Pepsico, Inc. (PEP) Value-Line Case Study

Robert L. Rodriquez, CFA and CEO of First Pacific Advisors in a speech to Institute for Private Investors on Feb. 15, 2012: “I met Charlie Munger in my USC graduate school investment class and had the opportunity to ask him this important question, “If I could do one thing to make myself a better investment professional, what would it be? He answered, “Read history! Read History!” This was among the best pieces of advice I ever received.”

The full speech  at Gurufocus is here (scroll down for the direct link): http://www.gurufocus.com/news/162873/caution-danger-ahead–r-rodriguezfpa

Value-Line Analysis of Pepsi

Our last analysis of a Value-Line Tear Sheet was Balchem (BCPC): http://wp.me/p1PgpH-CY

Now lets look at Pepsi Co., Inc. (PEP): Pepsi_VL

Without glancing at price (easy to do when flipping through the Value-Line at the library or open the digital PDF while looking away from your computer, scroll down and then focus on the numbers) I see Return on total Capital (ROTC) of 30% to 16%, now in the high teens. Return on Equity has ranged 42% to 29%. The 80% higher ROE than ROTC means debt is helping boost returns significantly. Debt is useful as long as its doesn’t impair the company under stressful conditions. The ten-year history of 16 to 25% ROTC shows that this is probably a franchise. Good. Value will be in the growth.

As a review for beginners from Value-Line:

Return on Shareholder Equity, meanwhile, reveals how much has been earned on just the stockholder equity. Value Line calculates this by dividing net profits by shareholder equity, which includes both common and preferred equity. Again, higher percentages are generally better.

Neither of these measures can be used in exclusion, however. They are best used as a starting point or as a comparison tool. Note that comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. Indeed, because of the differences between industry fundamentals, some industries will have a preponderance of low scores while others will have large numbers of companies with high scores. That said, using these two measures as a first screen can help to quickly limit the number of companies under review and will, generally, direct investors toward higher quality entities.

It is also interesting to compare these two measures for the same companies, which can provide insights into how well companies are making use of their debt. For example, if Return on Total Capital is going up but Return on Shareholders Equity isn’t following along, or, worse is static or falling, additional debt financing isn’t benefiting shareholders.

Another statistic to consider along with these two is Retained to Common Equity, which is colloquially referred to as the “plowback ratio”. Value Line calculates this measure by dividing net income less all dividends (common and preferred) by shareholder’s equity. It measures the extent to which a company has internally generated resources to invest in the company’s future growth. A high percentage here, coupled with an increasing Book Value, is a clear signs that management is increasing the value of its business. This can help validate both the above measures and provide a degree of reassurance that a business is self-sustaining. Like the other two measures, this data point is available in the Statistical Array of each Value Line report.

Back to the PEP Value-Line

Operating margins 20% and net profit margins at 10% with a slight trend down. This may be good or bad depending if margins will stabilize or go up. Even if the margins go down even more–if the company is earning more than its cost of capital and the market price is more pessimistic–then the company could still be a good investment, depending upon price. Just note the slight decline in margins, the business is under temporary stress? Higher capex, higher costs that are not passed through, etc.  We don’t know the details of the story, just a question we need to answer with further research.

Sales per share have been rising 8% to 10% for the past decade, and sales did not drop in 2009, so this company has a stable product with low cyclicality.

Book value shows a steady 6% to 7% increase. 40% to 45% of their earnings are being paid out to shareholders in the form of dividends, share count is declining very slightly. Good, the company is a slow grower and is returning excess capital to shareholders.  The danger might be if management leveraged the company too much.

A glance at the balance sheet shows $26.8 billion in long-term debt; $5.5 billion in net pension obligations and 1.6 billion in cap. leases then subtract 3 billion in cash so we have 30.9 billion or $31 billion in net debt (round up) to add to the market cap to reach our Enterprise Value (Remember we are buying the whole company including its debt). With 1.55 billion shares that is $31 debt/1.55 shares or $20 of net debt per share.

