For years, number-two soda maker PepsiCo (NYSE: PEP) has lived in Coca-Cola's (NYSE: KO) shadow. Perhaps it's the perceived golden touch in Warren Buffett's 8% stake in The Coca-Cola Company. Perhaps it's the stories of common folk who became millionaires today by holding just one share of Coca-Cola stock acquired in 1919 at the company's initial public offering. Perhaps it's simply because for years Coca-Cola executed a smarter business strategy by selling just the high-margin cola syrup, in contrast to PepsiCo who floundered in the low-margin and capital-intensive restaurant business.
Whatever the reasons behind Coca-Cola's legacy of superiority over PepsiCo, the fact is that today these two businesses look remarkably similar, with one key exception -- price. Coca-Cola carries a market capitalization of $111 billion versus PepsiCo's $64 billion. There's a myth to dispel here.
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During 2000, these two companies turned in a remarkably similar set of financial results. Coca-Cola generated $20.5 billion in sales; PepsiCo did $20.4 billion in sales. Coca-Cola earned $2.2 billion in net profits; PepsiCo also earned $2.2 billion in net profits. Coca-Cola generated free cash flow of $2.9 billion; PepsiCo cranked out $2.9 billion in free cash flow, too. Is this uncanny or what?! Based on their 2000 financial results, here's how the two companies stack up on our quantitative Rule Maker criteria:
Rule Maker Criteria Coca-Cola PepsiCo Sales Growth 2.8% 12.0% Gross Margin 69.6% 61.1% Net Margin 10.6% 10.7% Cash King Margin 14.2% 14.2% Cash-to-Debt 0.33 0.55 Foolish Flow Ratio 1.05 0.85
For those of you who've read our Rule Maker Criteria, you can quickly see that PepsiCo is either tied or has the edge over Coke in every category except for gross margins. PepsiCo is growing sales four times faster than Coke; PepsiCo has a better ratio of cash versus debt; and, PepsiCo has superior working capital management as indicated by a lower Flow Ratio. There's no doubt which company is running the better operation here.
If you were part of our just-completed Rule Maker 2001 seminar, you know that PepsiCo ranked quite well in our Rule Maker Top 25 Special Report (available for purchase on April 11). You also know that Coca-Cola was notably absent from our list. To quote a paragraph from our analysis on PepsiCo:
"Though Pepsi may be number two in soft drinks, the company is the clear leader in salty snack products. Indeed, Frito-Lay, PepsiCo's snack-food division, owns 58% of the market for salty snacks in the United States. Worldwide, Frito-Lay holds a 40% market share and is more than seven times the size of its next-largest competitor."
So on one side we have Coca-Cola composed of the world's leading beverage business, and on the other side we have PepsiCo with a strong number-two global beverage business and the world's leading salty-snack business as well. Again, these companies have almost identical profit margins, yet look at the valuation disparity:
Price and Valuation Coca-Cola PepsiCo Share Price $44.52 $43.25 Market Cap $111.1B $64.0B 2000 Sales $20.5B $20.4B 2000 Free Cash Flow $2.9B $2.9B Price-to-FCF 38.40 22.10
Coca-Cola has a market cap almost twice as high as Pepsi's. Similarly, Coca-Cola sells at a price-to-free cash flow ratio of almost twice Pepsi's. By way of comparison, the S&P 500 is currently selling for a price-to-free cash flow ratio of 26.9 according to Barra.
Part of the disparity in the above analysis is due to the fact that Coca-Cola's reported profits in 2000 were held down by a number of unusual restructuring charges, inventory write-offs, and a litigation settlement. Looking at forward earnings estimates adds some clarity to the situation. The First Call consensus earnings per share estimate for Coke in 2001 is $1.63. That means Coca-Cola is trading for 27.3x 2001 earnings. This estimate implies a return to Coca-Cola's traditional higher net margin level of around 18%. Pepsi is selling for 26.4x its 2001 EPS estimate of $1.64.
The forward-earnings valuation analysis is only meaningful if these companies deliver on their growth expectations. Over-promising and under-delivering has been the way of Coca-Cola for the past three years. That said, new CEO Doug Daft has been shaking things up internally in order to right the ship. On Thursday, Coca-Cola announced that its first-quarter unit case volume (the company's standard measure of beverage shipments) would grow 4-5%. The company is counting on accelerating growth in the remaining quarters of this year in order to meet its full-year 2001 target of 6-7% unit case volume growth. One can't help but be jaded by the fact that Coke's sales have grown only 4.3% annually since 1998.
In contrast, the rejuvenated PepsiCo -- now free of its bottling and restaurant businesses -- has grown sales 18.0% annually since 1998. PepsiCo continues to expect "double-digit" earnings growth for 2001, with the recent Quaker Oats acquisition being immediately accretive to earnings. Most importantly, the Quaker acquisition gives PepsiCo the Gatorade brand, which owns 80% of the sports drink market -- a market which Coca-Cola has been notably unable to penetrate with its Powerade brand.
The Quaker acquisition will also allow PepsiCo to better distribute its Tropicana products through Gatorade's more-extensive distribution network. Back in December, the Drip Portfolio, which owns PepsiCo, wrote in detail about the Quaker acquisition and the benefits it brings to the table.
By all appearances, PepsiCo bests Coca-Cola with a more diversified business, better growth potential, and a more attractive valuation. In the weeks ahead, we'll take a closer look at PepsiCo's business and its future potential. Also, next week's Dueling Fools just so happens to pair up Coca-Cola versus Pepsi -- be on the lookout for that feature on Wednesday.
Have a great weekend!
Matt Richey is a co-manager of the Rule Maker Portfolio and doesn't own shares of either Coca-Cola or PepsiCo. Recently, Matt drank a Pepsi when he found it was the only available beverage option in his refrigerator. Not bad, though you're more likely to see Matt sipping Diet Cokes throughout the day. The Motley Fool is investors writing for investors.
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