RBC Higlights Valuation Concerns In Coca-Cola, PepsiCo Downgrades

The bullish case for beverage giants Coca-Cola Co KO and PepsiCo, Inc. PEP has come to an end at RBC, mostly due to valuation concerns.

The Analyst: Nik Modi downgraded Coca-Cola's stock from Outperform to Sector Perform with an unchanged $55 price target. The analyst also downgraded PepsiCo's stock from Outperform to Sector Perform with an unchanged $153 price target.

The Coca-Cola Thesis: Modi said Coca-Cola's management team deserves credit for recent initiatives, including organizational redesign, optimizing the portfolio, among other initiatives, but it will "take time for the company to hit its stride" given many moving pieces.

For example, the organizational changes only came into effect on Jan. 1 and there will be "growing pains" for at least one to two quarters. Investors may not see signs of improvement until the third quarter while the full impact won't be realized until 2022.

Coca-Cola faces similar headwinds as every other company as social distancing and other health measures will likely remain in place until at least the middle of the summer, the analyst wrote in the note. Meanwhile, employers will continue to hold an "overly-cautious" view in asking workers to return to the office.

It's possible this thesis is wrong and society will enter "a roaring 20's type scenario" sooner than expected. In the meantime, Modi said Coca-Cola's stock is trading at around 26 times next year's EPS, marking the highest valuation level seen in five years and a 16% premium versus its large-cap peers.

The PepsiCo Thesis: Modi said PepsiCo's strong exposure to snacks and management's focus on new product launches like Pepsi Zero Sugar and new Mountain Dew flavors implies recent momentum can be sustained. Other encouraging initiatives in the pipeline include investing in Gatorade Zero and positioning Bolt 24 to compete against Body Armor which is partially owned by Coca-Cola.

However, PepsiCo's energy beverage line faces some near-term challenges after legal spats with Bang's parent company VPX. While a court concluded that VPX can't end its exclusive distribution partnership with PepsiCo until October 2023, the friction could pave the way for rivals to gain market share.

PepsiCo's stock is trading at 24 times next year's EPS, marking a 16% premium to its five-year historical average and within striking distance of its all-time high.

Price Action: Shares of Coca-Cola were trading lower by more than 3% Monday morning at $53.02, while shares of PepsiCo were lower by 2.3% at $144.92.