Soft Drinks Bubble in Hard Times


By Richard Joy One defensive group that has been gaining strength recently despite the market's persistent decline is soft drinks. This industry, dominated by Coca-Cola (KO) and PepsiCo (PEP), seems to be quenching investors' thirst for consistent earnings growth even in a lackluster economic recovery.

Year-to-date through Oct. 4, the Standard & Poor's Soft Drinks index fell 4%, much better than the 29.5% decline in the S&P 1500. The industry's recovery follows some volatility in Coca-Cola over the summer, as investors questioned whether soft-drink volumes and earnings would meet Coca-Cola's growth targets in a weak economy. PepsiCo shares were weak on concerns of slowing growth, particularly at its Frito-Lay snacks unit, which lowered prices to boost sales.

The summertime slump brought price-earnings multiples for the major U.S. soft-drink makers to the lower ends of their historical ranges of about 20 to 30 times forward earnings. We at S&P expect the industry index to modestly outperform the broader market in the near term, reflecting a continued rebound in volume growth trends in the U.S. and around the world.

PEPSI SPIRIT. PepsiCo's third-quarter earnings release on Oct. 8 helped lift the stock. We kept our 5-STARS (buy) recommendation after it reported third-quarter EPS of 56 cents, a penny above expectations, vs. 49 cents a year ago. Worldwide sales rose 4%, to $6.38 billion, reflecting 4% case volume growth in the period.

PepsiCo's snack profits gained 9.5%, while its Quaker Foods profits rose 14%. Worldwide, PepsiCo's beverage profits increased 12.5%, led by a 14% gain in Gatorade/Tropicana profits. Geographically, beverage profits rose 11% in both North America and international markets.

We expect PepsiCo's volume trends to continue to show improved momentum in the fourth quarter. We kept our 2002 and 2003 EPS estimates at $1.96 and $2.20, respectively, up from $1.72 in 2001, which excludes 6 cents per share in goodwill amortization. And we think the shares are attractive given PepsiCo's market leadership positions, growth potential, and EPS outlook.

COKE'S FIZZ. For rival Coca-Cola, earnings this year are expected to show a solid recovery, tempered by potential foreign currency headwinds. Coca-Cola, which is ranked 4 STARS (accumulate), will report third-quarter results on Oct. 16. We expect EPS of 49 cents (the consensus forecast is 48 cents), up from 43 cents a year ago. Earnings should benefit from 4% to 5% global volume growth, favorable raw-material costs, and higher retail pricing in the U.S.

Coke's volume growth should be lifted by the successful launch of Vanilla Coke earlier this year, along with strong growth for its Dasani bottled water. Beverage-case volume growth in North America is expected to be strong, at 3.5% to 4%. We should note that this volume measure does not include Coke's acquisition of the Seagram mixers and a joint venture with French food company Groupe Danone (DA) for Evian and Dannon bottled water. Including these deals, reported volumes for North America could be up in the 6% to 7% range.

Among Coke's regions, volume growth in Asia and Africa should show the most robust gains, of roughly 11% to 12%, in the third quarter. China and India should continue to report strong growth trends. Less robust volume growth is expected for Europe, up only 4% or so. The trouble spot remains Latin America, where several countries continue to face weak economies.

PROMISING PROSPECTS. Despite some soft areas, long-term prospects remain bright for Coca-Cola's international beverage businesses, as key markets such as Mexico and Germany are beginning to show improved trends. U.S. beverage companies should reap generous rewards in foreign markets, which represent significant opportunities for increased nonalcoholic beverage consumption.

While we're positive on the prospects for both companies, we prefer PepsiCo over Coca-Cola, primarily reflecting a more reasonable relative valuation coupled with a strong growth outlook for PepsiCo's beverage and snack food businesses. At a recent price of $41.57, PepsiCo is trading at less than 19 times our 2003 EPS estimate, vs. 26 for Coca-Cola, despite our expectation for more robust earnings growth for the former over the next three years. We view PepsiCo shares as undervalued and believe they'll approach $50 over the next 12 months. Analyst Joy follows beverage and food stocks for Standard & Poor's


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