Downgrading an American icon and buying another

These two buy recommendations have generated decent profits, but it’s time to pull the plug on one of them. Analyst Rodney Hobson explains his thinking.

16th October 2024 08:44

Rodney Hobson from interactive investor

Fine words butter no parsnips, according to an archaic saying, and they do not put the fizz into a bottle of cola. Reassurances that business is resilient at food and beverage group PepsiCo Inc (NASDAQ:PEP) do not fully compensate for a disappointing third quarter.

Pepsi admitted that net income fell 5.5% year-on-year to just under $3 billion in the three months to the end of September despite a slippage of only 0.6% in net revenue. The problem was that although the cost of sales fell 2.6%, administrative expenses rose 3.3%.

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Chairman and chief executive Ramon Laguarta reckons the business has remained “resilient”, which is a great word that smacks of optimism but in reality tells shareholders very little. For good measure, he refers to “subdued category performance trends” which carries even less meaning. Investors should always be suspicious when any company puts out senseless jargon.

Equally annoying – though this nonsense is widespread among groups that sell to consumers – is to talk of “incremental investments to improve our marketplace competitiveness." These are not investments. They are price cuts or promotions that reduce income and increase costs. This so-called “investment” will continue as the group faces faltering consumer demand. Growth will be subdued, so do not expect any price increases to boost income or margins for the rest of this year at least.

In contrast, the problems are tangible. Product recalls at Quaker Foods North America during the second quarter continued to hit the business, as did conflicts in the Middle East and elsewhere. Laguarta talks of “strong cost controls” but these have not prevented expenses from rising.

Pepsi claims to be gaining market share in its food businesses but that has not prevented growth on this side of the business slowing from double digits to single digits.

There are, we are told, “pockets of strength” in Southeast Asia, parts of Eastern Europe, India, and Brazil but China is slowing down and there is weaker growth in Mexico and Western Europe.

Pepsi still expects earnings per share to rise by at least 8% this year, a tough target after a 4.9% fall in the latest quarter. It admits that recovery in the US has been slower than it expected, and it has reduced its full-year guidance for revenue growth to low single digits, compared with 9.5% in 2023.

Only three months ago growth was revised down from “at least 4%” to just 4% and although the revisions are subtle, they are moving in the wrong direction. Pepsi reckons that it will not have to downgrade again in the final quarter but, since it does not expect any major changes to market conditions, nothing is guaranteed.

Pepsi shares have been moving sideways since the beginning of 2022, though they narrowly failed to push through the $200 barrier in May last year when sales were rising strongly. At the current level around $176 the price/earnings (PE) ratio is 26, which assumes optimistically that life will not get any tougher this side of Christmas and better times will start to roll in the New Year. The yield is some consolation at 3%.

Source: interactive investor. Past performance is not a guide to future performance.

Results from rival drinks maker Coca-Cola Co (NYSE:KO) are due later this month, and investors should watch closely to see if its stronger figures in the second quarter are repeated. The shares have performed better than Pepsi’s and are close to their high of $72.50, where the PE is slightly more challenging at 28.6 but the rating looks more justified.

Hobson’s choice: I have generally favoured buying Coca-Cola rather than Pepsi and that preference remains. Coca-Cola just about remains a buy, although investors may prefer to hold back and hope to buy in at a slightly lower level. Existing shareholders who followed my earlier buy recommendations are well ahead but should stay in. I am inclined to reduce Pepsi from buy to hold, as there are too many uncertainties.

Rodney Hobson is a freelance contributor and not a direct employee of interactive investor.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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