Will Pepsi Stay a Refreshing Investment?

Source: http://www.flickr.com/photos/mmarshall-photography/

Source: http://www.flickr.com/photos/mmarshall-photography/

PepsiCo (PEP) has been one of the better performing large-cap stocks year to date. So far the shares are up over 6 percent whereas the S&P 500 is up just 4 percent and Pepsi’s main competitor—Coca Cola—is actually down slightly for the year. PepsiCo reported an excellent first quarter—while revenues and gross profits were up only marginally, competitor Coke’s revenues and gross profits fell. Furthermore due to cost-cutting the company managed to grow its net income by over 10 percent, and its EPS by nearly 15 percent.

Despite this strong performance the company still trades with a price to earnings multiple of 20, which is below that of the S&P 500 and competitor Coke, both of which have P/E ratios of about 22. Pepsi also pays a healthy 3 percent dividend.

Pepsi shares are performing so well for a variety of reasons. The first is that investors have been flocking towards food stocks, and while Pepsi is best known for its soft drink division it has a large packaged food business: It owns brands such as Quaker and Frito Lay. There has been a lot of interest in packaged food companies because of the M&A activity we are seeing with Hillshire Brands (HSH). People often don’t realize that there is a lot of innovation and technology that goes into food production, as these companies need the expertise to produce large quantities of food efficiently. Being such a large company PepsiCo is not a take-over target, but the market is coming to realize the value of these companies’ technologies. This is a reason why the company’s shares are outperforming Coke’s, keeping in mind that Coke is exclusively a beverage business.

The second is that Pepsi has international exposure and, in particular, exposure to emerging markets and the growth that these countries are experiencing. The company has a large Chinese business, and while investors may not want to hear it right now, it has a large, growing Russian business, having acquired Wimm-Bill-Dann—a Russian dairy product producer—in 2011. As people in emerging markets become more affluent they want to consume things that Americans and other Westerners consume, and this includes Pepsi products.

The third is successful cost-cutting measures. An expense can only be cut once, so this doesn’t go far in helping the long-term investment thesis. But cuts today mean that the company has more cash-flow with which to invest in its growing businesses. In the first quarter of this year, the company reported sales of $12.6 billion, which is the same number the company reported during the first quarter of last year. But the company’s cost of revenue fell from $5.8 billion to $5.7 billion, and its total operating expense declined from $10.9 billion to $10.8 billion. That $100 million may not seem like a lot for a company with a $133 billion valuation, but again this money can be used to invest and produce growing returns for years to come.

Given these points, PepsiCo seems to be a compelling investment. It is well-managed, growing, and in favor with investors. Right now, with the stock trading at $88/share it is essentially at an all-time high, so prudent investors should wait for a pullback. Furthermore, in the past year PepsiCo shares have had trouble holding the $86/share level. So I wouldn’t be surprised if there was a correction to the low-$80s. Right now there is technical support around $82 – $83/share, and I suspect that this would be a good level to pick up some PepsiCo shares for the long term.

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

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