Waitress: Would you like a drink with that?
FI: Yes please, can I have a Coke?
Waitress: I’m sorry Sir, but I’m afraid we only have Pepsi.
FI: Oh OK then, I’ll take a Pepsi.
When I think of Pepsi I think of No. 2, Michael Jackson, and the Pepsi Challenge. One of those is negative, one is creepy, and the other dubious, but there is more to the modern Pepsi company than that. At least Nick Train must think so, because he has just made Pepsi the first new purchase in three years for his Global Equity fund. I admire Nick Train’s slothful but high conviction investing style and so try to pay attention on those rare occasions when he does actually do something.
The Modern PepsiCo
PepsiCo is actually much more than the consolation cola. In addition to Pepsi-cola itself, its brands include Quaker (grits, porridge, and granola), Mountain Dew (I thought this was Dr. Pepper’s), Lipton (Unilever’s), Doritos (a personal favourite), AquaFina, Muller (I am shocked!), Tropicana, Walkers (as English as cricket, I had thought), Fritos, Lay’s, Cheetos (awful), Gatorade, 7Up, and Ruffles. As any student of potato crisps (or chips, as they are confusingly known as in the US) will know, the only notable brands missing from this belt-bursting line-up are Pringles, Kettle Chips and Tayto; in fact, Pepsi’s dominance of the global snack foods market is such that Train points out it is 5x the size of its nearest competitor and a remarkable 11x the size of the number 2 in America. To me, this sort of gorilla-style dominance sounds like Standard Oil back in the good old days (good for its shareholders, at least) .
Totting up: long-term returns
So, how has that boa constrictor-like snack food dominance translated into returns for shareholders? Not all that well, as it happens. According to Morningstar’s table of total returns, over three, five and ten years Pepsi has returned 15.76, 10.58, and 7.52% respectively. The S&P has managed 19.36, 15.75, and 8.54% over the same periods. Pepsi did outperform by 3% if want to start the race 15-years ago, but that is a long-time to go back.
Everybody knows selling branded sugar and water is one of the best businesses there is, but selling bottled water and fried potatoes is hardly a money-loser, so has Pepsi punched below its weight in recent times? On the other hand, if you value some stability and ballast in your portfolio, then Pepsi’s earnings have obvious appeal. Take a look at their performance through the oxymoronic Great Recession:
- 2007 EPS: $3.52
- 2008 EPS: $3.30
- 2009 EPS: $3.79
- 2010 EPS: $4.00
The panic looks like a mere pea beneath the mattress. I would far rather see my earnings come in like that rather than the pinball style numbers reported by some of the more cyclical companies that might have managed to accrue better total returns for their shareholders (if, that is, they managed to stick with them throughout the white-knuckle ride of the last decade.)
Anyway, given Nick Train’s predilection for strong brands and durability, perhaps the more interesting question is not why did he invest in Pepsi, but why did he invest now?
Valuation
Pepsi is currently trading on a forward price/earnings of about 20, which is a shade more than the S&P. This is normal for Pepsi, which has usually traded at a premium of about 10% to the S&P. Given the stability of its business, relentless inevitability of its slow but steady growth, and the dependability of its dividend (42 annual increases, and counting) this seems entirely reasonable.
Train’s comment that this stake is his first new purchase in three years, however, makes me wonder how Pepsi looked three years ago and why he didn’t buy it then? Well, according to this Fortune article, Pepsi was a much tastier investment then – its shares having gone nowhere for the preceding five years, it was selling on a Price/Earnings ratio of 15 and yielding over 4%. Well of course it’s easy with hindsight and Kraft certainly hasn’t done badly since, besides, Lindsell Train were probably buying Disney three years ago.
Kraft and Hershey
One thing that did surprise me was that Train funded his PepsiCo purchase with proceeds from sales of Kraft and Hershey. While cashing in on Kraft is easy to understand (selling on a price/sales ratio of 2.8% it has raced up more than 50% over the last year following news of the Berkshire and 3G deal), I was a bit surprised to read he had sold his Hershey.
Yes it is richly valued, but when hasn’t it been? This is why:
- Gross Margins: 45%
- Return on Invested Capital: 25%
- Return on Assets: 16%
- Interest Coverage 16
According to Morningstar, it is also expected to grow more than Pepsi over the next five years too (8.3% vs 6.8%). Hershey, to my eyes at least, looks like the perfect forever company. Furthermore, there has been a mini sell-off recently (-7% YTD) and underperformance over the last year (+2% where the S&P is up 16%), which should surely be all the more reason not to sell?
In his fund commentary he says that the price “ran away” from them shortly after purchase, meaning that they were unable to establish a full position. But what is the harm in leaving a successful investment well alone, regardless of its size? Surely there is nothing wrong with having a small holding of a great company that you did manage to buy into at an attractive earnings yield and just allowing it to quietly carry on doing its own sweet thing?
Perhaps the minimal possibility of corporate action (the Hershey Trust rules the roost) or low possibility of a takeover (it is already selling on a price/sales ratio of 2.9) dulls its short to medium-term attractions. I don’t know – perhaps he just needed to raise the money or didn’t want too many companies to follow.
Split-ups and Spin-offs
So back to the question of why buy Pepsi now–does LT sense the whiff of profits from further takeover or restructuring activity perhaps? Let’s face it, it wouldn’t stretch the imagination with Trian Partners dogging every step Pepsi takes and 3G, backed-up by Buffett’s mighty elephant gun, lurking in the background. Carving the gently declining, albeit highly profitable, soda business away from the tastier snack part is one of those things that hedge funds seem to endlessly agitate for, while spinning off Quaker Foods or buying Mondelez are other oft-touted options.
Nick Train could certainly be forgiven for indulging in a bit of corporate work-out prospecting, given his recent track record. The acorn was Cadbury*, which was taken over by Kraft Foods. Kraft, in turn, spawned the ridiculously-named Mondelez (sounds like a low-grade Spanish tourist resort). Now that Kraft is to merge with Heinz, why not move the money on elsewhere that would provide the same characteristics but also holds out the possibility of more action?
Perhaps he sees in Pepsi a baseline of S&P-level performance with growing dividends, but the added kicker of a potential takeover bid or more “free” spin-offs?
The Pepsi Challenge!
PS: On the spurious grounds of research, I decided to indulge myself and subject my other half to the delights of the Pepsi Challenge. Two glasses, two drinks, no labels. The results? A split in the camp! Pepsi and Coke: still difficult to separate after all those years…
* Cadbury is now sold under licence in the US by the Hershey Company, but that’s another story…
Disclosure: Long HSY, not (yet) long PEP
Disclaimer: This post is not a recommendation to either buy or sell. Please consult your investment advisor.