Last April, PepsiCo (PEP) announced that it would purchase two bottling operations and gain absolute control over 80% of their North American bottling operations.  Speculation swirled as to how Coca-Cola (KO) would respond, and today they announced that after nearly a year of negotiations they would in fact buy the North America bottling operations of its largest bottler Coca-Cola Enterprises (CCE).  Both Pepsi and Coke had spun out these capital intensive bottling groups years ago, and the stockholders of KO in particular proved to benefit greatly as a result.  However, they both believe that the market is changing as consumers prefer healthier and more extensive options than just carbonated soft drinks.  These deals will give the companies much more control and flexibility in the distribution of their products.

Coke’s move reverses a strategy to divest bottling operations that began 23-years ago, although it never totally gave up all interest in CCE as it did still own 34% coming into the deal.  Judging by the relative performance of the stocks during that time, it is clear that the strategy had proved its worth.  Since CCE began trading in late 1986 it has returned just 249%, while Coca-Cola has enjoyed much faster growth as its stock advanced 1113% over the same period.  In terms of average annual return, CCE gained just 4% versus nearly 11% for Coke, as a benchmark, the S&P 500 returned about 5.5%.  When looking at the deal through the prism of history, it appears that Coke is trading growth for greater flexibility to address modern challenges.  In the case of Pepsi, the opposite is actually true as the bottling stocks outperformed their former parent company.

The deal valued at about $12.2 billion is actually an asset swap that will give Coca-Cola 90% control over its North American bottling, but will decrease its ownership of European bottling.  Coke is absorbing $8.88 billion worth of debt held by the bottler, but they say they will save $350 million in costs over the next four years and if the Pepsi deal provides any guidance it could be significantly higher.  CCE shareholders will get a $10 per share special pay-out and will receive one-share in the European-focused company.

While Coca-Cola has achieved impressive growth in emerging markets, volume in North America has been in steady decline since 2005.  It is still the largest and probably most important market, and Coke and Pepsi are confronting consumers changing tastes head on.  Control over bottling operations gives them the opportunity to more quickly shift priorities and strategies as they see fit.  However, the bottling operations come with lower margins and higher fixed costs than the old model of producing concentrate and selling that to the bottlers to mix and bottle it.

We had just upgraded CCE to Fairly Valued from Overvalued as of this week’s report, which gives us some concerns over the purchase price Coke is paying for this slower growth business line.  However, it is clear that both Pepsi and Coke see a changing environment in North America, and they must proactively seek solutions to new challenges as the cola business evolves.  Integrating the supply chain may put a slight drag on growth and apply pressure to margins, but in the end, unless Coke can more aptly serve North American consumers changing tastes, growth would continue to dwindle anyway.

Costco Wholesale (COST), the largest discount warehouse retailer in the nation, reported fiscal first quarter results that showed steady improvement from a year ago.  The quarter went just about as analysts had expected with EPS coming in at 60 cents per share.  Net income was up 1.1% from a year ago at $266 million.  Sales, including membership fees, also came in right in line with expectations at about 6% over a year ago, $17.3 billion in total.  U.S. same store sales showed a respectable gain of 3% as well, but international same store sales were really the highlight of the day coming in 13% better than last year.  The company saw margins pressured somewhat by lower food and electronics prices, as it fell nine basis  points to 10.88%.

In addition to the largely unremarkable quarterly results, the highly visible dispute between Costco and Coca-Cola (KO) ended today.  In mid-October Costco announced that they would no longer carry Coke products do to inflexibility in offering attractive discount pricing.  These sorts of rifts are certainly not out of the ordinary in the course of negotiations, but this one was notable because of the very public nature.  According to Costco, they never pulled the products off the shelf but instead simply did not order anymore.  As of today, differences were resolved and Coke products will be available at Costco in the coming days.  In reality, the squabble had a minimal effect on either of these massive company’s bottom lines, but some loyal Coke consumers may have been a little agitated by the nuisance.

Coming into this week we had a Fairly Valued stance on Costco, and there was nothing unexpected in the report that will make us change that rating in the coming week.  Based on  what the market has been willing to pay for Costco in the past ten years, it is currently comfortably within the expected price-to-cash earnings range.  However, at a price-to-sales of 0.361x, it is certainly near the low end of its traditional valuation range of 0.360x to 0.544x.  Given the consistent performance of Costco throughout what has been a tough time for retailers, we would expect to see Costco trading in the low to mid $60’s based on the current fundamentals.  That being said, there are other discount retailers that we believe are more attractive at current prices as you can see from the chart of discounters that we currently cover to the right.

The stock market is pointed higher on Tuesday morning in large part because of five Dow components reporting earnings that have beaten expectations.  Coca-Cola (KO), DuPont (DD), Caterpillar (CAT), United Technologies (UTX), and Merck (MRK) all reported earnings today and each of these stocks are bellwethers in their respective industries.  Easily the most impressive of these profit reports was Caterpillar who absolutely destroyed analysts estimates of $.22 per share reporting $.60 per share.  To demonstrate just how gloomy the estimates were, the results represents a decline of 67% in net income and revenues slid 41% in the quarter to $7.98 billion.  In fact, even though earnings were far better than anticipated, revenue fell well short of expectations for sales of $8.86 billion.

How does a company see its top line drop by 41% and then beat profit expectations by 272%?  There are two reasons, first Caterpillar has aggressively cut costs in 1H09.  They have slowed production and worked to reduce existing inventory, and they have dramatically reduced employment.  The company that had about 113,000 employees at the end of 2008 has planned to reduce headcount by about 20%.  In this very challenging and uncertain environment with revenue streams drying up, the company knew that it must get leaner in order to navigate this recession.

