It would seem to be a difficult moment to be a soft drink manufacturer like The Coca-Cola Co (NYSE:KO) and PepsiCo, Inc. (NYSE:PEP).
Last month, soda taxes were passed in San Francisco and Chicago, along with other, smaller, municipalities. Diet soda consumption, in particular, is plunging; overall U.S. soft drink sales hit a 30-year low in 2015. Concerns about obesity continue to rise worldwide, with soda often considered a key culprit.
And yet Coca-Cola and PepsiCo stock continue to shrug those concerns off.
Coca-Cola stock has weakened of late; its divergence from Pepsi seems to show that the market at least is giving soda concerns some consideration at the moment. KO lacks the diversification that Frito-Lay and Quaker Foods offer Pepsi.
But with both stocks trading at 20-plus multiples to adjusted 2016 earnings despite flat recent performance and significant challenges ahead, there’s a real question as to whether investors are being too sanguine about industry risks. PEP and KO already are relatively low-growth companies; yet they’re not priced as such.
With additional pressures on the horizon, there seems a significant possibility of a repricing of both stocks.
The Current — And Future – Challenges for PEP and KO
It’s not as if Pepsi and Coca-Cola stock are performing all that well at the moment. Should the company hit 2016 guidance of $4.78, Pepsi’s “core” non-GAAP net income would increase less than 2% total in the three years between 2013 and 2016. Coke’s similar metric (“comparable” net income) would decline about 11% over the same period should the company hit Wall Street consensus estimates in Q4. Free cash flow for both companies, per 10-K filings, has been stubbornly flat the last few years, at about $8 billion annually; Pepsi’s guidance implies a year-over-year decline in 2016.
To be fair, currency has been an issue. In its 10-K, PEP reported 10% constant-currency non-GAAP EPS growth in 2015, for instance, against a modest decline including the impact of the stronger dollar. But volume numbers show how weak top-line growth has been: Pepsi’s “servings” increased just 1% in each of 2014 and 2015 before accelerating to 2.5% in the first three quarters of 2016. Coke’s unit case volume rose 2% in 2014 and 2015 and just 1% YTD, including a decrease in sparking volumes over that period.
Even that meager growth largely has been purchased: both companies have sharply increased advertising and R&D, pressuring operating margins.
It’s not at all clear why growth should increase going forward, particularly in carbonated soft drink sales. Soda taxes for now may only represent a modest annoyance, but their impact should grow. A study of a previous measure passed in Berkeley, California, showed a 21% decline in soft drink consumption in low-income households. A nationwide tax in Mexico that added roughly 10% to end customer cost led to a 12% decrease in sales in what is a key market for both KO and PEP.
There’s an argument that the taxes themselves are less the driver of reduced consumption than the debate and negative sentiment surrounding the passages of those taxes. But that’s the point: Soda is becoming increasingly unpopular with each passing year. While in the U.S., soda taxes cover only a small proportion of the population (and worldwide, the figure is even smaller), it seems likely that additional levies will be on the way both in the U.S. and overseas.
There are concerns beyond taxes as well: Diet sodas are falling out of favor, with consumers increasingly concerned about the chemicals used to replace sugar. Sodas — both diet and regular — are increasingly cited as a key driver of obesity in the developed world. Overall, the key problem for both Coca-Cola and Pepsi stock seems relatively simple, and yet extremely difficult: The demand for the companies’ key products is declining, due both to consumer desires and regulatory pressures.
Looking forward, that problem seems likely to only get worse.
The Potential Response (Or Lack Thereof)
It would appear that Pepsi is better positioned than Coca-Cola to manage declining carbonated soft drink demand.
PEP has Frito-Lay and Quaker, which combined drove over a quarter of 2015 sales, and overall Pepsi has had strong results of late in Latin America. North American Beverages account for just one-third of total sales, and that segment includes Gatorade, which continues to post mid-single-digit growth according to PEP filings. For Coke, meanwhile, soda is more important: sparkling beverages drive nearly three quarters of unit case volume, and the Coca-Cola brand itself (including variations such as Diet Coke and Cherry Coke) is responsible for nearly half of the company’s total volume.
Still, both companies face headwinds — and both companies have made moves in response. On her company’s third-quarter conference call, Pepsi CEO Indra Nooyi discussed multiyear efforts to lower sodium and saturated fat across the portfolio, and said 45% of the company’s current portfolio was considered “guilt free.”
Coca-Cola, per its Q3 call, has over 200 initiatives to reduce sugar in its products. The long-term argument for KO and PEP shares is that both companies can follow demand within the beverage industry, with Coke substituting Minute Maid or Dasani Sparkling Water for Sprite sales, and Pepsi boosting sales of healthy snacks, Gatorade, or newly acquired probiotic drinks brand KeVita to offset declines in its namesake beverage or Mountain Dew.
There probably is some truth to that argument, but it’s hardly a fair swap for either company.
The brand recognition of Coca-Cola, in particular, is a huge competitive advantage: Forbes named it the fourth most-valuable brand in the world this year. Competition beyond soda will be more difficult: National Beverage Corp.’s (NASDAQ:FIZZ) LaCroix and privately held Polar Beverages are significantly outgrowing Coke’s Dasani and Pepsi’s Aquafina in flavored sparkling water, for instance. It’s too simple to assume the companies can easily pivot away from their entrenched brands, and even success in following demand trends implies only a continuation of currently depressed growth.
Even Pepsi’s snack food business isn’t immune to the broader trends of increased health concerns: the World Health Organization has called for not only a higher soda tax but similar levies on high-fat and high-salt foods, like Frito-Lay’s Doritos and Ruffles.
Bottom Line on Pepsi and Coca-Cola Stock
All told, it seems that Coke and Pepsi will have to work simply to maintain overall beverage market share — and given historical 1% to 2% overall market growth, that implies continued pressure on the top line. Yet 20-plus EPS multiples are pricing in consistent, long-term profit increases going forward. Flat free cash flow growth, however — similar to that posted the last few years — would imply a much smaller multiple, one that would value each company at about $100 billion. That suggests 33% downside for PEP, and a 40%-plus fall for KO.
Projecting such a steep decline in the stock prices of both companies might seem overly aggressive — and it may be. But there are very real challenges at the moment for Coca-Cola and Pepsi, and reason to believe those challenges will only get larger going forward. The market doesn’t seem to be pricing in any sort of risk at the moment; that seems far too optimistic, and makes the valuations of both Pepsi and Coca-Cola stock look extremely dangerous at the moment.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
