This Just In: Upgrades and Downgrades

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." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the worst …
Performance on the Nasdaq and the New York Stock Exchange was mixed this morning, but one stock is taking a definite turn greenward: PepsiCo (NYSE: PEP  ) . The snacks 'n' chips conglomerate imported an upgrade to "buy" from German banker Deutsche Securities this morning, and shares were up nearly 3% in response.

Prussians prefer Pepsi
According to Deutsche, Prussians prefer Pepsi to Coca-Cola (NYSE: KO  ) for several reasons. First and foremost, Deutsche just plain likes the price at this point: "PepsiCo remains a well-run company with solid defensive attributes (6% [free cash flow] yield, 3.5% dividend yield, net debt /EBITDA less than 1x). We believe share weakness (28% down M-T-D) has overshot earnings risk from global slowing and currency headwinds ..."

Also boosting the buy thesis, Deutsche sees Pepsi benefiting from "lower input costs next year" as commodities prices continue to slide. The recent collapse in corn prices may be doing no favors upstream at fertilizer makers Mosaic (NYSE: MOS  ) and PotashCorp (NYSE: POT  ) , as farmers struggle to pay for their products. But for buyers of corn (chips) and its byproducts (high fructose corn syrup) like Pepsi, it's manna from heaven.

Meanwhile, Deutsche argues that Pepsi has a better working relationship with bottlers like Pepsi Bottling Group (NYSE: PBG  ) than does Coke with its nephews -- such as Coca-Cola Enterprises (NYSE: CCE  ) and Coca-Cola FEMSA (NYSE: KOF  ) .

How exactly the relationship is "better," Deutsche does not make clear. But in a supply chain where each processor of products made by someone else is dependent on the prices that "someone else" pays for commodities bought from "someone else-else" -- well, you can see why trust is essential among mutually dependent suppliers. And in playground parlance, Deutsche says: "Pepsi and its bottlers appear to be playing much nicer together than Coke and Coca-Cola Enterprises at present."

And yet ...
Deutsche makes a lot of good points in upgrading Pepsi, and investors seem to be buying the logic -- and the shares -- today. Should you be buying, too?

I vote no, and for two reasons. First and foremost, Deutsche may be right on the reasoning, but wrong on the timing. Judging from its record on CAPS, this is often the case with Deutsche. According to our data, Deutsche is very often wrong on its predictions of what will and will not beat the market. About 56% of the time, its picks fail to work out, and your average Deutsche pick underperforms the market by about four percentage points.

And second, I think Pepsi is one such pick, destined to underperform the market. While I won't quibble with Deutsche's numbers, I disagree with its conclusion that Pepsi is cheap enough at 15 times earnings, when profits are only expected to grow at less than 10% per year over the next five years.

When you further consider that Pepsi generates only about two dollars in free cash flow for every three that it reports as "net income," the resulting price-to-free cash flow ratio exceeds 21. For a 10% grower, that seems awfully expensive to me.

Foolish takeaway
Just because Pepsi is "well-run" doesn't make its stock cheap enough to buy. For that matter, archrival Coke is selling for similar multiples and fails to attract me. If you absolutely, positively must buy a piece of the soda industry, consider looking even farther downstream to something less obvious, like Coca-Cola FEMSA.

It's selling for 11 times trailing free cash flow and expected to grow faster than 13% per year over the long term. In an industry where real bargains are as rare as a diet soda that tastes as good as the original, FEMSA looks to me like the real thing.

Fool contributor Rich Smith does not own shares of any companies named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 687 out of more than 120,000 members. Coca-Cola is a Motley Fool Inside Value pick. The Fool has a disclosure policy.


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  • Report this Comment On October 31, 2008, at 11:24 AM, BeverageAnalyst wrote:

    Coke is screwing up as they are picking fights with all their bottler including their biggest bottler. They slap CCE with 8% Concentrate Price increase and it is clearly undermine CCE's other shareholders. No wonder CCE would have to resort to ripping off its customers just to make some profit, as Coke has been milking CCE out of money. Coke as a shareholder has continuously ripping CCE by making a huge cut upfront through the sale of Concentrate before CCE even make a penny. Anybody holding CCE or any Coke affiliated bottlers shares should be advised to dump their shares as they are being milked by Coke. Coke perceive these bottlers as their milking cow and Coke would not care less about the other shareholders of these bottlers.

    Coke's Three Pillars of Consumer Marketing, Customer and Commercial Leadership, and Franchise Leadership as described in its Manifesto of Growth, which include their slogan of Winning with Our Bottlers with the 5 P (Profit, People, Portfolio, Partners, and Planet), is really an empty rhetoric. They are picking up fights with their bottlers across the world. It almost certain that by January 2010 Coke would terminate F&N Group, which is their bottler in Malaysia. And by October 2008, their only independent bottler in indonesia is switching to PepsiCo. Their bottler in Thailand also is considering breaking up with Coke. The bottlers just could not stand the way Coke treat them and this would present a big opportunity for PepsiCo to gain significant market share from Coke in Malaysia and Indonesia, as definitely Coke would not be able to maintain its market presence without its local bottlers who have tens of years worth of infrastructure, experience, and capabilities.

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