Company investment strategies and decision-making

Investing in a Company

The Coca-Cola Company and PepsiCo are the two major competitors in the global non-alcoholic beverage market. The two firms both have similar origins at soda fountains in the U.S. south, Atlanta for Coke and North Carolina for Pepsi. In the post-WWII era, both companies have expanded their operations around the world. Today, they remain locked in intense competition. The older and larger of the two, Coke has always held the higher market share in soft drinks in the key U.S. market. However, the two firms engage in competition on a number of fronts. Pepsi is the more diversified of the two companies. It operates 18 brands that do over $1 billion in business worldwide (2007 PepsiCo Annual Report). The three main business units of PepsiCo are Americas Foods (PAF), Americas Beverages (PAB) and International (PI). Coca-Cola, conversely, remains focused on the beverage business almost exclusively. Their organizational structure therefore remains broken down strictly on geographical lines.

Financials: Coca-Cola Company

In order to determine the quality of either an equity or a debt investment, we must first analyze the financial situation of the company. There are three main types of financial analysis. The first is with respect to liquidity, the second is profitability, and the third is with respect to managerial efficiency. For equity investments, we must also consider the price of the equity at present. To evaluate the value of a debt investment, we must analyze not only the capital structure, but the specific nature of the outstanding debts.

In terms of liquidity, Coca-Cola Company is a liquid operation. However, most of its key liquidity ratios have declined over the past year. The current ratio has dropped from 0.949 in 2006 to 0.915 in 2007. The quick ratio declined from 0.582 to 0.576. Times interest earned - Coke's strongest liquidity metric - declined from 29.9 times to 17.26 times. This was the result of a significant increase in interest expense. The only metric that improved was the cash ratio, which went up from 0.274 to 0.309. All told, however, Coke remains a liquid company with strong ratios on all fronts.

Coca-Cola saw a decline in profitability in 2007. Operating revenues increased 20%, but cost of goods sold increased 27%. This resulted in a decrease in operating margin from 66.1% to 63.9%. Operating margin also declined, from 26.2% to 25.1%. As a result, the net margin for Coca-Cola decreased from 21.1% in 2006 to 20.7% in 2007. That all three margins decreased in 2007 is indicative that Coca-Cola had trouble controlling costs during the year. The company did, however, grow the net income and earnings per share significantly. EPS grew 20%, the same as net revenues. It should be noted that the firm's growth rate in 2007 was much higher than in 2006, when growth was just 4% on the top and bottom lines. In general, revenue growth for consumer products was down around the world. Only the bottling investments showed an improvement in operating revenue growth rate in 2007 compared with 2006.

In terms of managerial efficiency, Coke's return on assets declined in 2007. In 2006, ROA was 16.9%; while in 2007 it was 13.8%. Similarly, the return on equity declined from 30.0% to 27.5%.

Overall, the company's financial performance is strong, but faced decline in 2007. While earnings per share were strong, most other key metrics deteriorated. This has corresponded with a significant increase in leverage for the company. The debt ratio has increased from 43.5% in 2006 to 49.7% in 2007. This is a significant increase in debt for such a large, mature company. Long-term debt more than doubled in the past year, and loans & notes payable increased nearly 90%. The increase in debtload is cause for some concern, but overall Coca-Cola Company still has strong fundamentals.

Financials: PepsiCo

PepsiCo is a liquid company. The firm's liquidity metrics are generally strong and are superior to those of Coca-Cola Corporation. The current ratio was 1.31 in 2007, compared with 1.33 in 2006. The quick ratio was 0.88, compared to 0.95. The cash ratio was 0.32 compared to 0.41 in 2006. Times interest earned improved in 2007 from 34.1 to 29.2. There is no universal direction change with respect to these metrics. The slight decline in the cash ratio is not considered to be of significance in light of the generally solid current and quick ratios. The improvement in times interest earned comes in the face of a significant increase in long-term debt at PepsiCo. The company's debt ratio increased to 50.2% from 48.6%. This was largely a consequence of a nearly 65% increase in long-term debt.

Pepsi's operating margin is 18.1%, down slightly from 18.5% in 2006 and 18.37% in 2005. The company's ability to maintain margin stability illustrates strong managerial control over the company's cost structure. This is because Pepsi has little control over costs in the ultra-competitive segments in which they operate. They also have little control over factor costs such as high fructose corn syrup, the cost of which is based on commodity costs. The company's net margin declined slightly in 2007 to 14.3% from 16.05% in 2006, but up from 12.5% in 2005. The company improved its earning per share slightly in 2007. Overall, profitability has been steady at Pepsi. The company has been able to grow sales without adding extra costs to their operations.

In terms of managerial efficiency, Pepsi's return on assets decreased to 16.3% from 18.8%. The return on equity declined to 32.3% from 36.5%. The decline in return on equity relates to the upward shift in leverage at Pepsi. The decline in the return on assets is more disappointing, as it confirms that managerial efficiency has declined slightly at PepsiCo in the past year. However, the company remains more efficient that Coca-Cola Corporation.

As an Equity Investment

At the end of 2007, Coke was trading at 61.37, for a P/E of 23.69 (MSN Moneycentral, 2009). PepsiCo was trading at 75.90, for a P/E of 21.81. Pepsi's quarterly dividend had risen to 75 cents per share; Coke's was now at 68 cents per share. Thus, Pepsi's dividend yield was 3.9% while Coke's dividend yield was 4.4%.

Therefore, PepsiCo is a more prudent equity investment. The company's financials are stronger in most respects. Pepsi has better product diversification. Pepsi has stronger cost controls. The dividend yield is lower, but the P/E is lower and Pepsi's cost controls give them greater opportunity to enjoy sustained, controlled earnings growth. In terms of broad strategy, Pepsi has been more aggressive moving into new beverage segments and with new product introductions. This has given Pepsi the opportunity to win market share in new segments more rapidly than Coke. However, in terms of core products, Pepsi remains the #2 and has struggled to make gains. Their differentiation is a natural response to the situation they face with their flagship product. It is believed that their strategic goals, cost controls and higher efficiency will allow them differential growth that is sufficient to make up the difference in dividend yield between the two companies.

As a Debt Investment