Investment Analysis of the Beverage Industry

- Background and Industry

Pepsi is a leading food and beverage company with operations in 220 countries around the world. It was first established in 1956 by Don Kendall and Herma Lay. Since then, the company has grown into globally recognized brand generating over $67 Billion in revenue. The most notable brands from the firm are its Pepsi Cola, Gatorade, Doritos and Lays brands. It also distributes many poplar beverages such as Tropicana, Aquafina, and Brisk. The overall industry is very saturated and competitive. Healthy drink options are now becoming a much more prominent choice for consumers. As a result, organic growth for the company has been roughly in line with overall GDP growth. The company’s primarily competitors are Coca-Cola, Dr. Pepper Snapple, and Red Bull within the beverage market. Its primary competitors in the snack market are Mondelez, General Mills, and Proctor and Gamble. Each competitor has very strong market share, financial resources and business acumen. As Pepsi has a very strong brand, it doesn’t necessarily compete solely based on price. It instead invests heavily in the brand to help it stave off competition.

2- The Financial Leverage Ratios

Year

Debt to Asset

Debt to Equity

Interest Coverage

(Source: https://www.stock-analysis-on.net/NASDAQ/Company/PepsiCo-Inc/Ratios/Long-term-Debt-and-Solvency#Interest-Coverage)

To begin leverage and solvency ratios are critical to determining the long-term viability of the Pepsi franchise. As the company is very consistent, with stable operations the company support a much higher debt burden than many cyclical companies. Also, the company generates substantial free cash flow in which to service the debt over long periods time. In the currently low interest rate environment, Pepsi is also in an advantageous position to issues bonds are very favorable rates to finance operations with very high returns. Due to these elements, the overall financial leverage of Pepsi is favorable.

The firm finances roughly 60% of its assets through equity with the remainder being financed with debt. Roughly 40% of its $78Billion of assets are comprised of property, plant and equipment and goodwill. In March 2020, the company issued roughly $1.5B of international bonds maturing in 2025 paying 2.25%. The company through a press release intends to use the bond for general and administrative purposes, to build an R&D facility in Valhalla, New York, and to transition its delivery fleet into lower-carbon models. These bonds on an inflation adjusted basis are yielding less than 1%. This low yield indicates that investors believe that payment coupons and principle at maturity are highly likely. It also indicates that investors consider Pepsi as a very safe investment over the next 5 years. There appears to be very little risk with the issuance of the bonds primarily due to the economic reasons mentioned above. For one, the company has a very strong and entrenched market position. Its global operations provide revenue and profit diversification that is difficult for its competitors to match. It also has strong brands that generate stable cash flows through any market cycle. As a result, investors are willing to accept a much lower yield as they perceive the risk of default to be minimal. Risk is typically measure through duration and convexity. Here, duration risk measures a bonds sensitivity to interest rates changes. As the latest issuance is fix years, the duration is relatively short. However, a steep increase in interest rates will cause the bond price to decline. Likewise, a further lowering of interest rates will cause the bond to appreciate in value. Another risk associated with the Pepsi bonds is that of a permanent capital lose as a result of default. In this instance, the investor must make a judgement as to the likelihood of a severe deterioration of the operations of the business resulting in a default. There is no scientific of formulaic approach to this method as it depends on the individuals risk assessment. The investor must research the company, its industry, and operations to determine, if the business will default prior to the bonds maturing. Based on the reasons given above, this appears unlikely.

3- Collect and evaluate the data about bond performance of the assigned company. (15% of the project grade).

Bond Quotations

Ratings

Last Sale

Issuer Name

Symbol

Callable

Coupon

Maturity

Moody

S&P

Price

Current Yield

Pepsi Co Inc

PEP.LB

Yes

A1

A+

Pepsi Co Inc

PEP.LE

Yes

A1

A+

(Source: http://finra-markets.morningstar.com/BondCenter/Results.jsp)

To begin the yield to maturity is the yield a hypothetical investor would earn if they held the bond to maturity. Typically, a purchaser of a bond may buy it at a price above of below par. An investor purchases a bond below par if the stated coupon rate is lower than the prevailing market interest rate. This occurs because investors can easily obtain a higher coupon rate by purchasing another bond issuance. To entice investors to purchase the bond, the price must fall so the yield to maturity approximates the return an investor would receive by purchasing comparable bonds. The opposite occurs with purchases above par.

