Pepsico

The stock market had a pretty good run since last September 2010. As the index goes up, opportunities in value proposition comes down. But there are some areas where the valuation is very compelling, and quite frankly, hidden in plain sight. Within the consumer staples space, there're a number of compelling valuations - Pepsico, P&G, Reckitt Benckiser, Anheuser Busch InBev, and Molson Coors for examples, and even Coca Cola though less compelling than the rest.

However, not many people are going to revved about it and say owning these consumer staples plays will outperform the market. Let me refer back to the previous note on risk - on a risk-adjusted basis, these looks like good excellent value in my opinion. This is, however, not for short term play or traders. Holding these companies would require a long term horizon where we expect to hold them indefinitely until better opportunities become available or we think we made a mistake. Moreover, such higher-quality businesses would not require as high a potential rate of return as a lower-grade security. Reason is we endeavor to evaluate equities just like a bond buyer would look at bonds - we don't go for the highest return without consideration on a risk-adjusted basis. If we will, we will only buy when the risk/premium is correct: like how it was during Mar 2009, you could buy any of the surviving banks at ridiculous valuation and and they were generally perceived by the market as very risky as the price tumbled, but the exact opposite actually happened, the more it fell, the less risk it presented, thus, the risk/premium for a class of stock that was then perceived as extremely risky was in fact priced for great future return in a low-risk manner at the extreme.

In today's market, certain consumer staples are selling not much more expensive than industrials or basic materials which are more cyclical in nature than consumer staples - in some cases, cheaper. Example, Emerson Electric, Boeing, United Technologies, Honeywell, 3M, all sell almost at par or over Pepsico valuation. The consumer businesses we are interested in make disposable products with very little economic sensitivity. In this economic environment, companies manufacturing industrial or consumer goods that have long lives - like autos, tractors, machineries, appliances or any durables - is an area of concern because their replacement decision can be easily delayed. The five consumer staples companies are basically higher quality businesses with market-leading positions in their principal products; well-recognized brand names; a barrier to entry; with long product cycles but short customer-repurchase cycles; and with relatively low capital requirements that allow the business to generate high cash returns on tangible assets while growing.

Personally, I own all the five companies (in addition, I own Coca Cola but Coke is not as cheap as it was last year so I don't recommend it at this time). Particularly, I would focus discussing on Pepsico in this note, PEP constitutes the largest of my position (close to 30% of my managed portfolio).

I started with a small position (less than 7%) back in Oct 2010 and added intermittently. With the recent retreat, my position was increased by another 50% because I think it is unfairly punished - at $64, it is selling for no more than 14.5x 2011 adjusted earnings for a business that has a long term potential growth of 9-11%. People often ask what is the market missing and what unique insight you bring. I bring no unique insight. It is as if you must be so astute, and have some very complex thesis or story that no one else sees in order to identify an undervalue proposition. Some times, it doesn't. The fact of the matter is there are times when quality businesses are undervalued and we just have to be alert and smart enough to recognize those moments and chose to own them. In 1988, when Buffett started buying Coca Cola, what special insights does he brings besides knowing that KO was selling at 12-14x earnings. That is all there is. Most times the market understands, sometimes it doesn't - that's why in most years, KO sells for 17 to 22x earnings while in a few others, 12 to 15x or 60x when it doesn't.

Pepsico is somewhat distinct from Coca-Cola in that Pepsico is a partial beverage and partial snack foods business. On the beverage front, Pepsi owns its namesake carbonated soft drink (CSD) brands, Mountain Dew, Gatorade and others. On the snack food business, the primary divisions are Frito-Lay and Quaker Foods. Pepsico is the dominant player in the snack food arena. If you walk down the chips aisle of a grocery store, it is hard not to find a bag that's a Pepsico brand. Sure, there're niche players but Frito-Lay has some of the highest market share of any major product in the grocery store. In fact, Pepsico's fortunes are much more driven by snack foods, rather than beverage. They are the powerhouse in snacks just like Coca Cola in CSD. Frito-Lay accounts for about half of Pepsico business and its margin and return on assets are far better than its beverage business.

