RealMoney.com

Return to Article

Core Concepts: Consumer Plays

Arne Alsin

In our search for undiscovered value using a methodical sector-by-sector approach, we've taken a look at chemicals, computers and office supplies, oil stocks, telecom, household products, machinery stocks and auto retailers. Today, we'll continue this quest for stock ideas by examining beverage stocks and grocers.

Not Much Fizz

Beverage companies are popular, in part, because they deliver consistent operating performance. Leading companies in this sector include Coca-Cola (KO), PepsiCo (PEP) and Anheuser-Busch (BUD).

While operating consistency is the hallmark of the group, it's the bane of bargain-hunters, who seek to take advantage of the market's tendency to overreact. But when it comes to beverage companies, the market doesn't get a chance to overreact to any perceived chaos because of their remarkable consistency. On the basis of my valuation work, not one of the premier beverage stocks named above has been materially undervalued (by 20% or more) for well over 10 years.

In addition to operational consistency, beverage makers are noteworthy for their amazing efficiency with capital. Coke will generate more than $6 billion in cash earnings this year, while using only $17 billion in equity capital. Anheuser-Busch will generate more than $2 billion in cash earnings this year, using only about $4 billion of equity capital.

Think of return on equity (ROE) as comparable to the rate of return that you generate on your "net assets" -- that is, your total assets minus debt. The fact that the beverage companies can consistently generate 35% to 50% annual returns on their net assets is quite impressive. By way of comparison, premier companies such as Costco (COST) and Target (TGT) generate ROE of 11% and 18%, respectively. My guess is that the average publicly traded company now has an ROE of 10% to 11%.

One beverage stock that I highlighted to RealMoney subscribers in a past column is Molson Coors (TAP). I included the stock as one of my Top 10 Turnarounds for 2006 when it traded at $66. Now at $85, the stock still has decent upside. Margins have been improving steadily since the 2005 merger of Molson and Adolph Coors. There's still plenty of margin leverage to be unlocked. I think the company can earn $6.55 per share in 2009, suggesting a $105 stock value (at 16 times earnings).

Shopping in the Grocery Aisles

Grocers compete in a market where demand is constant, but their sector has undergone massive upheaval over the past 15 years. Leaders such as Kroger (KR) and Safeway (SWY) are facing multiple problems, like severe price competition and additional capacity from Wal-Mart (WMT) and Costco. Also, Whole Foods (WFMI) has been gaining market share with its natural foods model.

The financials of Kroger and Safeway provide ample evidence of serious operating issues. Kroger's operating margin has been on the decline, slipping from 7.4% five years ago to 5.5% today. Safeway's operating margins have declined from 10.4% five years ago to 6.3%.

For every $1,000 of sales, then, Kroger is generating $55 in operating cash profit, down from $74 five years ago. That's a 26% decline. Safeway generates $63 in operating cash profit for every $1,000 in sales. That's down from $104 five years ago and represents a 39% decline.

The stocks of Kroger and Safeway are valued at about 18 times earnings. Because these are not compelling growth stocks, buyers of these stocks must be expecting margin expansion. That's a high-risk, low-probability bet, given the steady deterioration in operating metrics over several years. A methodical, long-term margin decline suggests that secular pressures, not cyclical forces, are at work.

In recent months, specialty grocer Whole Foods has stumbled badly, with lower sales comparisons and disappointing earnings. But bargain-hunters shouldn't get too excited by the stock's 40% decline over the past year. This is a case of an overvalued stock falling to reasonable levels, not to the bargain basement.

By the way, struggles at Whole Foods may have been the impetus for the recent $18.50-per-share cash offer for key competitor Wild Oats (OATS). I highlighted Wild Oats in multiple columns a few years ago, and Whole Foods' offer is consistent with my previous calculation of Wild Oats' value.