Buy, Sell or Hold: PepsiCo Inc.

By , Contributing Editor, Money Morning •

PepsiCo Inc. (NYSE: PEP) shares plunged 12% in a single day last Tuesday – their worst one-day showing in 26 years – after the world’s largest snack maker and No. 2 soft-drink producer announced it would slash 3,300 jobs after its profits fell more than expected for the quarter and it lowered its forecast for the rest of the year.

The shares, which have traded as high as $79.79 during the past 12 months, closed Friday at $53.88. Pepsi’s 52-week low is $50.65.
Allow me to get right to the point. There’s been a lot of talk about this being the “opportunity of a generation” in the U.S. stock market. To make that comment about all U.S. stocks – across the board – is a major overstatement.

But there truly are some generational opportunities with certain specific stocks and entire sectors. And Pepsi – one of the world’s strongest consumer franchises, with a history that reaches back a century – clearly fits that bill.

To understand how we reached this point, some insight on the current mindset of the market is needed.

The U.S. stock market is in complete disarray right now.  Waves of selling are interrupted by strong short-covering rallies and pronounced lulls.  In this environment, with volatility at an all-time record, it’s difficult to talk about trading.  By the time I establish and explain one strategy, a new development in this rapidly moving environment has changed the rules, requiring traders to develop a new strategy.

But history tells us that the massive sell-off in stocks is similar in magnitude to the average sell-off since 1890.  And value indicators already have been screaming, “Buy” for months. The market is terribly oversold and offers tons of value as banks, hedge funds and other leveraged investors have been forced to sell – not because of fundamentals – but because of losses they’ve taken (and, in some cases, continue to take) in unrelated investments that force margin calls.

Here’s the problem. In a market such as this one, traditional measures – such as the afore-mentioned value indicators (such ratios as Price/Earnings, Price/Book Value, Price/Sales, and others) – often don’t work as they should. That makes bargain-hunting a much-more challenging – and potentially risky – exercise. As you’ll soon see, we’ve factored this lack of predictability into our strategy for this stock.

In a market such as this one, the problem is that emotions have taken over, and are now ruling the “thinking” that individual investors are using to guide their buying-and-selling decisions. When that happens, you can almost be sure that individual investors will invariably make their moves – and at precisely the wrong moments (selling when should be buying, and buying when they, in fact, should be selling). This is something you can count upon (for instance, nobody was selling their homes at the top, nor buying the market in the 2002 recession).

This time around, the cause of this systemic sell-off is the fragility of the over-leveraged financial system – and not the long-term viability of the U.S. economy as a whole.  When banks are not lending to one another – and are instead hoarding that potentially lendable cash, because they distrust the financial condition of their counterparty – the blood that feeds the U.S. economy (credit) ceases to flow, choking off economic growth.

And we have already seen increasingly aggressive policy responses by governments and central banks from all around the world.  These policies have enough firepower to blunt the sell-off, to reverse it, and to jump-start economic growth by the middle of next year.
Under such circumstances, good companies are being sold off along with bad ones for two reasons:

  • Weak companies will founder in the crisis and “good” companies are sold to meet margin requirements of the few institutions that remain brave enough (or foolish enough) to remain leveraged in this environment, because they wish to maintain at least a portion of their positions.
  • The same thing happens because of institutions that were trapped with high leverage, and are therefore now trying to hang onto their positions, praying for a quick turnaround.  Most leveraged players, however, are forced to raise liquidity to meet obligations or merely for panic.

It is precisely in these very volatile and difficult circumstances that investors seek to find the babies that have been thrown out with the bathwater. Enter the Purchase, N.Y.-based PepsiCo.

Founded in 1898, the company has navigated recessions, the Great Depression, two World Wars, and every crisis that’s touched the United States. And Pepsi came out stronger every time.  And with good reason: PepsiCo’s products are consumer non-cyclicals that suffer very little even in the worst economic times.

But the company just reported third-quarter profits that were down 9.6%, missing analysts’ estimates by 2 cents.  This compares to the 14% profit rise reported by archrival The Coca-Cola Co. (NYSE: KO), which beat earnings estimates by 6 cents in the same quarter.

