Tuesday's Top Upgrades (and Downgrades)

Analyst says to buy PepsiCo and Monster Beverage, but not Coca-Cola.

Jun 10, 2014 at 3:32PM

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our featured analyst opens up the fridge and pulls out a pair of buy ratings for PepsiCo (NYSE:PEP) and Monster Beverage (NASDAQ:MNST) -- but not for Coca-Cola (NYSE:KO). What's up with that?

Have a Pepsi and a smile?
On a down day for the market, Pepsi shares are enjoying a modest rise today in response to an initiation at "buy" from Jefferies. The investment banker highlighted "improvement in PEP's NA beverage business" as one factor that could lift the shares toward a new $102 price target. But what really gets the analyst excited is Pepsi's salty-snacks business, which Jefferies calls "the gem of the portfolio."

But is that reason enough to buy the stock?

At 20 times earnings, but projected earnings growth of only 7% annually over the next five years, Pepsi shares look fairly expensive at today's price of $88 and change. That's before you notice that with only $6.3 billion in trailing free cash flow, the company isn't even generating as much cash profit as the $6.9 billion it reported as its net income for the past year. Then factor the company's sizable debt load -- $22 billion net of cash on hand -- into the valuation.

Long story short, Jefferies looks at Pepsi and says that "better execution" at the company could create "plenty of room for upside" in 2014. Perhaps. But isn't that always the case? Looking at how things stand now, and how much profit Pepsi is actually producing absent the "better execution" that Jefferies hopes for, the stock simply looks too expensive to buy.

So let's turn to Jefferies' other soda-pop pick.

How scary is Monster Beverage's stock price?
In Monster Beverage we have a company in better financial fettle than Pepsi. Cash-rich where Pepsi is poor (with $750 million in cash, and no debt on its balance sheet), and generating more free cash flow than it reports as earnings (Monster's $391 million in trailing free cash flow exceeds reported income by more than 5%), Monster seems a higher-quality investment than Pepsi.

The problem here isn't the company's cash reserves, or its ability to generate more cash upon command. It's quite simply a too-high stock price.

Quoted on StreetInsider.com today, Jefferies argued that "MNST is clearly the best secular growth story in the LRB space." ("LRB" is industry-speak for "liquid refreshment beverage" -- stuff you can drink.) Most analysts who follow the stock agree that Monster is likely to grow earnings at 15% annually over the next five years, which is more than twice as much as Pepsi. But with a share price more than 32 times trailing earnings, it's pretty clear that this growth rate is already priced into the stock -- more than priced in, I would argue.

In fact, even if Jefferies is right, and Monster grows sales at the "high-teens" rate that the analyst expects, it's hard to see how a 32-times multiple to earnings on the stock can be defended. The company would probably have to deliver 20% or even 30% annualized sales growth in profits -- and maintain this pace for years on end -- to justify a 32 times multiple to earnings. This is a feat Monster has not managed over the past five years, in which earnings growth was a superb 18.5% -- but still shy of 20%.

Given that most companies' growth rates slow over time, I'm not holding out much hope for this upgrade paying off for investors.

A smile of sympathy from Coke
When you get right down to it, I don't see either of the two stocks that Jefferies likes as much more attractive than the big-name soda maker that it does not like: Coca-Cola.

Initiating coverage of Big Red this morning, Jefferies posited a $44 stock price for Coke a year from now. That's only about 7% more than Coke costs today. Unenthused by this prospect, the analyst assigned Coke a hold rating. Sad to say, Coke deserves it. Or worse.

Priced at 22 times earnings, but projected to grow these earnings at less than 7% annually over the next five years, Coke costs more, and is growing slower, than archrival Pepsi. Its 3% dividend yield is only equal to its rivals, meaning there's no "income" rationale for preferring Coke over Pepsi. And with about $19 billion in net debt on its books, even Coke's balance sheet doesn't look markedly better than Pepsi's.

When you get right down to it, I'm forced to agree with Jefferies' conclusion about the stock. To wit: "KO is a great company, although it seems less likely to us that it will return to being a great stock in the current environment."

Yep. That just about sums it up -- and not just for Coca-Cola, but for the other stocks on Jefferies' ratings list today as well.

Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends Coca-Cola, Monster Beverage, and PepsiCo. The Motley Fool owns shares of Monster Beverage and PepsiCo, and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola.


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