Drip
Portfolio Report
Tuesday, January 13, 1998
by Randy Befumo
([email protected])
ALEXANDRIA, VA (Jan. 13, 1998) -- Our second finalist in the Great Branded Food Company round-up is PepsiCo (NYSE: PEP). Unfortunately, before we can go into the analysis, there is another issue that must be settled. This is an issue that in a way is almost as emotional and prone to irrationality as the subject of investing in tobacco stocks. The question, simply put, is why buy PepsiCo when you can purchase Coca-Cola (NYSE: KO)? Even a total Fool could see that Coca-Cola's return in this decade has outdistanced PepsiCo by a wide margin. Why not invest in a winner instead of putting money down on number two?
The hold that Coca-Cola has on the imaginations of the crowd is staggering. Pepsi Cola is number two both domestically and internationally to wunderkind Coca-Cola, but in the battleground of public opinion and investor sentiment, you would think that PepsiCo did not even exist. Yes, Coca-Cola has been the victor with its impressive 18.2% earnings per share growth from 1991 to 1997. However, opinion and sentiment have not completely digested the degree to which this managed earnings growth has been produced by purchasing bottling operations and later selling those same operations to Coca-Cola-dominated bottling companies. These transactions, I must protest, are hardly at arm's length.
Not all looks very good on the Coca-Cola earnings front right now. Even as the earnings growth has been "managed" by this accounting shell game, one that would frankly be undetected by cursory looks at inventories, receivables or cash balances, actual revenue growth has slowed to only 4.7% over the past three years and earnings growth has begun to slow, as well. Should Coca-Cola make current consensus estimates of $1.70 EPS for fiscal 1998, the five year earnings growth rate will drop 2.5% to 15.7%. Still impressive, yes, but the rear-view mirror looks quite different than the terrain that we see ahead through the windshield.
Many of the numbers on which an investment in Coca-Cola hinges are not entirely accurate. For instance, to get the 17% five-year growth rate analysts are estimating over the 1996 to 2001 period, assuming current earnings estimates stick, the company will have to generate 47% annual EPS growth in 1999, 2000 and 2001 -- heady growth indeed. More likely, even if the company can regain its 17% growth rate in 1999, 2000 and 2001, earnings per share growth over the five year period will come in at 14%. Here I would argue strenuously that coming out of a period where the restaurant business has been discontinued and Pepsi Cola business has gotten as bad as it can get, PepsiCo has a shot at creating equal or greater earnings growth -- for a fraction of the price.
One of the little known truths acknowledged in today's frenzy of Coca-Cola love is the fact that for substantial periods of time in history, returns at ol' PepsiCo have bested those at Coca-Cola. This difference has not necessarily been large, but in an interesting little dance of ten-year periods the two have swapped leadership for what some watchers with access to the data suggest goes back more than 30 years. What is a fact is that relative performance between the two for the period begun 1982 and ended 1987 ended with PepsiCo having the higher total return -- 22.3% versus 21.6% for Coca-Cola. In fact, much of Coca-Cola's excess return over the ten-year period has come in the last few, a phenomenon some might argue has eaten up excess returns over the next many years.
To those who argue that somehow the business model transcends all and the valuation is not worth 1/100th of what the business quality is, I would suggest that they have not done the math. Obviously there is a certain price at which the future excess returns -- meaning returns above the market average -- are consumed. Had Coca-Cola traded at $66 five years ago, shares would have been flat for the last five years, of course. Obviously, there is a point at which valuation overcomes stock returns, much like there is a point at which gravity overcomes a ball hurled into space.
Some of you might scoff at the above example. Coca-Cola was not at $66 five years ago, it was only at $20 1/16. Yes, on a split-adjusted basis Coca-Cola was only at $20 1/6 in 1992. But what if it had traded at $66? What would the valuation have been then? Looking back at the shares outstanding and the sales for 1992, if Coca-Cola had traded at $66 it would have traded at 13.2 times sales. With the shares currently at 8.44 times sales, you might think there was still room for great returns had they been at the same level in 1992. Let's check it out. Had Coca-Cola traded at 8.44 times sales in 1992, the shares would have been at $42. Unfortunately for Coca-Cola fanatics, that return from then until now would have been a meager 9.5% per year, a rate that would have sadly under-performed the S&P 500 index, which has gained an annualized 20.2% over the past five years.
The reality is that much of the excess returns at Coca-Cola came because the company traded at only 4.0 times sales in 1992. Not terribly cheap on an absolute basis, but much cheaper than where it currently sits. When Warren Buffett purchased the majority of his stake in Coca-Cola in late 1988, the shares were at a more attractive 2.0 times sales. Let me repeat that for emphasis -- Coca-Cola traded at only 2.0 times sales in 1988 when the famed Buffett purchase occurred. Why is this so important? Because since 1988, Coca-Cola has returned 33.5%. Since 1992, Coca-Cola has returned 23.6%. Notice a pattern? As the valuation has climbed from the starting point, the returns have dropped. The excess returns in Coca-Cola were completely dependent on the starting valuation.
It was valuation combined with the intrinsic quality of the business as equal partners that have created the massive returns in Coca-Cola that investors will talk about for decades. Intrinsic business quality provided fuel for the ascent, but the trajectory would have been much shorter had the valuation started out high. Think of valuation like the weight of the rocket, and the intrinsic business quality and growth the fuel for the rocket. All things being equal, the lighter rocket will go farther on the same amount of fuel. What kind of fuel did Coca-Cola have? From 1992 to 1997, Coca-Cola increased profit margins by 7.5% to 21.9% while quickly repurchasing relatively cheap shares. You can see why the stock has been such an incredible performer. In fact, one of the few companies in more recent memory to display these three criteria -- low valuation, increased margins, systematic share repurchases -- is Dell Computer (Nasdaq: DELL), another huge performer.
While both Coca-Cola and Dell Computer might have had plenty of similarities on the balance sheet, the most powerful similarity, and the one that explains a good portion of the incredible returns, is that they both started from a low valuation. The cost-cutting and systematic share repurchases, added to this potential rocket, fueled the ascent. In retrospect, what seems like a reasonable valuation for the global franchise that was Coca-Cola in 1992 was in fact the principal reason why the stock has returned 23.6% over the past five years. With PepsiCo offering a lower valuation today, combined with PepsiCo's ability to raise margins through cost cutting and to repurchase relatively cheaper shares, it is hard to see how Coca-Cola is really the better way to buy into the very attractive economics of the beverage business. Thus, we answer the question, "Why consider PepsiCo and not Coca-Cola?" Now we are free to explore PepsiCo in more detail tomorrow.
Update on Intel (Nasdaq: INTC) purchase and earnings: We received our Intel statement on Monday showing that we purchased 1.3849 shares of the stock on January 2 with our $100, at $72.20 per share. This brings our total Intel balance to 7.4666 shares, at an average cost-basis of $79.65 per share. Intel announced earnings today after the market closed of $0.98 per share on record revenue of $6.5 billion. $0.90 per share was expected, so Intel topped published estimates by nearly 10%. The company attributed the strong quarter to sales of new versions of its Pentium chips. At the earliest opportunity we'll look at Intel's fourth quarter results in depth, as we did last quarter. Fool on!
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