I see about $6 of “Cash Flow” and about $2 of capex for $4 of FCF per share. Note the jump in Capex from 2009 to 2010-what happened? With no growth I certainly would pay $40 to $45 for about a 10% return if I was confident of the company’s franchise. All metrics have grown 7% to 10% over the past ten years. Can that growth continue? This company seems like and inflation pass-through–Sales and profits will rise at least as fast as nominal inflation on average. Good. So if this company could grow at 5% to 6% and I was confident of that growth I would pay $65 to $80 per share for that cash flow, but my confidence level for that future growth had better be high.

Anyway, I have about $40 no growth value for the company but more like $65 to $80 for the business if I assume 5% to 6% growth–like buying a bond. My alternatives are 3% for 20 year US Bonds.

Now to the market price, I see we have a $66 share price as of April 4, 2012 so the market cap is 1.55 billion shares x $66 or about 102 billion but for simplicity–$100 billion then add the 31 billion in net debt for a total of $130 billion for the business (133 billion if we wish to be more precise) for an Enterprise value of $84 to $85 per share.

My range is $65 to $80 (aggressive assumptions?), so the company is out of my range by $5 to $20 or a 5% to 25% swing in price), but a swing of 10% to 15% in price (thank you index selling!) could make this an attractive investment.

Now I do a quick double-check. I have about $85 per share in enterprise value divided into $4 of FCF for an earnings yield of 4.7%. Growth has averaged 9% for the past ten years and I will knock that down to 4% to 6% to be conservative, then add that to 4.7% earnings yield–over 45% of that earnings yield is being paid out to me in the form of a 3.5% dividend yield based on the current market price. Now I have a range of return 8.7% to 10.7%. Not bad assuming I can have confidence in the franchise which 80 years of history leads me to believe I can. However, I do need to note the issues I brought up like the increase in capex from 2009 to 2010, insider activity and the terms of the company’s debt (ALWAYS check terms of debt and READ THE PROXY).

The company trades at a market multiple but is an above average company. If I HAD to own stocks, I would own PEP because you are getting an above average company for the market price. However, I (not you perhaps) seek a 12% to 15% return. A $8 to $15 dollar drop (certainly possible) could make this very attractive to me. Conversely I could sell a 2013 or 2014 put at a 55 strike for the amount of shares I would wish to own (I want a 20 to 25 company portfolio of “cash gushers” to supplement my spin-off asset investments).

I place this in the #2 work-on pile. Remember not to fool yourself. If I drove up to Pepsi’s headquarters in Purchase, NY (20 minutes from where I live) and spent two years studying the company, I don’t think I would understand the business better than reading the last 5 annual reports and proxies.  PEP is a world-wide conglomerate operating in 100 countries with 100s of different products in major food categories. I am looking at this more as a financial machine. Since the company is selling consumer products (branded food) I know the operational risks are lower than a cyclical steel company.  I will look for bombs on the balance sheet or any tricky accounting. If I can’t understand the financials, then pass. Time spent 2 minutes.

Miller Industries, Inc. (MLR)

Anyone want to take a crack at MLR: MLR_VL? I will post your analysis.

21 responses to “Pepsico, Inc. (PEP) Value-Line Case Study

  1. When I saw the word “Miller”, I thought it was Millers beer (sorry if that was a stupid assumption. I’m British). I saw the low low return on total capital and return on equity and wondered if I had the right company. Sales per share are erratic, and so is the cashflow. It didn’t look like a beverages company.

    Then I glanced down at the industry and business, and I saw “manufactures vehicle towing and recovery equipment”. OK, so that explains it. No franchise based purely on the numbers. Seeing the word “heavy” in its sector further confirmed my biases.

    Obviously, this is no Pepsi. If I were looking for franchise businesses only, it would be an immediate rejection.

    I thought about what I might pay for it anyway. Maybe it’s worth book, which is $12.86. Looking at it another way, I calculate that average FCF over the period is about $0.99ps (cash flow total 11.05, capital expenditure 3.10, spread over 8 years). I’d want a 10% FCF yield at the very least, which would put it at $9.90. If I wanted a 15% FCF yield, which would seem much more interesting to me, I’d pay at most $6.60. The stock is well above that, so it’s not interesting.

