By almost all accounts, shares of snack food and beverage company PepsiCo Inc. (NYSE:PEP) are behaving exactly as you'd expect a consumer staples name to act as stocks head into the tepid time of year. Rather than try and squeeze gains out of a market that's unwilling to offer any, many traders just choose to park some money in names they don't have to worry about. After all, how much safer could money be in the summertime than in a food and drink stock? And sure enough, shares of PepsiCo have rallied 11% since the March 18 low, while the S&P 500 has lagged with only a 2.3% gain.
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Add in the new backdrop of serious economic worries, with last month's job growth being nowhere near what analysts were expecting, and the need for defensive names in your portfolio swells. There's one potential problem with using PepsiCo as the solution to your portfolio's "staples" needs - the stock has got some subtle but significant problems of its own. (For more, see Guard Your Portfolio With Defensive Stocks.)
Not So Hot...
PEP isn't a consumer staple outlier. The iShares Dow Jones US Consumer Goods Sector Index Fund (NYSE:IYK) is up a solid 7.8% since the March 18 low as well, confirming the sector's budding strength. Unfortunately, that's where the strong similarities end.
PepsiCo is trading at 18.65 times its trailing earnings. That in itself isn't an unforgivable sin, but compared to the S&P 500 Consumer Staples Index's trailing twelve month P/E ratio of 16.45, it's nothing to dismiss either. The Coca-Cola Company (NYSE:KO), for instance, trades at 12.7 times its trailing earnings, while Procter & Gamble (NYSE:PG) - which competes with PepsiCo in some snack foods categories - trades at a slightly lower trailing P/E of 17.4. The point is, there are cheaper ways to satisfy the need for safety.
Worse, for the first time in a very long time, last quarter's per-share operating earnings fell. It was only slight drop, from $0.75 to $0.74, but it was enough to cast doubt and raise questions about future year-over-year dips, especially considering the way net margins have dwindled from the 13% area just a few years ago to the 10% area now. (For related reading ,see A Look At Corporate Profit Margins.)
... and Not Getting Any Hotter
The future not only doesn't look much better for PepsiCo, but it's starting to look even tougher.
PepsiCo did hit a homerun in fiscal 2010 in terms of revenues. The top line jumped from $43.2 billion to $57.84 billion - a 34% bump, but only thanks to the early-2010 acquisition of The Pepsi Bottling Group and PepsiAmericas. The problem is, earnings only improved by 9.6% - from $5.95 billion to $6.52 billion - and most of that improvement was actually driven by the original PepsiCo. At some point, the $7.8 billion in acquisitions has to start paying off.
To be fair, on a per-share income basis, there seems to be a measurable degree of growth. Plus, the company has been carrying some M&A costs over the last twelve months, which are part of the reason for shrinking margins. These costs were originally expected to end by 2012, after which time the merged organizations were expected to realize a $300 million annual synergy.
Even adding that $300 million worth of synergy back in would still only bring 2010's income up to about $6.6 billion, or an 11.8% improvement in 2009's income. That's still a pretty weak ROI.
It's not awful, but it's quite a leap of faith to expect investors to stick out an expense-laden 2011 with no clear assurance that 2012 will be significantly better, especially when there are so many alternatives in the consumer staples space. Indeed, the forecasted 8.8% improvement in EPS and an estimated 5.1% in revenue growth between 2011 and 2012 aren't going to be too exciting to anyone. (For related reading, see How To Evaluate The Quality Of EPS.)
The Ultimate Outcome
PepsiCo isn't a doomed company. The acquisitions of The Pepsi Bottling Group and PepsiAmericas, however, happened over a year ago, and owners have only seen a bigger top line paired with shrinking net margins and a mostly-flat bottom line. In a wildly-bullish market a company can get away with that. In this shaky environment though, there's little margin for error when margins are still dwindling from a year-old buyout. (For more, see Mergers & Acquisitions: An Avenue For Profitable Trades.)
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