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This Just In: More Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." While the pinstripe-and-wingtip crowd is entitled to its opinions, we've got some pretty sharp stock pickers down here on Main Street, too. (And we're not always impressed with how Wall Street does its job.)

Given that, perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.

Synchronized stockpicking on Wall Street
It's not every day you see a Wall Street bigwig flip from sell to buy on a previously hated stock. It's especially rare when you see two such firms come to the same conclusion simultaneously -- but for PepsiCo (NYSE: PEP  ) shareholders, that's just what happened on Monday.

First, French megabanker Credit Agricole then Hong Kong-based investment banker CLSA issued upgrades for Pepsi yesterday. And they weren't just any old upgrades but perfect 180-degree reversals, as each banker talked itself around to the opinion that Pepsi -- previously rated underperform, was in fact a fine candidate to outperform the market going forward. Of the two, CLSA was the most forthcoming in explaining its reasons for the upgrade, so that's the one we'll focus on today.

Coke [may no longer be] it
Noting Pepsi's recent share underperformance of archrival Coca-Cola (NYSE: KO  ) , CLSA wonders whether investors mightn't have become too pessimistic about Pepsi's chances. According to the analyst, sales growth is starting to revive at Pepsi, where "volume growth forecasts for Americas Beverages" are now up to 2% per year, and revenue growth could hit 3% or even 4%. CLSA believes we could see Pepsi earn $4.53 per share this year -- versus previous projections of just $4.50. In CLSA's view, this transforms the stock from a "sell" into a "buy."

Wait. Hold up a sec ... that's just three cents!
Excellent point. It is just three cents more than CLSA previously projected for Pepsi. And I agree -- basing a 180-degree reversal on a mere 3-cent bump in profits seems a bit optimistic. But could CLSA be right?

After all, there is some merit to this analyst's musings. CLSA bases its reversal of opinion on Pepsi on a belief that "expectations remain low" for the stock. Indeed, Wall Street consensus projections call for Pepsi to grow just 7.8% per year over the next five years. That's compared with 9% growth at Dr. Pepper Snapple (NYSE: DPS  ) , 9.2% for Coke, 14.6% for Hansen Natural (Nasdaq: HANS  ) ... and 14.9% for the drinks industry as a whole!

(And if you're wondering how the whole industry can grow faster than any of its component parts, look to the outliers. Tiny outfits like Jamba Juice (Nasdaq: JMBA  ) and Lifeway Foods (Nasdaq: LWAY  ) are both pegged for double-digit earnings growth, while Jones Soda (Nasdaq: JSDA  ) has a 50% growth expectation hung on it.)

Buy the numbers -- sell the hype
So yes, there's basis for CLSA's assertion that Wall Street is selling Pepsi short. Expecting perpetual industry-lagging growth from one of the beverage industry's two strongest companies does seem a bit pessimistic, and perhaps overly so. Regardless, I still think the analysts had it right when they pegged Pepsi as an underperformer, and I do not agree with their decision to "not pass go, not collect $200," and go directly to outperform on the stock. Here's why:

Right now, Pepsi shares sell for 18.5 times earnings. At 7.8% growth, that's clearly too high a price to pay for the shares even with their generous 3% dividend. But even if we agree that 7.8% growth is too low and bump the estimates up a bit, I don't see how we get to anything better than fair valuation on the stock at today's prices. Increase growth by half, for example, and Pepsi would still be selling for about a 1.6 PEG ratio. Why, even if you jack up growth to the supposed industry "average," Pepsi would still be "PEG'ged at 1.2." (And don't even get me started on how Pepsi's free cash flow lags reported net income, and what that would do to the valuation.)

Foolish takeaway
When you get right down to it, Pepsi remains that classic case of a "great company" that's simply selling at too high a price. CLSA may think the stock can still outperform, despite this handicap. As for me, I'll follow Warren Buffett's advice and wait for at least a "good" price before buying in.

Fool contributor Rich Smith does not own shares of (or short) any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 491 out of more than 170,000 members. The Motley Fool has a disclosure policy.

Rich's reservations notwithstanding, The Motley Fool owns shares of PepsiCo and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Coca-Cola, PepsiCo, and Hansen Natural. They have recommended creating a diagonal call position in PepsiCo. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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