Pepsi vs. Coca Cola, Case Study Example

Pepsi and Coca Cola are two of the world’s largest beverage companies and have a worldwide presence with strong brand recognitions. Both companies are part of the Fortune 500 group (Fortune). This paper looks at the financial statements of both companies to gain a better understanding of their operating performance, capital structure, financial picture, and competitive strategies among other things. Vertical analysis, horizontal analysis, and financial ratios have been calculated to reveal the information behind the data in the financial statements and possibly predict the future direction of both companies. It is expected that some ratios and financial strategies may be quite similar for both companies because they are major players in the same industry, closely watch each other’s actions, and compete with each other in multiple markets. Thus, their similar business economics means there are bound to be some similarities between them though their operational efficiency may vary. Meanwhile, the author will also present his thoughts on both companies as well as make recommendations.

The idea behind vertical analysis is that numbers by themselves have little significance unless they are considered in a bigger context. For e.g. a $5 million income will be an impressive figure when earned on total sales figure of $20 million but it will be a disappointment if earned on total sales figure of $500 million. Thus, $5 million income by itself has little information value until it’s considered as part of the company’s total sales performance. Similarly, the idea behind horizontal analysis is that a company’s performance can be better gauged by looking at multi-year data rather than single year data. A multi-year data will help us recognize the trend as well as predict the future direction. The company’s single year performance may still be impressive but if it’s worse than the previous few years, this will be a cause of concern rather than a reason to celebrate.

Vertical Analysis

As far as Pepsi is concerned, the company’s cost of sales remained constant as a proportion of net revenue from 2003 to 2005 at approximately 43%. Similarly, operating profit also stayed around 18% during the same period but net income declined each year from being 13.23% in 2003 to 14.39% in 2004 and 12.52% in 2005. The decline occurred due to an increase in selling, general, and administrative expensive. The possible reasons may be company’s increased marketing expenditure to protect its territory or aggressively market new products introduced during the period.

Coca Cola showed a more noticeable improvement in operating profit. The operating profit was 25.03% in 2003 and had improved to 26.34% in 2005. Coca Cola already has more efficient sales team as evident by its higher operating profits than Pepsi and the team further improved the lead. The company’s selling, general, and administrative expenses also increased which may be an indication of aggressive marketing war between Coca Cola and Pepsi. Coca Cola’s net income increase by 0.45% in 2004 as compared to 2003 but declined by 1.10% in 2005. Another possibility may be an increase in administrative expenses for both Coca Cola and Pepsi as both companies may be adding more people as well as improving compensation to retain talent.

Pepsi’s current assets as a proportion of total assets increased from 30.87% in 2004 to 32.95% in 2005. It is partly due to increase in cash reserves as they did increase by about half a billion over the period and other possible reason may be an increase in receivables in order to boost sales. The company’s fixed assets decreased from being 69.13% of total assets in 2004 to 67.05% in 2005. Pepsi might have delayed capital expenditure or decided to expand through rented assets instead of buying them outright. The company’s total liabilities also increased from being 51.68% of total liabilities and shareholders’ equity in 2004 to 55.08% in 2005. The company is probably choosing to finance expansion through long term debt instead of equity. Long term debt can be cheaper source of funding but it may also increase operating expense due to interest. The company’s total current liabilities have also increased which will have negative impact on day to day operational liquidity.

Coca Cola’s total assets declined during the period as opposite to Pepsi. The company might have sold of unprofitable properties or businesses and is streamlining its remaining assets to improve assets efficiency. The company’s current assets also declined from being 39.06% of total assets in 2004 to 34.83% in 2005. Some of the decline in current assets is due to decline in cash reserves that might have been spent on restructuring. The overall balance sheet of Coca Cola seems to indicate that the company is involved in companywide restructuring and the management decided to scale back to improve efficiency and control over the business. Total liabilities as a proportion of liabilities and shareholders’ equity declined from being 49.23% in 2004 to 44.42% in 2005. Most of the decline came from a decrease in current liabilities. The company might have paid back some of its account payable and this may also be one of the reasons for decline in cash reserves.

Horizontal Analysis

Pepsi’s net revenue continued to increase over the period. They increase by 8% in 2004 as compared to 2003 and by 11% in 2005 as compared to 2004. The increase may be due to success in capturing some of the market share from Coca Cola as well as introduction of new products that have been embraced by the consumers. Operating profit also improved by 10% in 2004 and 13% in 2005 which shows company’s improving operating efficiency. Net income improved by 18% in 2004 but declined by 3% in 2005. The decline was mainly due to an increase in selling, general, and administrative expenses that might have been due to higher marketing expenditure.

