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A Rare Wide-Moat Opportunity

Jeremy Glaser

Jeremy Glaser: For, I'm Jeremy Glaser. Recently we've seen an unusual divergence between the valuations of Coke and PepsiCo. I am here today with Senior Analyst, Phil Gorham, to take a look at why this might be happening. Phil, thanks for joining me today.

Philip Gorham: Hi, Jeremy.

Glaser: So let's take a look at some recent news that Pepsi has had first. They announced that they are buying a Russian-based fruit juice and dairy company. Do you think that this acquisition had anything to do with the valuation difference we are seeing between the two beverage giants?

Gorham: I don't think so. I think this is more of a long-term play. Perhaps they are trying to grow the nutritional part of top line and this is part of that. They have said that they are going to try and grow $30 billion business in health and wellness, snacks and drinks, and I think this takes it a step closer to achieving that.

Glaser: So you think that this deal makes sense for them. What about from a valuation standpoint?

Gorham: It's rich. It isn't a cheap deal. They have paid $3.8 billion for that stake, which is about 19 times EBITDA, 1.6 times sales. So it's quite expensive. They are paying to get the growth that this deal provides, but it's not – it isn't a crazy valuation.

Glaser: Does it change your opinion on the investability of Pepsi stock or the credit worthiness of Pepsi?

Gorham: No, it's not really moving the value estimate of the equity or the credit rating of the debt. They've said that they will use cash and short-term debt to finance it, so it's not really moving the needle on either of those.

Glaser: So that doesn't seem like it could be the issue. I know Pepsi is kind of at the forefront of other strategic initiatives. They are bringing their bottlers in-house and other – you know this move into health and wellness as you describe, do you think that then has more to do with why Pepsi is trading at such a discount?

Gorham: Right. It's trading at about 14 times what we think they'll end in 2011, which is quite cheap. It really shouldn't be trading at such a discount to Coca-Cola, which is trading at about 18 times next year's earnings, and it's rare to get that kind of divergence between the two.

 I think what's driving it, though, is the relative performance in mature markets, particularly North America where Coke has really turned its business around after the recession, and it's been able to eke out about 2% growth, which doesn't sound much, but it's quite impressive for such a saturated and a mature market.

At the same time, Pepsi is still really floundering in that market despite being the first to make a move to buy its bottlers, as you quite rightly said. So I think the market is pretty much fixated on the North American market and ignoring the fact that these companies are both a story about emerging markets where there'll be able to grow.

Glaser: So what kind of catalyst would we need to see then for those Pepsi shares to in order to make up that ground?

Gorham: I think it'll take either a return to competitiveness with Coke in North America or the market realizes that, look, Latin America is growing, Asia is a great growth market as is Eastern Europe. And so I think, when the market moves its focus and realizes that this is really an emerging market story, I think we'll see that multiple gap close.

Glaser: So right now Pepsi looks like it could be a good core holding that you could get for cheap?

Gorham: Correct.

Glaser: All right, great, Phil. Thanks so much for speaking with me.

Gorham: Thanks.

Glaser: For, I'm Jeremy Glaser.