The second reason for the huge earnings beat was that analysts were simply too bearish, and according to Yahoo! finance the consensus EPS estimates 3 months ago were 45% higher than they were coming into the release.  This wave of bearish sentiment seems to coincide with a general improvement in the global economy.  This is likely because in April the company reported its first loss in 17 years citing slumping sales and charges related to headcount reductions.  The company also lowered guidance for the full year at that time.  When the one time charges were stripped out, CAT did much better than estimated, but the loss sent analysts sentiment reeling in the face of an uncertain future.

The stock has bounced up as much as 12% in morning trading because of the much better results.  We continue to rate this stock as Undervalued because on a price-to-cash earnings and price-to-sales basis the stock compares favorably to where it has been valued in the past, including the declining fundamentals.  The results were accompanied by a lift to guidance saying that there is still a great deal of uncertainty and raised full year profit guidance to about $1.25 per share.  After today’s advance the stock is trading at over 30 times guided earnings for 2009, which is not particularly appealing.  However, there are comments from the company that are optimistic towards the second half and beyond.  The company, being the largest producer of construction and mining equipment, is a bellwether for the global economy.  So, we have attached some key portions of their global outlook for the rest of the year.

• One key component to the outlook is global stimulus efforts.  Caterpillar estimates that governments around the world have allocated $4 trillion in stimulus spending with about $1.8 trillion of that dedicated to infrastructure spending.  There exists the possibility that more spending programs have yet to be announced.  Clearly, Caterpillar would be a primary benefactor of this money.
• Economic activity has slowed in the first half, but that decline appears to have moderated.
• Growth from developing countries has outpaced growth in the developed world thus far in the cycle.  China in particular has started to grow through eased monetary policy and spending on infrastructure.
• Caterpillar expects the global economy to shrink by 1.3% in 2009, with developed countries slightly worse than the mean declining 1.5%.

“I would say non-financials, we have been talking enough about the banks, what about DuPont and Caterpillar and Coke, a lot of the companies, America, reported earnings that haven’t been that strong and the guidance has been ugly.” Fox Business Network 4/21/2009

The exuberance exhibited during the six week, nearly 30% rally is showing signs of weakening.  The rally was fueled mostly by a sense that the financial stocks are stabilizing, and the bottom has already been put in.  However, as more non-financials report to the market, there is a recognition that there is a significant amount of difficulty ahead for the rest of 2009.  

Caterpillar (CAT) shares are trading down about 4% this morning as the Big Cat swung to its first loss in 16 years and lowered guidance for the rest of the year as a difficult sales environment is expected to persist.  Sales were particularly weak, down 30%, in the U.S. because of the contraction in home building and other construction projects.  Housing starts are less than one-quarter the level they were at their peak in January 2006.  The company also took a charge of $558 million or 58 cents per share related to reducing employment levels.  Excluding that charge the company was profitable in the quarter, but the CEO warned that more job cuts could be ahead.  When Caterpillar’s CEO Jim Owens speaks many people listen, as he is a trained economist and predicted the current recession just months before it began.

In comparison to Caterpillar, Coca-Cola (KO) and DuPont’s (DD) earnings were pretty decent.  DuPont beat earnings forecasts while revenue declined by nearly 20%.  While Coke’s earnings were in line with consensus estimates, revenue again was lower than expected.  Coke is trading slightly down, while DuPont is up about 3% in morning trading.

Along with financials, tech companies continue to be the stars of the earnings season as Monday’s after the bell reports from IBM (IBM) and Texas Instruments (TXN).  Both companies did better than analysts expected, and were able to reaffirm full year guidance.  So far it seems to be the tale of two earnings seasons: the market is seeing a bottom forming for financials and tech, while everyone else is still struggling to deal with a tough environment and revenue on the slide. 

“$6 billion dollar deals, right, Pepsi could be buying two separate firms…if it happens. Bottling operations, sort of an about face I heard an analyst call it. What happened there, PepsiCo about ten years ago, spun off these capital intensive bottling operations. If you don’t know the bottlers actually buy the concentrate from Pepsi, along with the syrup and then add the water and other ingredients to make what we know as Pepsi and the other soft drinks that they produce. Well, these are capital intensive operation’s they spun them off, but now they want control back of those.

The whole market out there is changing, soft drink sales are down and non-carbonated sales are what happened here, so Pepsi cola will buy the two biggest bottlers for $6 billion in cash and stocks and $29.50 for Pepsi Bottling Group $23.27 a share for PepsiAmericas, both are 17% premiums to where those bottlers stock prices closed in Friday’s trading session. The deal basically would give about 80% control to PepsiCo of its North American operations, it’s biggest operations in the world and would really reshape its business model in a changing environment out there.” Fox Business Network 4/20/2009

That was part of a longer discussion related to one of the big stories of Monday morning; Pepsi (PEP) made an unsolicited offer for its two largest bottlers Pepsi Bottling Group (PBG) and PepsiAmericas (PAS).  This represents a major change in Pepsi’s strategy as they will once again control almost the entire process of bringing their products to market.  There is a lot of speculation out there about how Coke (KO) will respond.  Obviously, Coke will need to determine for themselves whether buying their biggest bottler, Coca-Cola Enterprisies (CCE), is in the best interest of the the company.  There may be more information tomorrow via Coke’s quarterly earnings report.  CCE is benefiting from the speculation and activity in the sector as shares are up nearly 2%, while the rest of the market flounders.

Interestingly, both PBG and PAS are trading higher than the offering price as the market thinks that perhaps the bottlers will ask for a little richer valuation than the first bid.  By our valuation methodology, PBG was Fairly Valued prior to the offering but PAS was actually Undervalued.  Based on what the market has historically been willing to pay for PAS price-to-sales and price-to-cash flow, we think they could actual be worth as much as $27.50 per share based on the current fundamentals.