PepsiCo May Have Lost Its Fizz

Everyone knows PepsiCo Inc. (NYSE: PEP). The question is whether investors should still love it.

Shares of this leading producer of food, snacks, and nonalcoholic beverages dropped after the company released its second-quarter earnings report.

Profits declined about 6.5%, and the stock handed back its runup from this spring. Share prices are flat for the year, and there's slower growth on the horizon, as CEO Indra Nooyi discussed on the earnings call. Did the market overreact, or did it react correctly?

The general tone of the call was that PepsiCo was the victim of a turbulent market, and that it is battling "headwinds" from increasing commodities prices (a devalued US dollar) and lower overall consumer demand (recessionary spending impact). My interpretation: Nooyi blames the US government. Though that's a widely popular (and likely accurate) thing to do right now, I doubt it's the right way to handle the flat share prices.

Specifically, PepsiCo is facing declining US demand for carbonated soft drinks. Consumers are becoming more health-conscious and substituting alternative beverages for products such as Pepsi. This isn't a huge deal, because the company is very well diversified across the beverage market (it owns Gatorade and Tropicana) and beyond into snacks and quick-ready foods (FritoLay and Quaker).

Looking directly at its primary competitor, The Coca-Cola Company (NYSE: KO), we see a much larger focus on the carbonated soft drink market (and 100% of Coca-Cola's business is beverages). But we also see a greater spread across a global distribution network, where the shenanigans in the US Congress, a declining US dollar, and the US recession have much more limited impact.

Looking at a cross-section of some of the food and beverages players can help us paint a clearer picture of PepsiCo's position.

The two stats I tend to rely on the most are the price-to-earnings-growth (PEG) ratio and the free-cash-flow (FCF) margin. The PEG ratio is a quick and dirty comparison tool for spotting value opportunities. A low PEG means we can buy projected earnings at a discount. Relative to its competitors, PepsiCo is not a standout, and it had a PEG in line with Coca-Cola until the latest dip.

Although PepsiCo's revenues have grown consistently over the past eight years (primarily through acquisitions), we see a steadily sinking FCF margin, sliding to 7% from 12% in 2002. This is an unhealthy trend for the important metric of cash generation.

Modeling the valuation for myself, in light of the longer-term trends and the executives' projections on the earnings call, I arrived at a target valuation range of $53.35 to $57.92 per share.

This chart shows the projected valuation range stretched over time, considering a 10.5% discount rate and a projected growth rate of 7.7%. The buy/sell bands are a function of the stock's historical price volatility.

When it comes down to it, if you buy PepsiCo, you're buying the expectation of a US recovery and stabilization, since that is the core driver of the company's business, according to the latest earnings call. Unfortunately for PepsiCo, at a 0.53 beta, I can think of a number of investments I'd rather be in for that play.

On the other hand, if you're putting your faith in the global economy, Coca-Cola's healthier margins would suggest it isn't an unreasonable choice.

All this beverage talk is parching my palate. My apologies, Pepsi and Coke, but I'm going to go enjoy a beer.