Coca Cola’s net revenue also increased by 4% in 2004 and 6% in 2005. The ability of both Pepsi and Coca Cola to continue to enjoy increasing sales means that there is still much room for growth in both U.S and non U.S markets. Coca Cola’s cost of sales declined by 1% in 2004 but increase by 7% the next year. Operating profit also improved by 9% in 2004 but only 7% in 2005 which is in contrast to Pepsi. This is a worrisome trend for Coke because it proves Pepsi’s sales team is more efficient than Coca Cola’s. The company’s net income also showed disappointment. It increased by 12% in 2004 but by only 1% in 2005. But some of the decline was inevitable as Coca Cola might have been forced to increase marketing and administrative expenditure to deal with Pepsi’s rise. This may also be why the company scaled back expansion activities so that it can deal with problems first.

Unlike Coke, Pepsi continues to expand as is evident by its balance sheet. Almost every category on its balance sheet improved even though not everything was a positive news. The company’s accounts receivables increased by 9% which may indicate Pepsi’s aggressive sales push and which would also increase the probability of bad debts. The company’s total liabilities increased by staggering 21% which would eat into its profits in the future as the interest payment comes due. Shareholder’s equity also improved due to improved earnings.

Coca Cola’s total assets declined by 6% from 2004 to 2005, its current assets declined by 17% and its cash reserves declined by 30% during the same period. This shows that Coca Cola is feeling the competitive pressure from Pepsi and is trying to respond by improving its efficiency and control over its operating. This is why the company is trying to scale back and paying off its debt to lower leverage. We do see that its current liabilities also declined by 12% though long term debt remained at the same level.

Financial Ratios

The financial ratios reveal quite a different picture. Coca Cola earned earned more net income than Pepsi in absolute amounts despite having reasonably lower sales which explains its quite impressive profit margins of 22.29% and 21.09% in 2004 and 2005 as compared to Pepsi’s 14.39% and 12.52% during the same period. Similarly, Coca Cola also outdid Pepsi in other profitability ratios such as ROA and ROE though the lead was less impressive than that in profit margins.

As we concluded earlier, Pepsi did outdo Coca Cola when it comes to asset utilization. Pepsi is more efficient in its use of assets which may explain why Coca Cola has decided to take a second look at its operations instead of continue to expand aggressively like Pepsi. Pepsi’s turnover ratio was 18.99 in 2004 and 19.23 in 2005 while Coca Cola’s was 15.31 and 16.22 during the same period. This means that Pepsi sells its inventory faster than Coca Cola and has lower storage costs. Pepsi’s inventory management system is more efficient than Coca Cola’s. Total asset turnover also paints quite a similar picture.

Pepsi also retains edge in liquidity ratios but Coca Cola may catch up as the company has reduced its current liabilities which should reduce its interest obligations and improve profits. Pepsi’s current ratio was 1.28 in 2004 and 1.11 in 2005 while Coca Cola’s was 1.10 and 1.04 during the same period. Pepsi’s lead becomes less when quick ratio is considered which is more aggressive measure of short term liquidity.

Conclusion

The financial statements show that Pepsi is winning the competitive race but the expansion is not coming without a cost. Some of the expansion is coming at the expense of lower profit margins. Because Pepsi seems to be the winner, it is more likely that Pepsi’s shares have higher price-earnings ratio which makes them more expensive. The problems of Coca Cola means that it is being punished by the stock market to some extent. But the company is taking steps to scale back and improve its efficiency which should further improve its profit margins. As the stock market takes notice of Coca Cola’s improvements, Coca Cola’s share price will see a greater increase in value than Pepsi’s. In terms of management, Pepsi has been a marketing genius but in terms of investment, Coca Cola’s stock is more likely to be cheaper and thus, has a greater profit potential. But we of course assume that Coca Cola will emerge as a better company which is not guaranteed. It is likely that Pepsi is able to grab further share of the market and is also able to figure out ways improve its operating efficiency. Surprisingly, we only checked the news after carrying out our financial analysis and we did find that Coca Cola embarked on a restructuring campaign of its North American division in 2005 (Red Orbit, 2005).

References

Fortune. (n.d.). Fortune 500: 2011 Full List. Retrieved July 5, 2011, from CNN Money: http://money.cnn.com/magazines/fortune/fortune500/2011/full_list/

Red Orbit. (2005, July 29). Restructuring at Coca-Cola Enterprises Could Mean Layoffs in Atlanta Area. Retrieved July 5, 2011, from http://www.redorbit.com/news/science/191052/restructuring_at_cocacola_enterprises_could_mean_layoffs_in_atlanta_area/