What's the expected returns if we buy shares today at $64? On a forward basis, we estimate PEP to earn a normalized $4.42. They should be able to keep about 80% of that (from 1994 to 2010, they had kept between 79-135% of normalized earnings). So free cash flow would be around $3.53 per share. That's a 5.5% free cash yield. On top of this, Pepsi should deliver an annual volume growth of 1.5-3%, primarily from increase snack-food sales and international expansion. Add in some pricing of 2%, largely to compensate for inflation, the expected annual return is 9-10.5%. Compared to S&P, S&P500 is estimated to earn $95 for 2011, of which you keep maybe 50% as free cash flow. At 1300 on the index, the resulting FCF of $52 gives you a 3.7% free cash yield. Add on 3% inflation and 1.5% for organic growth, the average investor is potentially looking at 8.2% annual return from the market. In my opinion, Pepsico is a higher-quality business with lower risk than the average S&P 500 company, it should trade at a premium to the market rather than a discount. When an excellent company like this trades at a decent annual rate of return and with that kind of discount to the market, it's a very attractive risk-adjusted buy.

One thing when you focus on the forward rate of return is it keeps you centered on the fundamentals of the business, its economics and its cash flows. Thus, we are not counting on others to pay us a higher multiple or trying to figure out what the future P/E or cash-flow multiple should be - if they will, all the better. For example, in five years time, PEP should deliver at least $6.8 per share in adjusted earnings. If P/E multiples remains the same as today of 14.5, stock price will be $98.6 - an annual compounded return of 9% excluding dividend. Obviously, if the market values the multiples more by then, the annual compounded would be more than 9%. But we don't need to rely on that in order to make money. All we need is just to focus on the fundamentals. Owning a solid business with a 9-10% real return while lying in wait for better opportunities to emerge seems to me a pretty sound approach to making money.

Selected actual historical performance of Pepsico provided:

Table 1

Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
Non-GAAP EPS	4.14	3.71	3.67	3.38	3.00	2.66	2.32	2.07	1.96
Trailing 10-yrs annual compound growth	9.55%	9.84%	11.54%	11.29%	10.54%	8.92%	6.73%	6.62%
Trailing 5-yrs annual compound growth	6.61%	6.87%	9.67%	10.28%	8.92%	9.85%	9.81%	10.92%	11.06%
Dividend	1.89	1.78	1.65	1.43	1.16	1.01	0.85	0.63	0.6
Payout as a % of non-GAAP eps	45.70%	47.88%	44.90%	42.20%	38.64%	37.99%	36.70%	30.42%	30.39%

Continued table 1

Year	2001	2000	1999	1998	1997	1996	1995	1994
Non-GAAP EPS	1.66	1.45	1.23	1.16	1.10	1.13	1.21	1.09
Trailing 10-yrs annual compound growth
Trailing 5-yrs annual compound growth	8.57%	5.09%	0.42%	1.22%	2.37%
Dividend	0.58	0.56	0.54	0.52	0.49	0.45	0.39	0.35
Payout as a % of non-GAAP eps	34.60%	38.27%	43.38%	44.45%	44.47%	39.34%	32.30%	32.09%

Table 2

Stock price in USD
Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
High	68.11	64.48	79.79	79	65.99	60.34	55.71	48.88	53.5
Low	58.75	43.78	49.74	61.89	56	51.34	45.3	36.24	34
Year-end closing price	65.33	60.8	54.77	75.9	62.55	59.08	52.2	46.62	42.22
Annual compound growth since low of 1994 to end of respective year	9.20%	9.31%	9.20%	12.48%	11.83%	12.34%	12.26%	12.29%	12.50%

Continued table 2

Stock price in USD
Year	2001	2000	1999	1998	1997	1996	1995	1994
High	50.46	49.94	42.56	44.81	41.31	35.88	29.38	20.56
Low	40.25	29.69	30.12	27.56	28.62	27.25	16.94	14.63
Year-end closing price	48.69	49.56	35.25	40.88	36.25	29.25	27.94	18.13
Annual compound growth since low of 1994 to end of respective year	16.22%	19.05%	15.79%	22.82%	25.47%	25.99%

Table 3

Stock price in SGD
Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
High	89.26	89.57	114.18	114.08	104.26	101.56	95	84.3	96.84
Low	83.52	65.54	72.22	94.95	90.97	84.53	76.98	62.87	60.36
Year-end closing price	84.11	85.33	78.82	109.39	95.93	98.32	85.28	79.29	73.32
Annual compounded growth since low of 1994 to end of respective year	8.17%	8.80%	8.84%	12.09%	11.94%	13.23%	13.05%	13.61%	14.24%

Continued table 3

Stock price in SGD Year 2001 2000 1999 1998 1997 1996 1995 1994 High 92.38 86.73 71.51 71.43 63.46 50.72 41.6 33.03 Low 71.76 50.76 51.1 48.04 40.31 38.81 24.79 22.13 Year-end closing price 90.13 85.81 58.73 67.88 60.74 40.94 39.52 26.48 Annual compounded growth since low of 1994 to end of respective year 19.19% 21.36% 17.66% 25.13% 28.71% 22.76%