  2. Good analysis. You’re right, it is not Pepsi, much more cyclical.
    The key is whether you can “normalize” earnings or FCF.
    I come up with about $0.90 cents to $1.10 in FCF per share. a 15% FCF yield or 6.66 times brings about $7 then add back $3 in excess cash (assuming you have confidence that you don’t need to discount the value of that cash due to management mis-allocation), I would be interested under $10 off the top of my head.

    I would put this in the watch pile.

  3. Hi John,

    Funny you should do this one. I was just looking at PEP’s VL report myself a night or two ago. I found it instructive to compare it to KO and DPS. Both are purer beverage plays so its not apples to apples, but a couple of things stood out to me. First, I came to similar conclusions on the valuation. Second, it appeared to me that PEP is a great snack foods franchise with a good, but perhaps less well run, beverage franchise. It seemed like PEP, while number 2 in market share in beverages, was the number 3 operator (which surprised me). I guess I didn’t expect to see better margins on DPS given the scale PEP has. Frito Lay is the same percentage of sales but a larger percentage of operating profit seems to indicate PEP’s beverage business is actually far less well run than KO or DPS. I suppose it could be because they bought in bottlers faster than KO, I don’t know. I was also interested to see more of that FCF coming back to shareholders, especially in DPS.

    It seems to me that value could be unlocked here by separating out Frito and Pepsi. Frito clearly deserves a better valuation and Pepsi could probably benefit from focusing solely on beverages. If that happens at some point, I know the current CEO says no, but you never know, PEP could be even better. A sum of the parts, which admittedly I haven’t had time to do, would probably indicate a higher value. There’s probably some option value in that happening.

    That all said, its probably something I’d like to own if Mr. Market gives me an opportunity. My only real concern with PEP at the moment is if they get skittish about losing more share and the game of prisoner’s dilemma gets a little less rational.

    Best,
    Gary

    • Thanks for your thoughts–much appreciated by many on this thread. Yes, the next step is looking at the annual report. The different businesses, their different values/problems/markets could be analyzed, then a more refined valuation could be attempted.

      One lesson from experience, you need to diversify unless you really have an edge. Your supposition is that this SUPER TANKER will not sink overnight while you are onboard. If you can buy these at a 20% to (30% rarely and if you think you are buying at a 50% discount then something is wrong with your valuation excpting 1930, 1974, 2009–3 years out of a 100!) discount to IV, then the closing of the price to IV plus profitable growth earns you a more than adequate return. Also, the P/IV tends to close faster than two to three years, so your annualized return can be even higher. Note Chieftain Capital’s 16% to 18% returns. They do concentrate in 6 to 10 ppositions because they are the best at knowing their companies.

      My goal is 1. don’t overpay, 2. try to buy at a discount. Some worries are difficult to analyze like your price war fears. Remember that your fears are shared by many–what is overdiscounted? Don’t be too cute.

      That said, swing when Mr. market throws you a beachball.

      • “Your supposition is that this SUPER TANKER will not sink overnight while you are onboard.”

        John, what kind of timeframe on average would you expect to be holding these types of business?

        • 2 to 4 years and when the P to IV closes then I exit. I have held KO for over two years though the position has been considerably reduced. but some companies if they can keep the IV growing as fast or faster than the price, I will keep for years (five or more).

  4. John,
    re: your PEP analysis. I would take into account the after-tax cost of PEP LT debt (2-3%) since we don’t have insignifiant leverage here. Should meaningfully skew your valuation upwards. We can pretend to buy the entire company but then we also have to pretend to pay the bond holders … why pay them 12-15% 🙂

    Morningstar is ok for bond yields.
    http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=pep

    • Thanks Comatozz. I am paying the bond holders with return that should accrue to the EQUITY shareholders thus my valuation is too low.
      Let me ruminate and reply later. Thanks.

      I have plenty to learn from you and all the readers here.

