Why You Should Get a Taste of PepsiCo Stock

Source: Thinkstock

Source: Thinkstock

PepsiCo (NYSE:PEP) has been a very strong performer thus far in 2014 with shares rising 10 percent. This price action is especially promising considering that the company’s main competitor—Coca Cola (NYSE:KO)—has actually fallen slightly for the year. Despite this, PepsiCo remains cheaper on a price to earnings basis despite its relatively strong earnings growth.

PepsiCo has been successful because it has a large mix of popular products besides its namesake (e.g. Frito Lay and Quaker). PepsiCo has also generated a substantial return on equity—29 percent–and this has been about 10 percent stronger than Coca Cola’s 26 percent return on equity.

But while I think that Pepsi is the better of the two investments, I would consider taking profits. There are a couple of reasons for this. First, while PepsiCo is cheaper than Coca Cola, it is not cheap at 20.7 times earnings. The company’s earnings actually fell in the second quarter by about 1 percent, although on a per-share basis they rose, thanks to share repurchases. Now this profit decline isn’t so bad when you consider that the company was hurt in its foreign businesses by the strong dollar and that its second quarter 2013 profits were lifted by the one-time sale of assets in Vietnam.

Still, with a company as large and diversified as PepsiCo these currency fluctuations and one-time items are regular occurrences. If we split the difference between the company’s actual 1 percent decline in earnings and its 6 percent gain in “normalized” earnings, PepsiCo grew its earnings by about 2.5 percent. For a company trading at 20.7 times earnings this growth is insufficient.

Second, PepsiCo is showing signs of plateauing earnings and decelerating sales growth. This has been going on for a couple of years now, although investors have bid up the shares as stocks have become more favorable assets to own. But in fact the company’s annual sales peaked in 2011. However, thanks to cost cutting measures, the company was able to exceed its 2011 profits in 2013 by about 5 percent. It should be able to do the same in 2014, but it is going to be difficult for PepsiCo to grow earnings in the long term on cost cutting measures alone. Since the company’s 20.7 earnings multiple is pricing in growth I think that the risk that PepsiCo has trouble growing in the future is not priced in, and investors should be concerned.

Finally, PepsiCo has been a beneficiary of falling commodity prices in the past few months, but this wasn’t really reflected in the company’s second quarter earnings, which again fell by about 1 percent. Since commodities such as corn and sugar are central input ingredients for many of PepsiCo’s products, I find this somewhat surprising. On the one hand, it reflects management’s ability to hedge the company’s commodity risk. But on the other hand it leaves open the possibility that PepsiCo’s operating margins are vulnerable in the event of rising commodity prices. While this can be offset by price increases, this is generally a risky tactic.

Given these points, and given PepsiCo’s strong performance, I think now is a great time for investors to take profits. I wouldn’t short the stock, as low interest rates will place a bid under these stable companies that function as bond alternatives. However, given that the Federal Reserve is on the verge of tapering, and given the downside risk in bond prices, I think there is significant risk in PepsiCo shares that isn’t being priced in. This sentiment is bolstered by the fact that not one analyst has a “sell” rating on the stock: this one-sided optimism is disconcerting.

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Disclosure: Ben Kramer-Miller no position in PepsiCo or in any of the stocks mentioned in this article.

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