I personally would not purchase any Pepsi bond. As an investor, I typically wouldn’t purchase any bonds in this interest rate environment. A purchase of an investment grade practically ensures that you will have mediocre to below average investment returns. Interest rates are at 0% around the world. There is a possibility of negative interest rates, but I personally don’t believe it is likely given the pending economic recovering. A current yield of 2.2% is not attractive to an investor when the maturity is nearly 20 years. A purchaser of these bonds is equivalent to purchasing a stock at 50 times earnings with absolutely no ability to grow those earnings. This is compounded by the fact that the fed has a mandate of 2% inflation per year. On an inflation adjusted basis these bonds yield next to mothering for the investor. Finally, in the event that interest rates do go negative and the bonds appreciate further, they are callable. So, in this instance the bond investor will not participate in the upside. Here a bond investment in Pepsi Co. is unwarranted. I would rather purchase the stock which has a dividend yield or roughly 1.5% and participate in the overall earnings growth of the company. Even if the bonds were not callable, it would not change my overall investment decision due primarily to the paltry yield. In terms of financial ratios that support the purchase of a bond, there are many. The company has great ratios, but that is not as relevant as the risk return ratio. By purchase one of the above-mentioned bonds, the investor is guaranteeing below average returns for the next 20 years! The bond are selling above par and are only yielding 2.2% without adjusting for inflation. There is no question the company will have the ability to service the debt. There is no question regarding the economic merits of the business franchise. There are questions regarding the yield and its merits relative to alternative asset classes. Here a bond investment will simply not suffice.

With the above being said, a bond investment would be beneficial for some high net worth and institutional clients. These clients may not necessarily be interesting in high returns but instead preservation of capital. To preserve capital, I would recommend a Pepsi Co bond. Here the investor is not necessarily looking for appreciation but rather immediate income in a low interest rate environment. Although low, a 2.2% return does have some merit for institutions looking simply for income.

4- Collect and evaluate the data about stock performance of the assigned company for the last one year. (totally 35% of the project grade).

Pepsi

Year

Price to Earnings

Price to Book

EPS (Diluted)

DPS

Source: https://www.morningstar.com/stocks/xnas/pep/financials

Coca-Cola

Year

Price to Earnings

Price to Book

EPS

DPS

Source: https://www.morningstar.com/stocks/xnys/ko/financials

When comparing Pepsi to Coke, there is very little differentiation between the two. The both trade at a similar multiple to earnings. They both payout roughly 70% of their earnings in dividends. Pepsi trades at a higher P/B ration which may indicate that investors value the assets of the company somewhat higher than that of Coca-Cola. Other than this difference the market appears the value both companies as equal and rightfully so. Both have very similar business models and brands. Coke does not have the dominate snack brand that Pepsi does, but it compensates for this with a much mor vibrant marketing campaign. This results in it being the number 1 soft drink in the work, with a very strong brand and entrenched position.

As it relates to the common shareholders, they are receiving adequate return on their investment. Pepsi shareholders are receiving 79% of the company’s earnings in the form of dividends. The remainder is being invested to grow the business to grow earning per share. The company has a very strong ROE at roughly 40% for the year. It also has a strong ROIC at 13%. This is in stark contrast to the bonds we mentioned earlier which yield just 2.2%.

As it relates to the P/E ratio, the stock is fairly valued. The 5 year average of the P/E ratio is roughly 26, which the current ratio be 28. The higher ratio is attributable to a low interest rate environment which increases asset prices. Also, do to the low rate environment there are practically no alternatives in terms of yield that can be acquired. Securities that offer higher yield often come with much higher risk. As a result, I believe the shares are fairly valued and thus would recommend purchase.

As it relates to CAPM, the required rate of return on the stock is as follow

Rf + B(Risk Premium)

Beta Source: https://www.zacks.com/stock/chart/PEP/fundamental/beta

Beta is simply the covariance of the stock relative to an index such the S&P500. If a stock has a beta of 3, for every percentage point move upward/downward of the index, the stock will move 3 points upward/downward from the index.

10 Year Treasury Source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldYear&year=2020

Market Risk Premium- Given at 5.35%

Formula = 1.88%+(.57)(5.35%) = 4.9295%

Sustainable Growth Rate Formula = 51%*(1-79%)

Sustainable Growth Rate= 10.71%

Dividend Payout Ratio Source: https://www.morningstar.com/stocks/xnas/pep/financials

Gordon Growth Model Calculation: P = D/ (r-g)

Solution: Not applicable as the required rate of return is lower than the growth rate. The dividend discount model would be more appropriate here. Please see calculation below

Discount Rate

Year

Divided

Growth Rate

Discounted Cash Flow

Present Value of Dividends and TV

5- Develop a specific recommendation, with supporting rationale for your client

Based on the above-mentioned notes related to the market position I believe a long term investment in stocks is warranted. Based on the able model the stock appears to be fairly priced. The discount rate used is over 100% of the 10year treasury. The growth rate is roughly 20% below the sustainable growth rate. These conservative estimates lead me to believe that the stock has a decent upside relative to my assumptions.

6- Develop a specific recommendation, with supporting rationale for the COMPANY’S management

Based on the current financial strategy of the company, I would make no changes. Here the company is adequately capitalized from both asset and liquidity perspective. The company has a strong competitive position and a strong economic moat around its operations. As a result, I wouldn’t change any of the financial leverage ratios to optimize leverage. Shareholder wealth is being maximized based on the current operations.