Table 4

PE based on non-GAAP eps
Year	2010	2009	2008	2007	2006	2005	2004	2003	2002
High	16.47	17.39	21.71	23.39	21.98	22.69	24.06	23.61	27.32
Low	14.21	11.81	13.54	18.33	18.65	19.31	19.56	17.5	17.36
Year-end closing price	15.8	16.4	14.9	22.48	20.83	22.22	22.54	22.51	21.56

Continued table 4

PE based on non-GAAP eps
Year	2001	2000	1999	1998	1997	1996	1995	1994
High	30.36	34.44	34.51	38.67	37.49	31.72	24.33	18.85
Low	24.22	20.47	24.42	23.79	25.97	24.09	14.03	13.41
Year-end closing price	29.3	34.18	28.58	35.28	32.9	25.86	23.14	16.62

Observations:

1. Non-gaap eps compounded at a rate of about 9% from 1994 to 2010, from $1.09 to $4.14, on US dollar basis.
2. Today, stock price is priced about 14.5x 2011 eps. In July 1994, PEP was priced 13.5x (a little better than now) at its low for the year. Had an investor bought at its low of $14.63 (in July 1994), he would have compounded at at rate of between 9.2% to 25.99% on USD basis, depending on his holding period. Had he held till 2010, he would have achieved 9.2% compounded return (ex div) for 17 years, or at end of 1996 knowing the rate of return is unsustainable, he would have sold and achieved a compounded rate of 25.99% for 3 years and waited for better chances (all figures on US dollar basis).
3. Let's say the investor is a Singaporean, he would have paid SGD22.13 in July 1994, and compounded at a rate of between 8.17% to 28.71%. If he held till end 2010 for 17 years, he would have achieved a compounded rate of 8.17%. If he sold at end of 1997, he would have compounded at 28.71% for 4 years of work. All are exclusive of dividends.
4. In addition to above gain, for an investor who bought in 1994, and not sold PEP stock before 6 Oct 1997, he would be entitled to 0.1 Yum! Brands stock for every PEP stock he held. And if he had held on to the YUM stock to 2010, the 0.1 YUM stock is worth about USD4.9. That means, the PEP stock which he bought in 1994 low, would have been worth USD65.33 (PEP stock) + USD5.2 (YUM stock) = US$70.53

If an investor buys today and holds for the long run as in 15 to 20 years, he'd likely get decent return. In between, the stock can go about anywhere (maybe if lucky enough again, you could get a 20% compounded return in any of the years in between the very long term. Then when you find the pendulum is at the extreme, you could always sell and wait. The pendulum is hardly at its happy medium. Otherwise, even if the stock don't misbehave, you still will likely get 9-10% return which isn't all that bad, or if I am wrong, 6-8% (on US dollar basis).

Now, what're the alternatives in July 1994 for a Singaporean investor? We know a Singporean PEP investor would have make 3.8x (excluding YUM stock) from his initial outlay of SGD22.13. Here're a few alternatives:

1. OCBC: July 1994 @ $3.5, Dec 2010 @ $9.88, return of 2.82x
2. UOB: July 94 $7.54, Dec 2010 @ $18.2, return of 2.42x
3. DBS: July 94 $7.66, Dec 2010 $14.32, return of 1.87x
4. Haw Par: July 94 $2.98, Dec 2010 $6.13, return of 2.05x
5. APB: July 94 $8.1, Dec 2010 $19.6, return of 2.42x
6. NOL: Jul 94 $1.93, Dec 2010 $2.18, return of 1.13x
7. F&N: Jul 94 $2.66, Dec 2010 $6.41, return of 2.41x
8. Singtel: Jul 94 $3, Dec 2010 $3.05, flat return

(All prices obtained from Reuters interactive stock chart)

It's hard to find an outlier but not that there's none. There's one - Sembcorp Marine that sold for $0.86 in July 1994, and ended at $5.37 in Dec 2010, giving a return of 6.25x - double even the best return among the 8 examples. The problem is the stock was flat, fluctuating between $0.50 to $0.8, for the next 10 years. Share prices hardly go no where for a decade for no reason. The reasons for a flat return could be numerous: 1) business could be ill-managed, or 2) lack of decent business economics or growth, or 3) simply priced too aggressively where future gains have been priced into the current price, or 4) others. So that meant the investor who bought in 1994 had bought at the highest price point during the next 10 years. Then from 2005 onwards, the stock simply just spiked up. So why the surge? I don't know the exact cause because I don't follow SembCorp but if I have to guess, it was either the stock was too unloved where people have forgotten about and then woke up to reality, or there was a very major structural change to its business economics where it enjoys a high growth rate.

