper Snapple Group (DPS) has been able to increase volume, even if only by 1%. By contrast, Monster,makers of various energy drinks and other beverages, has seen increases in total case volume in the high-teens.

Another important mark against PepsiCo is that, relative to its peers, it has lower operating margins. Although these have risen from 11% to 13% of late, that seems pretty anemic, relative to Coca-Cola’s current 22%. Coca-Cola has managed to keep its operating margin in the low-to-mid 20s for several years. PepsiCo’s operating margin also lags behind Dr. Pepper Snapple, though not by much, given the recent Dr. Pepper Snapple slide from nearly 20% to just over 15%. Once again, however, Monster is leading the pack with an operating margin of 26%. That’s downright impressive. But, those lower operating margins at PepsiCo might very well be chalked up to its overseas food product baggage.

Reading between the lines

Remember that 20% growth in EPS I mentioned earlier? You have to read a bit between the lines of the financials to see what’s really happening there. Just about all of that increase can be traced to a significantly reduced one-time tax provision. If the tax provision was changed to be the same as the previous year, PepsiCo’s EPS, in reality, saw a decline. Meanwhile, other companies all posted gains in EPS, with Coca-Cola clocking in a 15% increase in EPS, 12% at Monster, and 5% at competitive Dr. Pepper Snapple. Once again, PepsiCo is clearly lagging behind other industry players.

Then, there’s the matter of stock repurchases and dividends, the ways a company returns money to shareholders. In fiscal year 2012, PepsiCo gave back $6.4 billion through repurchases. But, with the 5% increase in dividends, it’s going to be buying back fewer shares this year. Perhaps even more disturbing, however, is the company’s expectation of an increase in interest expenses because of its expanding debt. This means it is borrowing money to do the buybacks, which is not a good thing when its debt/equity ratio already stands above the magical number 1 -- 1.05 to be exact. That’s a lot higher than Coca-Cola’s 0.45, and Monster’s completely debt-free balance sheet. Only Dr. Pepper Snapple has a slightly higher ratio than PepsiCo with 1.2.

It will be interesting to see how much PepsiCo’s ratio increases this year. But, one thing is getting clearer every passing quarter -- PepsiCo's competitive position in the industry does not appear to be heading in the right direction.

A muddled mess

Some analysts might say that PepsiCo is doing the right thing by having its snack and other food product divisions. After all, doesn’t this diversify its revenue stream? My response is a firm “No.” Coca-Cola has, as its sole focus, its carbonated beverage products. That laser focus has resulted in the company’s superior performance. What’s the No. 1 soda in the world? Coke. What’s the No. 2 soda in the world? You might be tempted to say Pepsi, but you’d be wrong. The No. 2 soda is Diet Coke.

Even PepsiCo’s current CEO is unable to focus on the core business; she speaks of promoting healthier alternatives. And, while that is well and good, there are many who rightly view this as a distraction from the company’s core business. Until the company can figure out what it’s really about, performance is likely to continue to be sub-par.

The bottom line

PepsiCo has some serious marks against it as an investment opportunity – flat volumes, the lowest operating margin in the industry, declining EPS (without the lower taxes), and expanding its debt accounts to finance share repurchases and dividends. This is one company that has too much baggage to qualify as a good investment.


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