​Over the past week, I have been researching the Beverage Industry looking for potential investments for my clients.  In doing so, I stumbled across the following news item:

Sugar the new tobacco? Bottled water to soon surpass soft drinks

• "I've never seen anything like it," says Beverage Marketing Corporation chief Michael Bellas, as bottled water continues to grab market share from soft drinks. Coca-Cola (KO) and Pepsi (PEP) have obviously noticed and carry their own bottled water lines, but these are low margin. Both have failed to gain much traction in the more profitable business of so-called enhanced waters.
• Nearly 90% of doctors globally tie the epidemics of type II diabetes and obesity to excess sugar consumption, according to a loud new Credit Suisse report, titled, "Is Sugar Turning The Economy Sour?"
• Sugar - and its cousin high fructose corn syrup - can be found in pretty much every single item of processed food available nowadays, but the biggest villain is soft drinks, with CS estimating 43% of added sugars in our diets coming from sweetened beverages. "Recent research shows that as the sugar is in a solution, it is easily and completely ingested, giving a large injection of calories without the consequential feeling of being full." The good news (or bad news if you own a purveyor of sugar) is the public is catching on - though this varies significantly by demographic.
• Public policy is catching on too, with Credit Suisse - in a nod to tobacco - noting sugar "meet(ing) the criteria for being a potentially addictive substance." Mexico (not Bloomberg's NYC) may provide the first test case as the President has proposed a tax on sales of sugary drinks.
• More on the CS report and sugar from Izabella Kaminska.

Bottled water, being a low margin business, will most certainly have a great impact on both companies’ margins in the future, especially when they also have the added problem that consumers are slowing down their purchases of each companies’ diet soda’s as well. Therefore with two strikes against Coca-Cola and Pepsi, I decided to do an analysis of their free cash flow numbers and see how their financials are doing.

This analysis will use the following six free cash flow ratios:

• CapFlow
• FROIC
• Price to Mycroft Free Cash Flow
• Mycroft/Michaelis Growth Rate
• Free Cash Flow Payout Ratio
• Free Cash Flow Reinvestment Rate

Those new to this analysis can find an introduction by going here that will explain in detail how each ratio is calculated. When used together, these unique ratios generate a quantitative picture of a company's underlying fundamentals, taking into account both strengths and weaknesses.

The "2014 Mycroft Free Cash Flow per share" estimate in the table above was generated by taking the trailing twelve months (TTM) free cash flow result for both companies and then adding the Mycroft Michaelis Growth Rate into the equation in order to generate forward looking estimates for 2014. That growth rate is generated by using the FROIC ratio (Free Cash Flow Return on Invested Capital).  Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed.

Coca-Cola has a FROIC of 16%, which means that for every $100 of invested capital, they generate $16 in free cash flow.

Pepsi has a FROIC of 17%, which means that for every $100 of invested capital, they generate $17 in free cash flow.

Now my Mycroft/Michaelis Ratio takes that FROIC result for each company and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income.  It is calculated as follows:

Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).

Or;

Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).

By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.

Therefore from this we can determine that Coca-Cola has a reinvestment rate of 37% and went on to use 63% of its free cash flow to pay out its dividend. Thus by taking 16% (FROIC) x 37% = 5.92% (rounded off at 6%). From there we add the dividend yield of 2.89% (rounded off at 3%) and we have a Mycroft/Michaelis growth rate of 6% + 3% = 9%.

Pepsi has a reinvestment rate of 53% and went on to use 47% of its free cash flow to pay out its dividend. Thus by taking 17% (FROIC) x 53% = 9.01%.  From there we add the dividend yield of 2.84% and we have a Mycroft/Michaelis growth rate of 9.01% + 2.84% = 11.85% (rounded off at 12%).

Coca-Cola’s Mycroft Free Cash Flow per share of $1.94 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 9% or 1.09). Once we have our result, we then take its current market price of $39.91 and divide it by $1.94 and get a Price to Mycroft Free Cash Flow result of 20.57.  I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.

Pepsi’s Mycroft Free Cash Flow per share of $5.46 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 17% or 1.17). Once we have our result, we then take its current market price of $82.73 and divide it by $5.46 and we get a Price to Mycroft Free Cash Flow result of 15.15.    

The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.

An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.

Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.

The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.

Hold (opinion) = 15 to 22.5 (I use 15 in the table).

Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the table).

Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the table).

The CapFlow ratio result that you see in the first table above is an original ratio I created in order to tell me how much Capital Spending is used as a percentage of Cash Flow. A result of less than 33% is considered ideal and with Coca-Cola coming in at 24%, means that 76% of the company's cash flow is actually free cash flow and can be used to buy back stock.  Pepsi on the other has a CapFlow of 27%, which allows it to use 73% of the company’s cash flow to buy back stock.   

In conclusion, investors in both companies would have done very well over the last 5 years, while Coca-Cola outperformed Pepsi by some 21% over that time period.  On the other hand Coca-Cola shares are starting to lose momentum as they are approaching our sell signal, while Pepsi has outperformed Coca-Cola by some 10% as it is still ranked a strong hold.  If I had to make a choice between either, it would surely be Pepsi as it (unlike Coca-Cola) is more diversified in other product segments besides soft drinks as the table below shows.  Both companies should see declining profit margins in the future, as more consumers make the switch away from soft drinks.