New Trade – $PEP: Pepsi Challenged

by Dan September 29, 2014 2:23 pm • Commentary

I think it is safe to say that the Federal Reserve’s policy of zero interest rates was largely intended to stimulate economic activity.  However, another consequence for corporate America was the potential for massive financial engineering following a period where companies dramatically cut costs and got their balance sheets in order despite tepid demand.   The liquidity provided by the Fed has been the prime impetus for equity gains for the last five years, with share buybacks a major target of that increased liquidity.  In some instances like CAT and IBM, where there has been long single digits or even negative sales growth, companies have used a disproportionate amount of their free cash flow to buy back shares to lower their share count and thus positively affect their earnings per share.

CAT is exhibit A for this earnings growth strategy as highlighted in our trade post from Sept 9th:

despite 2 consecutive annual sales declines (2014 sales are expect to be down 16% from 2012’s peak):

Earlier this year the company completed a $1.7 billion accelerated buyback and after the companies Q2 revenue miss, and subsequent decline announced another accelerated share repurchase (ASR) this time to the tune of $2.5 billion.

I guess desperate times call for desperate measures.  How could you argue with the strategy, the Fed is practically begging investors of all  shapes and sizes to go balls long equities?? At the end of Q3 2014, CAT will have bought back $4.2 billion of stock (current market cap about $68 billion), so despite what analysts expect to to be a 9% earnings increase in 2014, net income is only expected to be up 2.5%.  In the 5th year of an economic recovery, this activity seems fairly mental to me.

In CAT’s situation, they have chosen to buy shares aggressively, retire the shares and meet current quarter earnings estimates.  The year to date chart shows the late January announcement of a $1.7 billion accelerated share buyback (green circled), and then the late July announcement of a $2.5 billion accelerated share buyback (blue circled).

CAT ytd chart from Bloomberg
CAT ytd chart from Bloomberg

The fact that the stock rallied 10% from the August lows during the buyback, and has since given all of the gains back and now sits below the Aug lows is downright pathetic.  If investors cheer an earnings beat when they report Q3 on Oct 23rd, then shame on them.  That’s assuming they do beat. At this stage of the game, serial share purchases would need to accompany some sort of sales and net income growth to work from these levels.

But here is the thing – the Fed’s zero interest rate is likely coming to end.  At least market participants will start anticipating such with the end of QE next month.  With global growth concerns re-emerging, companies levering up to buy back stock may find themselves in a less than advantageous environment at the start of the rate rise cycle.

In Factset’s Buyback Quarterly,, published on Sept 17th, they highlighted the following trends:

Quarterly Buybacks Declined Year-over-Year: Dollar-value share repurchases amounted to $123.7
billion over the second quarter and $539.3 billion for the trailing twelve months. Quarterly buybacks
declined year-over-year (-1.1%) for the first time since Q3 2012. And, due to record post-recession
activity last quarter, Q2 showed the most severe quarter-over-quarter decline (-22.9%) since Q4

Buybacks Relative to Free Cash Flow Hit 2008 Levels: Despite the sequential decline in quarterly
buybacks, trailing twelve-month share repurchases still grew 29.4%. This growth compared to a
decline of 0.5% free cash flow generation. As a result, the ratio of share repurchases to free cash flow
continued to rise, and hit the highest level (82.2%) since Q3 2008.

In other words, buybacks are taking up an increasing share of free cash flow relative to market history.  That’s a concern for the long-term sustainability of the consistent share buyback bid to the market.

Pepsi is another example of a mega cap stock that has hardly grown sales or earnings over the past 3 years, but the stock has zoomed higher nonetheless.  Annual sales in PEP are on track for $67 billion in 2014, vs. $66.50 billion in 2011. Annual EPS is expected to be $4.58, vs. $4.40 in 2011.  Meanwhile, the stock is up nearly 50% in the past 3 years.  The trailing 12 month P/E multiple for PEP is now at 6 year highs and trading at almost 19x next year’s earnings that are expected to grow at only 8%:

PEP trailing 12 month P/E, courtesy of Bloomberg
PEP trailing 12 month P/E, courtesy of Bloomberg

The major bull case for PEP here is not valuation or sales or earnings growth.  It’s return of capital.

PEP sports a 2.75% dividend yield and is on track to buy back about $5 billion worth of shares in 2014, which is around another 3.5% of yield for shareholders.  But at a 6.25% yield, including the buyback, the shares still hardly seem cheap. PEP is up 12% year-to-date nonetheless, another curious case of shareholders overlooking long-term growth for short-term yield.

I have no idea when this shell game ends, but it will, and I suspect it does at some point in the months following the end of QE.  I want to take a near term, near the money bearish view in PEP with defined risk:  

TRADE : PEP ($93) Bought to Open Jan15 92.50/82.50 Put Spread for 2.35

-Bought Jan 92.50 put for 2.85

-Sold Jan 82.50 Put at .50

Break-Even on Jan15 expiration:

Profits:  between 90.15 and 82.50 make up to 7.65, max gain of 7.65  at 82.50 or lower

Losses: between 90.15 and 92.50 lose up to 2.35, max loss of 2.35 above 92.50

Rationale:  I am risking 2.5% of the underlying stock price which breaks-even down 3% to have short exposure between now and mid January (about three and a hlaf months).  With the stock just 1.3% from the recent all time highs, I like those odds that at some point over the next three and half months that PEP shares will see at least a 3% sell off from current levels.  The company reports Q3 results on October 9th before the open.