  5. Case Study: Reading Value Line – Miller Industries (MLR)

    Over the last 8 years (2003-2010) return on total capital (ROTC) has been erratic, ranging from 3.2% all the way up to 25.4%. ROE has roughly tracked ROTC, ranging from 2.7% to 28.9%. The large variance in ROTC and ROE over the last 8 years leads me to believe this company is cyclical. Therefore, I may want to purchase shares in the business at a discount to conservatively estimated normalized FCF. I don’t want to pay for growth. Is this a franchise? Can a franchise be cyclical? This company averaged 12.5% ROTC over an entire cycle, not bad but not great. This is a decent business.

    Operating margins averaged 6%+ over the time period and net profit margins about 3.5% and have been erratic over the last 8 years, further evidence that we are dealing with a cyclical company. Glancing at the sales line, we see a peak of $409m in 2006 and a low of $238m in 2009. This company is small, with only $300m in revenue. What is the size of the market for towing and recovery equipment? Who are the main competitors?

    Note: This company is cyclical but remained FCF positive in 2008-2009. Sales were off 50%+ from the high. Interesting. How was the company able to slash capex so much in 2009 to only $.07 per share? Look into.
    Balance sheet: This Company is debt free. No capital lease obligations or pension liabilities either. We have about 11.71m shares outstanding and $35.7m in cash ($3 per share in cash). What has management done with the cash over time? Management completely paid down debt. Share count is flat over the last 7 years and the company just started paying a dividend in 2010. Does this company require significant capital investment to maintain its business? Book value per share has grown roughly 20% annually over the last 8 years. ($3 per share to $12.86 per share)

    Valuation: Normalizing the FCF over the last 8 years, this company can earn $10m to $12m over a cycle (This includes a very bad 2008-2009). On the 11.71m share count, this is roughly $.85-$1.00 in FCF/share. Since this is a cyclical business with limited profitable growth opportunities, I want to use an 11%-12% discount rate. Assuming no growth we get a value of $7-$9 per share. Add the cash back in and we’re looking at $10-$12 per share. Value #1

    Value #2, we have a book value of $12.86 per share. We want to work with tangible book, so we would need to double check to make sure goodwill and other intangibles aren’t baked into our number.
    Price check: $16.50, above our estimate of IV. Note the huge disparity in the price paid for this business. Low of $4.25 in 2008 to the recent high of $21.29 in 2011 (that’s a 400% differential!!). I guess the market isn’t ALWAYS efficient?

    Value #3: Any private market transactions we can use?

    Questions:

    Do I understand the business? Yes, the company makes tow truck towing and recovery equipment.

    Do I understand the nature of the business and industry? No, I will need to read some annual reports and perhaps industry trade journals to familiarize myself with the business and industry.

    File under company for further review. We understand the business. There might be opportunities to acquire shares of the business in the future during the bottom of another cycle.

    • The MLR case raises some interesting questions.

      1. Can a franchise be cyclical? Evidence of a franchise (From Comp. Demystified) is high ROTC and stable market share.

      2. How high do the returns on capital need to be?

      3. Is there any way to determine if MLR has a franchise just from looking at the VL page? Most franchises we’ve reviewed in the past have more stable ROTC and ROE over time.

      Thanks.

      • Yes ALL businesses are somewhat cyclical. And there are cyclical franchise companies like BOEING, Catepillar, etc.

        RET. on TOT CAPITAL above 10%/12% is considered by many to be a prettry good business. What you want is a company that can grow profitably above its costs of capital (that is one dif. of a franchise).

        Growth means nothing outsside a franchise (BTE). See my post on Valuing Growth.

  6. John, you add the earning yield to the growth rate as if they were both apples, but I think it’s wrong. You can’t add a figure that is the growth of FCF to the percentage of FCF as a part of the Market cap.

    If you were valuing a growth company, with an FCF yield of 0.000001% and a growth of 15%, adding them would make you think it’s cheap.

    Did I misunderstand what you did?

    • Dear Arden:

      Good question. I will answer you in a blog post Valuing Growth in a few minutes. Download the two documents, read and then we can discuss further. Always be asking questions.

      Thanks.

  7. Hi John,

    Thanks for posting your Valueline cases.
    I follow the logic of your analyses but need help with some of the calculations to complete the picture.

    I’m working through your analysis and it would be really helpful if you could spell out the calculations for those of us still on training wheels.

