Wednesday, December 17, 2008

Marcial: Why the Pros Pick PepsiCo

Marcial: Why the Pros Pick PepsiCo

In these times of economic distress, investors are constantly seeking safety in companies whose earnings are predictable and whose stock prices are relatively stable. That's too high a bar for most companies to clear these days, but one of the few that meets the challenge is PepsiCo (PEP).

The Pepsi name is widely recognized worldwide as a leader in beverages and snack foods. The company's stable of market-leading products has helped bolster earnings despite the global recession. In fact, PepsiCo's business outside the U.S. is fueling much of its earnings growth these days.

"Any company that can grow earnings, even a little in this very weak economic environment, should be prized," says Edwin Walczak, chief investment officer at Vontobel Asset Management, which owns shares. PepsiCo, he adds, can be regarded as a defensive stock in this tough environment.

Relatively Cheap Stock

PepsiCo's stock hasn't been immune to the market meltdown, in spite of how well its earnings are holding up—and rising. Walczak figures the company will earn $3.66 a share for 2008 and $3.76 in 2009, which are below consensus analysts' estimates. The company earned $3.34 in 2007.

With the shares now trading at 52 each (down from their 52-week high of 79 on Jan. 10), PepsiCo is selling at a price-earnings ratio that's lower than its "normal" annual average p-e of 20-21. Based on Walczak's 2009 profit estimate, the stock is selling at a p-e of just 14. For a company that has a "great franchise worldwide, that is a bargain," he says.

PepsiCo should be regarded by investors as a "food [snacks] company with a beverage component rather than the other way around, as most investors do," says Eric Schoenstein, a principal at Jensen Investment Management, which owns shares. He notes that its food operations, such as Frito-Lay and Quaker, accounted for 36% of operating profits and 29% of total sales, while the beverage components, including Pepsi, Mountain Dew, and Tropicana, generated 28% of operating profits and 26% of sales. PepsiCo International, which includes both snacks and beverages, accounted for 29% of total profits and 40% of sales. In the third quarter, the international unit continued to perform well, and the outlook ahead remains robust, says Schoenstein.

Workforce Cutback

The company's snacks and cereals spell the difference between PepsiCo and Coca-Cola Co. (KO), which doesn't have a large food component, says Schoenstein. And the company intends to expand the foods unit through acquisitions. PepsiCo has done a good job expanding product lines in sodas, and thus can focus acquisitions on stronger growth areas such as foods, he says. Meanwhile, the foods operations are growing at a faster pace than the beverage business, and should continue to do so in the years ahead, according to Schoenstein.

Although there are pockets of slowing growth in the company's international markets, "the business is holding up well," says analyst William Pecoriello of Morgan Stanley (MS), who rates PepsiCo overweight with a price target of 74. The brokerage firm's internal analysis shows there is little correlation between a country's gross domestic product growth and growth rates of salty snacks, Pecoriello says. Frito Lay, for example, remains "rock solid" in foreign markets as well as in the U.S. (Morgan Stanley has done investment banking for PepsiCo).

With the economic slowdown, the company has announced a cost-cutting plan that includes a reduction of 3,300 workers, or nearly 2% of its total workforce, and the shutdown of six plants in order to save $1.2 billion over the next three years. The rise in commodity prices cut into the company's top and bottom line results, prompting PepsiCo to lower its earnings forecasts. That, in turn, spurred analysts to trim their sales and earnings estimates.

Nonetheless, for long-term investors the stock is appealing, says analyst Tom Nikic of investment research firm Value Line (VALU), in part because of PepsiCo's earnings predictability and financial strength and its dividend yield of 3%. "With all things considered, we see a good risk-reward scenario" in the stock, says Nikic. He gives PepsiCo the highest rating on Value Line's safety scale.

Also bullish is analyst Esther Kwon of Standard & Poor's, who rates the stock a buy based on the company's "domestic and international growth opportunities, pricing power, and healthy cash-flow growth." In addition, she says, PepsiCo's leading positions in its markets and its emphasis on health and wellness through its products "should continue to drive the top line." (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP.)

Slowing economies worldwide present difficulties for companies of all stripes. The Pepsi challenge, of course, is to continue to add fizz to its bottom line amid the downturn.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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