Coca-Cola’s Not the One — Dr. Pepper Is

The world�s largest beverage company, Coca-Cola (NYSE:KO), announced�second-quarter earnings on Oct. 18. Wall Street generally liked what it heard, but the stock went sideways. Not everyone is drinking up Coca-Cola�s story. UBS lowered its price target from $78 to $73 because of currency concerns. If UBS is correct, investors can expect a total return of 13% over the next 12 months. That�s not bad, but you can do better. My recommendation is to sell Coke and buy Dr. Pepper Snapple Group (NYSE:DPS). Here�s why.

No Longer Cheap

Coke�s 2012 earnings per share estimate is $4.19. Its closing stock price on Oct. 19 was $67.03, which gives it a forward P/E of 16. The S&P 500�s 2012 earnings estimate is $104.78 and its closing price on Oct. 19 was 1209.88. Its forward P/E is 11.5. According to Fortune�s November issue,�Coke�s stock historically trades at a 20% premium to the index. At present, it�s at a 39% premium, or double the norm.

Investors have pushed its stock well beyond its limits, rationalizing that emerging markets will keep the earnings engine fired up and moving forward. If so, then why the lower earnings estimate by UBS? In the third quarter, Coke�s operating profit on a comparable basis was up 21% to $3 billion with 30% of its increase from the currency exchange. UBS obviously feels the U.S. dollar is going to hold its own in 2012, or at least remain somewhat neutral.

I have no opinion on the subject, but certainly if there were no currency gains, Coca-Cola�s operating profit in Q3 would have been $149 million, or six cents per share lower. This amount in the grand scheme of things is immaterial, but it does beg the question why defensive investors would continue to support a stock whose valuation has gotten a little frothy by historic standards.

Leverage Ratio

When Coke acquired�the North American operations of Coca-Cola Enterprises (NYSE:CCE) for $12.3 billion last October, it assumed control of a business with 2009 revenues of $15.1 billion and operating income of $1.1 billion. It was all part of Vision 2020,�its plan to create value and make a difference. Upon purchasing its North American bottling operations, it consolidated all five North American business units into Coca-Cola Refreshments USA. The acquisition itself made sense. It never seemed right that a company so steeped in America tradition wouldn�t own all of the plants where it makes its products. However, the deal came with a price tag, and I�m not talking about the purchase price. I�m referring to the assumption of debt.

KO�s balance sheet took on $8.9 billion as part of the deal, which upped its risk level considerably. Not so much that one needs to worry about it going out of business, but enough to make conservative investors like the late Ben Graham sit up and take notice. Prior to the deal, its long-term debt was $5.1 billion. Afterward, it was $15.3 billion or three times its previous level. Graham would pass on any company whose financial leverage ratio was higher than two. Coke�s ratio was 1.92 before the deal, 2.33 after and 2.44 as of the third quarter. Certainly, times have changed since Graham came up with this rule back in the 1970s, but it should give pause to conservative investors who believe that if it�s good enough for Warren Buffett, it�s good enough for me. Times do change. Coca-Cola is no longer the risk-free investment investors think it is.

PepsiCo

Coca-Cola and PepsiCo (NYSE:PEP) have fought the cola wars since the beginning of time it seems. Whether you�re talking about beverages or stocks, each camp has its supporters. But what about poor old Dr. Pepper Snapple? Who loves it?

Investors passing on Coke but still interested in the nonalcoholic beverage industry are turning to the good doctor instead of its longtime rival. How do I know this? I don�t. However, DPS stock is beating the stuffing out of PEP year-to-date, and over a three-year period Dr. Pepper has a commanding 17% lead on an annualized basis.

There�s no question Pepsi is losing the battle for the hearts of investors. Yes, it�s a much bigger company, but the truth is Pepsi has become a bore, seeking the approval of the health and wellness crowd.�Meanwhile, over at Dr. Pepper, it�s taking free cash flow and reinvesting in its business. Canada Dry, a brand close to the hearts of most Canadians but largely overlooked in the U.S., is going into expansion mode — just one example of the great decisions being made down in Plano, Texas, where the company is headquartered.

At the end of the day, Dr. Pepper has such an incredible number of strong brands that Coke and Pepsi were willing to pay $1.6 billion in 2009-10 to distribute its products in the U.S. When the time is right, it will take its show on the road outside North America, and Coke and Pepsi will be right there with checkbooks in hand. Bob Olstein, manager of the Olstein All Cap Value Fund, suggests Dr. Pepper�s free cash flow per share could be $3.50 by 2014. DPS stock currently trades at eight times its trailing 12-month free cash flow per share compared to 55 times for PEP and 70 times for KO.