Is The Market Undervaluing PepsiCo Stock vs. Coca-Cola?

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PEP: PepsiCo logo
PEP
PepsiCo

Why is the market letting you buy $50 of PepsiCo’s revenues for a price of roughly $144 per share of PepsiCo stock (NASDAQ: PEP) – implying a price-to-sales (P/S) multiple of close to 3x – while for its close rival Coca-Cola (NYSE: KO), you need to shell out almost double, 6x? Coca-Cola’s 6x multiple is based on its $37.3 billion in 2019 sales ($8.80 in sales on a per-share basis) and a stock price of $53. The contrast is not any better if you use the sales figure from the last four quarters instead of the last fiscal – using numbers of the last four quarters, PepsiCo’s P/S multiple is marginally lower than 3x, compared to Coca-Cola’s 6.8x. More importantly, the mismatch isn’t due to any drop in PepsiCo’s stock price, as its P/S multiple would still be 3x (as opposed to 7x for Coca-Cola) even if its shares were trading at the all time high of $147 seen a couple of months back.

Here’s what’s going on. The price-to-sales, or P/S, multiple for a company is higher when the sales growth is higher, and it has a demonstrated ability to translate those sales to profits, with an expectation to do so consistently.

Sure, PEP’s revenue growth is much higher (2.3% average annual revenue growth over the last 3 years vs about -3.4% for KO). However, PEP’s returns are low. Over the last 4 quarters, PEP’s net income margin (net profits as a percent of revenue) stood at 10%, significantly lower than KO’s 25% margins. Using another measure of return, PEP’s 15% free cash flow margin (net profits adjusted for non-cash expenses as a percentage of revenue), is also lower compared to 23% for KO. Understandably, the market sees more risk in PEP’s ability to translate its revenues to profits and cash flow, compared to KO’s track record.

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Our dashboard PepsiCo vs. The Coca-Cola Company: Is PEP Stock Appropriately Valued Given Its significantly lower P/S Multiple Compared to KO?  details the fuller picture based on Revenue Growth, Returns (ability to generate profits from growth), and Risk (sustainability of profits), parts of which are summarized below.

1. Revenue Growth

  • PEP’s growth has been stronger than KO’s over the last three years, with PepsiCo revenues expanding at an average rate of 2.3% per year from $62.8 billion in 2016 to $67.2 billion in 2019, versus Coca-Cola revenues which declined 3.4% from $41.9 billion to $37.3 billion.
  • PepsiCo’s growth is driven by strong performance in the Frito-Lay segment along with acquisitions like SodaStream. Coca-Cola, on the other hand, has been refranchising its bottling plants (franchise owners record revenues from bottling plants, while Coca-Cola earns fees from these franchisees), which is a high-revenue but low-margin business.
  • With the food and beverage industry being affected in early 2020 due to the coronavirus pandemic, investors are preferring companies with diversified operations like PepsiCo, which offers beverages as well as snacks, in comparison to Coca-Cola which only deals in beverages. This explains the rise in PEP’s P/S multiple over recent months. Despite this, PEP’s market capitalization still stands at a little less than $200 billion, compared to KO’s market cap of about $225 billion.

2. Returns (Profits)

  • Coming to Returns, Coca-Cola’s strategy of refranchising its low-margin bottling plants has helped it register much better profit growth compared to PepsiCo over recent years.
  • KO’s Free Cash Flow as a percentage of revenue over the last three years stood at about 23%, much more than PEP’s 15% over the same period.
  • Average total shareholder return for PEP was also marginally lower than KO over the last three years.
  • Only when it came to return on invested capital, PEP fared better than KO.

However, PEP’s metrics should improve as it will reap the benefits of recent acquisitions over the next few quarters. Also, as Coca-Cola’s y-o-y gains from refranchising diminish, the gap between the margins of these two companies will narrow.

3. Risk

  • PEP’s Debt-to-Equity ratio stood at 17x in 2019 while KO’s ratio was lower at 14x. However, PEP has been far more successful at deleveraging over recent years as its Debt-to-Equity ratio has declined from 27x in 2016 to 17x in 2019. In comparison, KO’s ratio went down from 21x to 14x.
  • Additionally, PEP has adequate liquidity to manage its operations and service its debt. Though its cash position is slightly lower than KO ($9 billion vs $11 billion), PEP’s cash-to-assets ratio is significantly higher at 0.40x, compared to KO’s 0.11x.

 

The net of it all

In summary, though PEP’s sales growth is higher, KO’s higher price-to-sales multiple compared to PEP may be a reflection of KO’s better track record of translating its sales to profits. However, we believe that this benefit was due to the refranchising efforts over recent years and might not continue to last for long. PepsiCo will eventually narrow its profitability gap with Coca-Cola. In fact, much more successful deleveraging over recent years and a strong liquidity position, along with better product diversification, is likely to lead to better valuation for PepsiCo over the coming quarters, which is expected to be reflected in a higher P/S multiple compared to its current levels.  As per PepsiCo’s valuation by Trefis, we have a price estimate of $150 per share, higher than its current market price.

What if you’re looking for a more balanced portfolio instead? Here’s a high quality portfolio to beat the market, with over 100% return since 2016, versus 55% for the S&P 500. Comprised of companies with strong revenue growth, healthy profits, lots of cash, and low risk, it has outperformed the broader market year after year, consistently.

 

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