And where does it Pepsico stands? With PEP return of 3.8x (on SGD basis) from 1994 to 2010 (17 years, that is a long run), it will be ranked top among the 8 examples. But if you include Sembcorp, PEP would come in second place but I personally think Sembcorp, at that time, would not be an easy investment decision that could be made with strong conviction.

Sure, among the 8 examples, there may be some that were simply too expensive and thus became a disadvantage and created an anchor to future stock price gain because when it is expensive, investors are simply bringing future gain into the present. For example, Singtel was listed in Nov 1993 at $3.5 or something. That was priced at 45x earnings. So instead of acting as a tailwind to advance the stock price, it acted as an anchor when compared to PEP which at that time (July 1994) was priced at a low PE. Had Singtel been priced reasonably in July 94, say at 12x earnings, it would be available at $0.93 instead of $3 to $3.5. And it would have delivered a return of 3.27x by end of 2010, topping all the 8 SG examples. Had it been priced at 10x pe, it'd end up with 3.9x return, topping PEP. But history is not so. So what does all these tell us? That fundamentals and multiples matters more than anything else.

But I have to say even PEP at today low P/E would not provide spectacular return, somewhere in the region between 9-11%, excluding forex losses, which is almost a sure thing for the long horizon. It's hard to tell how hard SGD will depreciate against USD for the next decade or two since that is the time horizon I am proposing to hold. Currency don't fall in a straight line - up next year, up again the year after, down the next and so on. Is it possible that SGD will depreciate at the rate of the past 2 years? It could but unlikely in my opinion. Let's take a look at history. Below shows the average rate of decline for the currency pair of SGD/USD since 1960.

	1960	1965	1970	1975	1980	1985
Average annual rate of decline to 2010	-1.5925%	-1.7642%	-1.9771%	-1.5528%	-1.4770%	-1.8615%
Continued

	1990	1995	2000	2005
Average annual rate of decline to 2010	-1.3932%	-0.3040%	-2.1982%	-3.4310%

From 1960 to 2010, a period of 51 years, USD has depreciated by 66% against SGD, at an average of rate of -1.59% annually. If you noticed, the fx from 1960 to 1970 was flat. SGD was initially pegged to Sterling Pounds till the early 1970s and then pegged to the US dollar for a short period of time. It was only from 1973 onwards, that SGD was unpegged. That probably explains why SGD against USD was almost flat from 1960 to 1972, going from 3.06 to 2.8, respectively, before plunging to 2.45 in the year after it was unpegged in 1973. So taking 1960 to 1973 numbers would likely distort the real picture of the long term average rate of decline. It's better to look at numbers from 1975 onwards. From 1975 to 2010, a period of 36 years, the average rate of decline is 1.55% annually. 1980 to 2010 is 1.477%. And so forth.

The period of 2005 to 2010 is either an outlier or the new normal rate of decline. Let's say it's the new normal rate of decline (but things can always be worse, there's no such thing as a worst-case short of total loss), taking into account that US economy is not as vibrant and healthy as it was in the 1980s to 1990s. So if the new normal is an average decline of 3.4-3.5%, then it did take away about 3.8% from the 9% of PEP growth, ending up with yearly return of 5.2%. So where does 5.2% real return brings you in 17 years? You will have 2.36x of your principle (excluding dividend), which is about the same performance had you purchase UOB, F&N or APB in 1994 and held for the next 17 years.

Another table for additional info which shows the SGD/USD rate of decline in the respective 10-year period:

For the period	1971 to 1980	1981 to 1990	1991 to 2000	2001 to 2010
Average annual rate of decline	-3.4783%	-1.5210%	-0.0220%	-2.7910%

However, none of the above reflects the worst rate of decline in a 10-year period since 1960. The worst 10-year period average rate of decline was 1986 to 1995 at -4.2%. If for the next 17 years, the average rate of decline is 4.2%, then it did chop roughly 4.5% off the top of 9%, giving a real return of 4.5%, which will exactly double your principle in 17 years. Is that the worst case? Of course not because worst case means total loss and many things (including externalities) or assumption can go wrong, it is just a matter of likelihood and if you have thought through it logically, clearly and deep enough.