Dueling Fools
Cola Wars
April 21, 1999

Pepsi Bull's Rebuttal
by Warren Gump ([email protected])

Matt did a great job of explaining why Coke has done so well over the past century. Despite the current turmoil being experienced by the company, resulting in 1999 earnings expectations equaling those from two years ago in 1997, I expect that Coke will continue to do well in the future. Similarly, I expect PepsiCo -- and Frito-Lay in particular -- to do equally as well. As I mentioned in my opening arguments, both Coke and PepsiCo are expected to post earnings growth of about 15% in the future. When evaluating two excellent companies with similar growth prospects, the crux of my investing decision is based on valuation. Here, PepsiCo easily takes the advantage.

Let's talk in terms of price/earnings ratios, where Coke is trading at 46x 1999 earnings estimates and Pepsi is trading for less than 30x 1999 estimates. Looking at those numbers may be somewhat nebulous. What do they actually mean? Let's assume that earnings is a good proxy for cash flow. Assuming an investor's objective is to earn 12% annually from an investment (only slightly better than the long-term average for the stock market), Coke will have to increase earnings 15% per year for the next 10 years. After that, it will have to increase earnings 8.5% annually every year forever to justify the current price.

The current stock price for PepsiCo incorporates less aggressive assumptions. It discounts earnings growth of 13% per year for the next 10 years, followed by 7.0% annual growth in perpetuity. I feel more comfortable with these more conservative hurdles to jump. Why? All companies run into trouble, as Coke's recent lackluster earnings performance demonstrates. If someone completed a discount earnings model on Coke two years ago making the same assumptions I just made, Coke would be in trouble. With two years of flat earnings, the company would have to revert to earnings growth of over 19% over the next eight years to make up for the two years of sub-par performance. Now that does sound somewhat ambitious!

While I don't expect Pepsi to have any significant missteps in the years ahead, I like the margin of safety created by its current valuation. The company doesn't need to meet the 15% earnings projected by analysts -- it only needs to post 13% growth. If PepsiCo does meet analyst projections over the next few years, the stock should be worth about 15% more than the current price (and that still includes the assumption of only 7% growth after the 10th year)! Coke, on the other hand, doesn't have any flexibility. If the company sees global volume growth continue to slow down, the company will find its value fall below the current price in my model. Considering that earnings and volume growth warnings from Coke have become fairly regular events over the past few quarters, I don't like those odds.

Before closing, I do need to comment briefly on Matt's arguments. Many consumers outside of the U.S. find $1 for a 20-oz. soda to be quite expensive. Coke has seen its volume hurt by severe upheavals in the Brazilian and Russian economies. To combat these problems, Coke recently decided to reduce its prices in those countries. While a smart move from a longer-term perspective, this action shows that soda prices cannot be raised indiscriminately, which is an unfortunate reality for both Coke and Pepsi. Even in North America, the two companies have engaged in constant price wars, which have reduced profitability.

To call Pepsi a "mediocre" business is interesting. While Matt may not be impressed with a division that generated $10.7 billion in sales and produced $1.2 billion in ongoing operating earnings last year, I am. Earnings growth for the division has been lackluster over the past five years (although it was actually down only 2% excluding one-time charges), but the company was addressing significant problems within its bottling network. Now that those problems have been resolved and the spinoff of the Pepsi Bottling Group completed, Pepsi is well positioned to again grow its operating earnings in the years ahead.

More importantly, don't forget that Pepsi is actually the minority business of PepsiCo. Fully 63% of the company's profits came from Frito-Lay, which saw operating earnings jump 32% over the past five years. Based on the strength of that division, the opportunities for Pepsi to continue to grow and throw off cash, and the valuation disparity between Coke and PepsiCo, my money is going to continue drifting into PepsiCo stock.

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