    On your Balchem analysis:

    “I estimate Free Cash Flow is about 1.3 (or 1.6-.28).

    How did you estimate the 1.6 or .28 numbers? Ballpark? Average growth rate projected next year?

    How did you get the cost of capital of 10-11%?

    How did you determine the perpetual growth rate of 5-6% (real growth of 2% and 3 to 4% nominal growth, inflation?) “based on its past 22% growth in sales, earnings, cash flow and book value…” How does the past 22% (how did you get that too) show you to use 5-6%?

    Finally for Balchem, can you provide the calculation for the $40s estimate with the 10% growth expectation?

    The numbers I’m getting are different, and it would be nice to get it right.

    For the PEP analysis:

    Can you elaborate this part: “With no growth…$40 to $45 for about 10% return”
    How did you come up with $40?

    Thank you very much.

  8. John,
    How to value a growing cashflow when growth is greater than cost of capital? I was looking at Oracle and the growth in earnings, Book value and cash flow are in the twenties.

    Thanks

  9. Dear Bargain Stocks:

    First, normalize those numbers. What is sustainable? If you can’t do that, then you can’t invest.
    Secondly as a test take out your spreadsheet and grow sales, CFs and earnings at those reates for 15, 25, 35 years—what amounts do you arrive at? Do you think the company will be that huge–what does that imply?

    Out of 1200 companies probably 5 to 10 will grow all metrics at 15% for 15 years. A freak occurrence. Google Fortune on the 15% illusion of growth by Carol Loomis:http://money.cnn.com/magazines/fortune/fortune_archive/2001/02/05/296141/index.htm
    Read, think and then if you are unsure–ask again.
    Good luck.

    • John,
      Thanks for the quick and informative reply. After reading the article, It is clear that any company can not grow @15% over long term. However I am finding it difficult to come up with reasonable growth rate in valuation. In the PEP case above, you have assumed growth of 5-6%. What factors made you assume growth rates of 5-6% ? Why not 3 or 4% ? In your experience what is the maximum value you have used for g and what is the minimum ?

      Thank you

      • Dear Bargainstocks:

        You can have 50% growth for three to four years as the company moves from start-up to its middle stage, then you have slow growth of 5% or 10%. This depends upon the business so you can do a two or three stage DCF. But DCFs are USELESS unless the ASSUMPTIONS are reasonably correct.

        I chose 5% to 6% because the company has show its ability to grow at 8% or higher, so I discount that to be conservative. Plus, I estimate inflation of 3% to 5% with 1% to 2% real growth because PEP can pass on cost through raising prices (based on its past 70 year history.

        But I don’t know 100% that 5% to 6% will be correct, perhaps (I hope) PEP grows 8% to 10% for another five years. I am making an assumption based on past history, competitive advantage and structure of the industry. Spend as much time fleshing out your assumptions 100x as plugging in the figures into a DCF.

        Read about the industry, read 5 years of annuals from the company and ALL competitors. Do the work.

  10. I think you all are undervaluing MLR by quite a bit. EPS over last 6 years = average $1.36. Most recent balance sheet (4Q11) shows $4.55/share in cash. 12% ROTC average over last 6 years “deserves” 10-12x multiple…. So I get $13.60-16.32 +3.50-$4.00 excess cash = $17.20-20.32. Management has become much more disciplined in allocating capital.. Div. increase and share repo of $20mm in 2011. Outstanding shares are now 11mm… I’m a buyer at $14 and aggressively so at $11.

    • Dear radioheadok3:

      I mostly agree with you and different views make a market. Your assumptions (based on your knowledge of the company/industry) may give you a better handle on what to pay for the business. I have a price alert at $15 so I will prepare to be ready, but let me buy first :).

      By the way, subscribe to the company’s free towing magazine; you will learn a lot about all the different models/types of tow truck and how important a dealer network is for this company. The more models, the better offerings for a wider customer base which brings more dealerships. Good dealerships provide low down-time for the TTs and more customers–a reflexive circle. MLR has much better returns than a car manufacturer, for example. There is SLIGHT customer captitivity.

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