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Rating Change Detail - PEPSICO, INC. (PEP) - 2/20/2013
The stock was downgraded from Some Interest to No Interest on 2/20/2013 by the Patient Investor Strategy based on the principles of Warren Buffett. The score according to this strategy fell from 82% to 68%. A full detailed analysis of PEP using this strategy is included below. For a full detailed analysis of PEP using 12 proven strategies of Wall Street Legends, take a free trial to Validea.com

Detailed Analysis of PEPSICO, INC. (PEP)

Strategy: Patient Investor - Based on: Warren Buffett

STAGE 1: "Is this a Buffett type company?"

A bedrock principle for Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business. Companies with a "durable competitive advantage" are more likely to be found in these sub-industries: Brand Name Fast Food Restaurants, Brand Name Beverages, Brand Name Foods, Brand Name Toiletries and Household Products, Brand Name Clothing, Brand Name Prescription Drugs, Advertising, Advertising Agencies, TV, Newspapers, Magazines, Direct Mail, Repetitive Services for Businesses, Low Cost Producers of Insurance, furniture, or Low Cost Retailers. While you should be easily able to explain where the company's pricing power comes from (i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn't changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition), there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.

LOOK FOR EARNINGS PREDICTABILITY: [PASS]

Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 2.04, 2.41, 2.39, 3.34, 3.43, 3.21, 3.77, 3.92, 4.03, 3.92. Buffett would consider PEP's earnings predictable, although earnings have declined 3 time(s) in the past seven years, with the most recent decline 1 years ago. The dips have totaled 10.0%. PEP's long term historical EPS growth rate is 3.0%, based on the average of the 3, 4 and 5 year historical eps growth rates.

LOOK AT THE ABILITY TO PAY OFF DEBT [PASS]

Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. PEP has a debt of 23,544.0 million and earnings of 6,130.9 million, which could be used to pay off the debt in less than five years, thus passing this criterion. Buffett would prefer, however, for a company to have sufficient earnings to pay off its debt in less than two years.

LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY: [PASS]

Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for PEP, over the last ten years, is 31.8%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 10 years, from earliest to latest, is 29.4%, 30.0%, 27.8%, 35.6%, 31.9%, 41.2%, 35.1%, 29.3%, 30.7%, 27.2%, and the average ROE over the last 3 years is 29.0%, thus passing this criterion.

LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON TOTAL CAPITAL: [PASS]

Because some companies can be financed with debt that is many times their equity, they can show a consistently high ROE, yet still be in unattractive price competitive businesses. To screen this out, for non-financial companies Buffett also requires that the average Return On Total Capital (ROTC) be at least 12% and consistent. In addition, the average ROTC over the last 3 years must also exceed 12%. Return On Total Capital is defined as the net earnings of the business divided by the total capital in the business, both equity and debt. The average ROTC for PEP, over the last ten years, is 22.4% and the average ROTC over the past 3 years is 14.5%, which is high enough to pass. It is not enough that the average be at least 12%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROTC must be at least 9% for Buffett to feel comfortable that the ROTC is consistent. The ROTC for the last 10 years, from earliest to latest, is 25.7%, 25.5%, 23.9%, 30.6%, 25.7%, 25.0%, 24.4%, 15.0%, 15.3%, 13.2%, thus passing this criterion.

LOOK AT CAPITAL EXPENDITURES: [PASS]

Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. PEP's free cash flow per share of $1.56 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.

LOOK AT MANAGEMENT'S USE OF RETAINED EARNINGS: [FAIL]

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $18.12 and compares it to the gain in EPS over the same period of $1.88. PEP's management has earned shareholders a 10.4% return on the earnings they kept. This is unacceptable to Buffett, as management is not profitably allocating retained earnings. Essentially, investors would be better off if the company paid all earnings out to shareholders and let them invest the earnings on their own.

HAS THE COMPANY BEEN BUYING BACK SHARES: [BONUS PASS]

Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. PEP's shares outstanding have fallen over the past three years from 1,581,000,000 to 1,564,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.

The preceding concludes Buffett's qualitative analysis. If and when he gets positive responses to all the above criteria, he would then proceed with a price analysis. The price analysis will determine whether or not the stock should be bought. The following is how he would evaluate PEP quantitatively.

STAGE 2: "Should I buy at this price?" Although a firm may be a Buffett type company, he won't invest in it unless he can get a favorable price that allows him a great long term return.

CALCULATE THE INITIAL RATE OF RETURN: [No Pass/Fail]

Buffett compares his type of stocks to bonds, and likes to see what a company's initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $3.92 and divide it by the current market price of $75.50. An investor, purchasing PEP, could expect to receive a 5.19% initial rate of return. Furthermore, he or she could expect the rate to increase 3.0% per year, based on the average of the 3, 4 and 5 year historical eps growth rates, as this is how fast earnings are growing.

COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD: [PASS]

Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 3.47%. Compare this with PEP's initial yield of 5.19%, which will expand at an annual rate of 3.0%, based on the average of the 3, 4 and 5 year historical eps growth rates. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.

CALCULATE THE FUTURE EPS: [No Pass/Fail]

PEP currently has a book value of $14.52. It is safe to say that if PEP can preserve its average rate of return on equity of 29.0% and continues to retain 51.40% of its earnings, it will be able to sustain an earnings growth rate of 14.9% and it will have a book value of $58.33 in ten years. If it can still earn 29.0% on equity in ten years, then expected EPS will be $16.93.

CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now take the expected future EPS of $16.93 and multiply them by the lower of the 5 year average P/E ratio or current P/E ratio (19.3) (5 year average P/E in this case), which is 16.7 and you get PEP's projected future stock price of $283.42.

CALCULATE THE EXPECTED RATE OF RETURN BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now add in the total expected dividend pool to be paid over the next ten years, which is $22.55. This gives you a total dollar amount of $305.96. These numbers indicate that one could expect to make a 15.0% average annual return on PEP's stock at the present time. Buffett would consider this a great return.

CALCULATE THE EXPECTED FUTURE STOCK PRICE BASED ON AVERAGE EPS GROWTH: [No Pass/Fail]

If you take the EPS growth of 3.0%, based on the average of the 3, 4 and 5 year historical eps growth rates, you can project EPS in ten years to be $5.29. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio or current P/E ratio (19.3) (5 year average P/E in this case), which is 16.7. This equals the future stock price of $88.53. Add in the total expected dividend pool of $22.55 to get a total dollar amount of $111.08.

CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: [No Pass/Fail]

Now you can figure out your expected return based on a current price of $75.50 and the future expected stock price, including the dividend pool, of $111.08. If you were to invest in PEP at this time, you could expect a 3.9% average annual return on your money. Buffett likes to see a 15% return, and would even go down to 12%.

LOOK AT THE RANGE OF EXPECTED RATE OF RETURN: [FAIL]

Based on the two different methods, you could expect an annual compounding rate of return somewhere between 3.9% and 15.0%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 9.5% on PEP stock for the next ten years, based on the current fundamentals. Buffett accepts a 12% return, although 15% is preferable. This return is unacceptable to Buffett, thus failing the criterion.

For a full detailed analysis of PEP using 12 proven strategies of Wall Street Legends,
take a free trial to Validea.com

Rating Change Detail - PEPSICO, INC. (PEP) - 2/20/2013

Detailed Analysis of PEPSICO, INC. (PEP)

Strategy: Patient Investor - Based on: Warren Buffett