Are Coke and Pepsi still Value Investments?

The never-ending drama known as the Cola Wars has taken a surprising turn. Both Coca-Cola (NYSE: KO) and PepsiCo (NYSE: PEP) reported significant revenue losses in 2015.

Naturally this will cause many people to ask: are these two companies still classic value investments or not? Most value investors are aware of Warren Buffett’s belief that cola companies are a reliable value stock, because the demand for their products is fairly constant.

Yet, recent revenue figures show that may no longer be the case. Coca-Cola’s revenue fell by $1.71 billion in 2015, Coke started the year with revenues of $46 billion and finished with $44.29 billion in revenues. Pepsi suffered a revenue collapse in 2015, with a decline of $3.62 billion. Pepsi reported revenues of $66.68 billion in December 2014; and $63.06 billion a year later.

The revenue fall at both cola giants indicates a major drop in sales. It also raises the question: are the cola makers still making money? The answer to that is yes. The soda business is still very profitable, and both the cola giants are still flushed with cash.

The Cola Makers Still Generate a Lot of Cash

Coca-Cola reported a net income of $7.351 billion, a profit margin of 12.37%, a free cash flow of $1.255 billion, $10.53 billion in cash from operations and $19.9 billion in cash and short-term investments in December. Pepsi reported a net income of $5.452 billion, a profit margin of 9.24%, a free cash flow of $2.51 billion, $10.58 billion in cash from operations and $12.01 billion in cash and short-term investments.

These numbers make both cola giants value investments, because they have a lot of cash and generate a lot of float. It is obvious that they have really good business models; even though they may no longer have the momentum they once had.

Yet even if the momentum has stopped, both of these companies will continue to make a lot of money for a really long time. The cash from operations figures show these companies’ cash flow is very healthy.

Pepsi’s cash from operations actually increased slightly in 2014, rising from $10.51 billion at the beginning of the year to $10.58 billion at the end. On the other hand, Coke’s cash from operations fell slightly dropping from $10.62 billion at the beginning of 2015 to $10.53 billion at the end of the year.

Coke and Pepsi are obviously very healthy companies for now, but how long can that continue if their revenues keep dropping. The situation here reminds me of McDonalds (NYSE: MCD) – which is a very healthy company with dramatically declining revenues.

Why are Coke and Pepsi’s Revenues in Decline?

It looks as if the well-reported “Decline of Big Soda” has finally hit home at Coke and Pepsi. A number of trends are cutting into Coke and Pepsi’s sales and beginning to have an impact on revenues.

These trends include:

• There is simply less demand for Coke and Pepsi’s signature product: full-calorie cola. The New York Times reported that sales of full calorie cola dropped by 25% between 1995 and 2015. Daily soda consumption by teenagers in Philadelphia dropped by 24% between 2007 and 2013.

 

• The biggest cause of decline is simply that there are far more alternatives to soda out there including bottled water, Starbucks and other high-end coffees and teas, energy drinks, bottled juice, bottled ice tea and fancy sodas to name a few. Many of these products compete directly against soda in convenience stores and vending machines.

 

• Growing health concerns about soda and other sugar-sweetened beverages. This includes media reports linking soda to diabetes, heart disease, cancer and obesity. Such concerns have prompted widespread calls to ban sodas, tax them or limit sales.

• The decline in sales and revenues at major fast food chains which are among soft-drink makers’ biggest retailers. McDonald’s revenues fell by $2.03 billion in 2015 as the company struggled with a well-publicized drop in sales. Wendy’s (NASDAQ: WEN) saw its revenues fall by $146 million in 2015. Yum Brands (NYSE: YUM); which owns KFC, Taco Bell, Pizza Hut and A&W, reported a $17 million drop in revenue.

 

• The growing trend of major grocers such as Kroger (NYSE: KR), Safeway and Walmart (NYSE: WMT) to use low-priced house brand colas as a loss leader. Kroger sometimes peddles 12 packs of its Big K soda for as little as $1.67 each. On April 15, 2016, Walmart was selling 12 packs of its Great Value cream soda for just $2.68 apiece. In contrast a 12-pack of Coke normally sales for $4.49 and up. This trend could get worse with aggressive private-label discounters like Aldi expanding in the US market.

 

• A related problem is the use of all soda as a loss leader by big retailers such as Kroger and Walmart. This can generate sales but not necessarily revenue.

 

• Finally there’s income inequality and wage stagnation. As I have noted elsewhere incomes for most Americans have fallen. The average middle class family saw the value of its assets drop by 28% between 2001 and 2013 and its income fall by 4% in the same period. People simply have less money to spend on luxury products such as soda pop.

 

So given these trends are the soda pop makers still a good investment? I would say yes, because of the cash they generate and the dividends they pay. On April 15, 2016, Coke was offering a dividend of 35¢ a share and Pepsi a dividend of 70.3¢ a share.

The soft drink giants may not see any real revenue or sales growth anytime soon, but they will continue to generate a lot of cash for years to come. Nobody is going to lose any money on these stocks anytime soon.