Both companies are cutting costs, and Pepsi will be trimming some 3,300 jobs, or about 1.8% of its global work force, and will shutter as many as six plants.  This will cost between $550 million and $600 million in the fourth quarter, and will save the company $1.2 billion over three years.

Pepsi today has almost 50% of its sales coming from outside the U.S. market, including such economies as Japan, which has seen its currency strengthen substantially against the U.S. dollar over the past several years. What’s more, PepsiCo reported overall sales growth in both the second and third quarters – despite reduced volumes in the U.S. market. The company’s reduction in profit margin, which reversed gains made in the second quarter, has had more to do with the timing of its commodity hedges. Since the second quarter, the price of commodities (which Pepsi very prudently hedges), actually have dropped, which leads us to believe that margins will soon expand, creating a double-barrel benefit when viewed in tandem with the cost-savings being implemented.

While the company’s sales in the United States and in Europe will suffer some additional minor decline – as has been the case in every economic downturn – the benefit from expanding sales in emerging markets, widening margins and new-product introductions will restore Pepsi’s financial leadership position.

Emerging-market growth, even if slower than before, was still being estimated by the International Monetary Fund (IMF) this month at around 6% for next year.  The implementation of the policy responses by G7 countries around the world will be successful in re-liquefying the financial system, and emerging economies have plenty of room in their monetary, fiscal and foreign-trade policies to stimulate their economies.

As they do this, we will see these markets shift overwhelmingly to being driven by internal demand.  Incomes in these regions will continue to increase, and that obviously will translate almost immediately into higher purchases of such former “luxuries” as carbonated soft drinks and snacks such as Fritos Corn Chips.

And with harsh times ahead for the U.S. economy, “staying in” (which some theorists like to call “cocooning”) will trump dining out, which we believe also bodes well for Pepsi sodas and PepsiCo’s mega-brand snacks, produced by its Plano, Tex.-based Frito-Lay subsidiary, the largest snack food company in the world. As families weather the economic storm at home, watching sports events, movies and reality TV, what’s better to help pass the time but sodas and snacks?

That will translate into increased volumes and profits.

And some funds will start investing in the stock well ahead of the expiration of some anti-trust provisions, which will occur in a couple of years, which preclude the distribution of Gatorade by Pepsi bottlers.

Another strong positive of this type of company and specifically of PepsiCo is that in these times of banking illiquidity, cash is king.  And with cash and short-term investments of about $2 billion and a an annual operating cash flow of another $4 billion, Pepsi looks a lot like a money-printing operation, recognized by the strong investment grade ratings of its debt.  PepsiCo’s debt, even in these very distressed times, was trading at merely 200 basis points over U.S. Treasuries, or slightly more than 5%.  The dividend yield – as of Friday’s close – was 3.16%, a payout in line with U.S. Treasuries. But with Pepsi, investors also get all the capital-appreciation potential of a near-bullet-proof company (one that won’t succumb to such calamities as the one that befell American International Group Inc. (NYSE: AIG)), that can actually expand its margins and grow its profits while the United States stumbles through a financial-crisis-induced slowdown.

PepsiCo benefits from its long history of earnings consistency and growth, even in the worst of times.  With the just-announced cost-cutting plan, the company’s management team is working to return to that consistent performance. This long history, combined with the management’s current fix-it plan, will make Pepsi’s shares attractive to institutional buyers seeking stable growth with low risk, despite the recent earnings miss.  Confidence, however, might take some time to rebuild, as the company executes its cost-cutting strategy. 

Pepsi is trading at 13 times earnings and features a somewhat high Price/Earnings to Growth Rate (PEG) ratio of 1.43.  These high quality franchises, with their ability to deliver stable returns over the long haul, are typically terrific purchases in such unusual markets as this one.

Action to Take: Buy PepsiCo Inc. (NYSE: PEP). **

However, given the current market volatility, buy Pepsi’s shares in an increasing percentage as the market moves, by purchasing increasing amounts of the stock over the next 10 weeks, with the goal of holding this for the long-term – for a huge gain.

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[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]
** Special Note of Disclosure: Horacio Marquez holds no interest in PepsiCo Inc.