Pepsi and Coca-Cola's 2010 North American bottling acquisitions

Pepsi or Coke

Forward Integration

During 2010, both Pepsi Cola and Coca-Cola completed the acquisition of their previously independent North American bottling affiliates. PepsiCo, Inc. (NYSE:PEP) acquired The Pepsi Bottling Group, Inc. (PBG) and PepsiAmericas, Inc. (PAS). These deals closed on February26, 2010. (Pepsi PRNewswire, 2010) Almost immediately, Coca-Cola (NYSE:KO) announced that it would acquire the North American operations of Coca-Cola Enterprises (NYSE:CCE) and sell to CCE its bottling operations in Norway and Sweden. The Coke deals closed in October 2010. (Kwon, 2011)

PepsiCo has trumpeted the benefits of the consolidation with its bottler, including substantial cost savings and improved speed to market for new products. Coca-Cola named all the same advantages, headlined by an expected $350 million in eventual synergies (following one-time costs of $425 million). Coca-Cola assumed $8.8 billion of CCE's debt along with $580 million of employee benefit obligations. Notably, the bottling business is a significantly lower-return operation: CCE's return on capital (ROC) was 11%, compared to 16% for Coca-Cola before the acquisition. The merger will realize cost synergies, which, as analysts have speculated, would allow Coca-Cola to pass along savings in the form of lower prices, all without compromising margins. However, analysts observe that the primary advantage in owning the North American bottling business boils down to flexibility for Coca-Cola -- both in product innovation and pricing. On the former, U.S. consumers are losing their taste for soda specifically, and packaged nonalcoholic beverages in general. With the North American supply chains fully under their own control, PepsiCo and Coca-Cola should both be able to adjust more quickly to shifting consumer preferences. The big question for investors is how long will it take to reap the benefits and which company will take better advantage of the opportunities? Warren Buffett, whose Berkshire Hathaway (NYSE: BRK-A; NYSE: BRK-B) holds Coca-Cola shares, gave the deal his nod of approval, while noting that "there's a lot of execution problems in doing anything like that." (Pienciak, 2010)

Comparative Financial Analysis

Current Ratio

The current ratio is a gauge of a company's ability to pay back its short-term liabilities (debt and accounts payable) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. (Investopedia, 2011) Both Pepsi and Coke had current ratios in the 1.1 range at the end of 2010. The ratio for both companies has deteriorated over the past two years, indicating pressures on the cash conversion process. No particular advantage for either company is apparent.

Payout Ratio

Payout Ratio is a calculation that depicts the percentage of earnings that are paid to stockholders in the form of common stock dividends. Coke has been reducing its payout from 61% in 2008 to 46% in 2010. Pepsi also has been cutting back its dividend payout from 51% of earnings in 2008 to 45% in 2010. Given the economic environment, it would not be surprising to see the payout for both companies decline even further over the next two-three years.

Investment Comparisons

The Profitability Ratios are definitely in favor of Coke, but the investors will be looking for evidence of sustainable growth in earnings going forward as a reason to add one of these consumer staples stocks to the portfolio.

PepsiCo Inc., which recently cut its profit forecast, has "buy" ratings from 13 analysts and continues to trade at a discount to soft drink leader Coca-Cola Co. Still, Coca-Cola is the large-cap name preferred by analysts. Coke trades at about 16 times expected earnings, while Pepsi, which has larger exposure to commodities through its food business, trades around 14 times. Esther Kwon, an analyst at S&P with a Strong Buy recommendation, says of Coca-Cola:

For 2011, we project that sales will rise over 25% from 2010's $35 billion, on a full year's results from North American operations of Coca-Cola Enterprises and, to a lesser extent, higher prices, international volume growth, and positive foreign exchange. In 2011, we expect operating profit to accelerate as cost-cutting initiatives and positive operating leverage outweigh an unfavorable geographic mix, with lower margin emerging markets recovering faster than developed ones. Our 12-month target of $73 is based on an analysis of historical and comparative peer P/E multiples. KO's forward P/E has ranged between 16X and over 40X over the past few years. Given a more challenging economic environment, we think a multiple in the lower half of that range is appropriate. (Kwon, 2011)

Carlos Laboy, an analyst at Credit Suisse, recently published the following recommendation with an Outperform rating:

