A Paired Trade Idea in Soft Drinks
Hedge the next market swing with our paired trade idea: long Pepsi, short Hansen
PepsiCo (PEP) is undervalued, as the market is fixated with the floundering soft drinks business. PepsiCo is trading at an historically wide valuation discount to its great rival Coca-Cola (KO). Over the last five years, Coke has traded at median and mean forward P/E ratios of 18.0 times and 17.9 times, respectively, while Pepsi has traded at 16.5 times and 17.2 times, respectively. Today, that valuation gap has widened While Coke still trades at around 18 times forward earnings, Pepsi has been trading in a range of between 14 and 15 times for several months. We think that falling unemployment and Pepsi's rebranding efforts could provide a catalyst for that valuation gap to close later this year. We think value investors should take a close look at Pepsi, while growth investors may like the emerging markets story. Dividend investors may be interested in the 3% yield.
Will Overseas Investments Keep Profits Fizzing?
Coke is investing more in emerging markets, which could justify a higher multiple. As shown in Exhibit 1 below, the company has stated it will invest $20 billion in four emerging markets over the next decade, a theme repeated by management at the meeting. This investment is more than Pepsi's $15 billion, and represents a commitment to long-term growth that could justify a slightly higher multiple, particularly as Coke already has leadership positions in most markets. We think the $12 billion investment in Africa could yield the highest payoff. With a population of around 1 billion people, around 65% of whom are under 25 years of age according to the World Health Organization, a GDP of $1.6 trillion in 2009, and per capita consumption below the global average, the continent offers the Coca-Cola Company years of growth. We're told that the investment in Africa will increase the firm's manufacturing and distribution footprint, particularly in noncarbonated categories. The 1,200 distribution centers that will be built in 2011 should help make distribution more efficient.
Pepsi is ramping up its investment in Russia, but is playing catch-up to Coke. The $9.4 billion investment it is making in the country is comprised of a $4 billion cash investment in infrastructure, and the $5.4 billion acquisition of Wimm Bill Dann dairy and juice manufacturer. Although these investments will undoubtedly close the gap, Coke has a strong lead over Pepsi in the country, with a 38% share versus Pepsi's 20%. With per capita consumption in Russia at 141 eight-ounce servings per head in 2009 (versus 736 per capita in the U.S.), and with around 40% of market share held by local brands, we anticipate further investment by Coke in the region in the form of bolt-on acquisitions.
Coke is outperforming, and has a competitive advantage in the restaurant channel. In the fourth quarter of 2010, Pepsi's volume grew 1% in North American beverages, following several quarters of decline, while Coke's volumes soared 8%, an impressive performance given the lack of consumer confidence and the absence of growth in the North American market. We expect a similar pattern to emerge in the first quarter of 2011. In addition, Coke dominates the fountain (quick service restaurant) channel, with the top two accounts by outlets - Subway and McDonald's (MCD) - and there are some switching costs to changing suppliers, including potential disruption to service. Therefore, while Pepsi can regain some market share in retail channels, overcoming Coke's dominant position in restaurants may be difficult.
The market is ignoring the strength in Pepsi's snacks business. Around two thirds of Pepsi's revenue is derived from snacks, so we think comparisons with Coca-Cola are not apples-to-apples. In fact, Pepsi is more dominant in snacks than Coke is in soft drinks, due to the absence of a single major player in the industry. The firm holds leading macrosnack market shares of around 39% in the U.S. and 23% in Europe, allowing its snacks business to generate significant economies of scale. Therefore, we believe that Pepsi's economic moat lies in the scale and global distribution of its snacks business, and we think the firm should trade at high-teen multiples, similar to other dominant firms in the consumer staples space.
Falling unemployment and beverage rebranding efforts could provide an upside catalyst in 2011. Recent data suggest that the unemployment picture in the U.S. is improving. The unemployment rate fell 60 basis points, to 8.8% in March, and initial claims are down to early-recession lows. This is good news for consumer staples firms, because there is a strong historical correlation between unemployment and retail demand. Single-serve soft drinks are by far the most profitable in the U.S., and a rebound in impulse purchases as a result of growing consumer confidence is likely to boost revenue. If the fragile recovery can survive the cessation of QE2, and the recovery holds, Pepsi's North American beverages business, the source of the weakness in its stock, in our opinion, could rebound.
Hansen looks overvalued on acquisition rumors.
At 23 times forward earnings, Hansen Natural (HANS), on the other hand, looks overvalued. The market appears to be pricing in perfection: a rebound in demand in the U.S., and growth overseas. We think the market may also view Hansen as a takeover candidate, but we think an acquisition is unlikely at the current market value.
The market is assuming that recent growth rates will continue for the foreseeable future. After two weak years in 2008 and 2009, demand for energy drinks staged a vigorous rebound in 2010, and Hansen achieved low double-digit volume growth in the fourth quarter of 2010. Demand for energy drinks is cyclical due to the younger, lower-income core consumer, but the rebound in volume during the recovery suggests to us that energy drinks are here to stay, at least in the medium term. In fact, consumers are willing to pay a premium for functional beverages that are perceived to fulfill a need, and energy drinks sell at retail for almost 4 times the price of other carbonated soft drinks. However, the market appears to be assuming double-digit revenue growth for the next ten years, a scenario that we think is unlikely.
However, demand could fade in the medium term over health concerns. Energy drinks are high in sugar content, and with consumers migrating away from other sugary categories such as cola to healthier alternatives, energy drinks could also suffer volume declines in the years ahead. The risk of an unfavorable shift in consumer tastes will increase as Hansen's core consumer - teenagers and males in their early twenties - grow older.
But Will Overseas Markets Boost Energy Drink Sales?
There is no guarantee that consumer acceptance will be as strong internationally. Having expanded throughout the U.S., Canada and into Mexico, Hansen's growth opportunity now lies in international markets. Energy drinks are clearly popular in Europe, but in most European markets, Red Bull has a first-mover advantage and strong brand equity thanks to its sponsorship of Formula 1 motor racing events. Elsewhere, we think there is a risk that consumer acceptance of energy drinks may not be as high as it has been in North America. In Asia, for example, consumer tastes may not be suited for the sweet taste and high sugar content of Monster Energy.
At current market prices, we doubt that potential suitors will be attracted to Hansen. Coke and Pepsi are playing catch-up to Hansen, and may prefer to conquer the energy category through acquisition rather than investing in their own brands. With Coca-Cola distributing Monster in many markets in the U.S., we think Coke is the more likely acquirer. The market has consistently attributed a rich multiple to Hansen's stock, so any acquisition would not come cheap, and the premium to market value that would be required may put off potential suitors.
The risk to our thesis lies in international markets. If we are incorrect about Monster's growth potential in international markets, and Hansen generates double-digit total revenue growth for a sustained period, an acquisition may, indeed, be on the cards. Coke and Pepsi may be adopting a wait-and-see strategy to Monster's performance internationally before making a move. However, the higher Hansen's market value goes, the worse the risk/reward profile of an acquisition becomes, and we think Coke and Pepsi may find it difficult to create value from an acquisition at current levels.
Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.