Our $70 2011-year-end target price for KO is based on our 2012E proforma EPS estimate of $4.30 per share and implies a 16.3x multiple. There is still room buy KO at a relative low to food and household names which trade at a similar PE but offer less top-line growth and questions regarding the hypercompetitive environment in the case of slow growth in the U.S. food category. Few companies offer the prospect of double digit

EPS over the next three years and a serious acceleration of ROC from a trough, as Coke. KO, has not even restored its 15-20% premium relative to its bottlers. (Laboy, 2011)

Credit Suisse analysts Carlos Laboy and Emily Klingbell recently published an industry report with the subtitle "Divergent Philosophies Make Different Growth:"

Faced with weakening core U.S. beverage brands in 2009, PepsiCo bought the bottlers. Coke responded by also merging its improving U.S. marketing business with its broken U.S. bottler and Pepsi's task got tougher. It was easier for Coke to improve its bottler than for Pepsi to retool its marketing department and reverse some high profile weak brands. Now, the pressure of a soft consumer, higher commodity costs, stepped up investment and a more muscular core Coke portfolio, has led PEP to cut "guidance" by 38%. (Laboy & Klingbell)

These two analysts continue with the provocative assertion that "There is no U.S. beverage category problem, just a Pepsi problem."

PepsiCo puts heavy emphasis on more robust innovation of what the consumer will want next. Coke's view is different. It emphasizes innovation within its core brands more than the next product idea. PepsiCo dropped its earnings guidance range from 11-13% growth to 7-8% for 2011 and to "high single digit" longer term. We do not believe that this is an example of the game of "beat the estimates and then raise guidance." When management breaks with legacy guidance, sometimes they mean it. PepsiCo's model is higher risk than Coke's as it requires stepped up investments just as commodity costs, weak consumer trends and a stronger Coca-Cola are hammering at Pepsi's core brands. We believe Pepsi management is being honest with the Street and are reflecting the reality of their current competitive position. (Laboy & Klingbell, 2011)

Investment Recommendation

Based on superior margin controls, a more compelling product development strategy, dramatically higher revenue growth near-term (25% vs. 7-8%), better upside on entering new markets overseas, potential for greater multiple expansion, and additional operational benefits yet to be realized from the acquisition of Coca-Cola Enterprises, Coca-Cola appears to be the better investment alternative compared to PepsiCo. The potential for price appreciation over the next 12 months is in the 9-12% range. Risks to this view include the possibility of adverse foreign currency movements and unfavorable weather conditions along with possible execution risks.

PepsiCo and Coca-Cola Company

($Millions, except EPS)

Pepsi

Coke

2010

2009

2008

2010

2009

2008

Current Assets

17,569

12,571

10,806

21,579

17,551

12,176

Current Liabilities

15,892

8,756

8,787

18,508

13,721

12,988

Current Ratio

1.11

1.44

1.23

1.17

1.28

0.94

Net Income

6,338

5,979

5,142

11,859

6,824

5,807

Total Assets

68,153

39,848

35,994

72,921

48,671

40,519

Return on Assets

9%

15%

14%

16%

14%

14%

Shareholders' Equity

21,273

17,442

12,582

31,003

24,799

20,472

Return on Equity

30%

34%

41%

38%

28%

28%

Total Capital

41,787

24,842

20,190

46,948

30,458

24,130

Return on Capital

15%

24%

25%

25%

22%

24%

Total Liabilities

35,891

22,406

23,412

32,549

18,780

15,709

Debt Ratio

1.69

1.28

1.86

1.05

0.76

0.77

Net Sales

57,838

43,232

43,251

35,119

30,990

31,944

Net PPE

NA

12,671

11,663

NA

6,276

6,243

Fixed Asset Turnover

NA

3.41

3.71

NA

4.94

5.12

Dividends

1.85

1.77

1.65

1.62

1.64

1.52

Payout ratio

45%

47%

51%

46%

56%

61%

Price 2011/2/25

63.61

P/E

64.31

P/E

EPS 2009

3.77

16.9

2.93

21.9

EPS 2010

4.13

15.4

* 3.51

18.4

EPS 2011 (E)

4.50

14.1

3.85

16.7

* adj.