Why You Should Not Buy Kraft, Coca-Cola

By David Gould - September 6, 2012 | Tickers: KO, KRFT, PEP | 0 Comments

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The problem with investing in safe stocks is that a lot of the times they are simply overpriced… especially now. That means that when the economy starts picking up, investors will move from lower-risk securities into higher-risk securities and cause stock prices to fall in the former. Kraft Foods (NASDAQ: KRFT) and Coca-Cola (NYSE: KO) may be quality name companies with stable growth ahead, but they appear expensive at current levels. Below, I review the fundamentals of both.

Kraft Foods

Kraft is valuable because of its product portfolio that arguably markets the most brand name lines in the world. These brands include Oscar Mayer meat, Cadbury chocolates, Cheez Whiz, Cheese Nips, Jell-O, Nabisco, and the list goes on and on. By having products with a recognizable name, Kraft has carved out a sustainable business in an industry that is ripe with competition.

Clearly, Kraft has great fundamentals. But, in terms of valuation, there is not much more upside left. It trades at a respective 20.6x and 15.1x past and forward earnings with a dividend yield of 2.8%. The beta - an indicator of volatility - is roughly half that of the broader market. While earnings growth is still forecasted at 10.8% annually over the next 5 years (~10 bps higher than the tough preceding 5 years), it is not enough to justify the current valuation. Hence, the PEG ratio stands at 1.92.

While Kraft could arguably expand its multiples even more should the economy go south, I do not it expect to outperform the market in the current state. After rising 21.6% over the last 12 months, shares are right near the 52-week high. Other brands, while also not undervalued, have more to gain…

Coca-Cola

Coca-Cola also has a strong brand. It trades at a respective 19.9x and 17.2x past and forward earnings with a dividend yield of 2.7%. Analysts forecast only 7.5% annual EPS growth over the next 5 years, which is some 380 bps below what was realized during the preceding 5. There is thus a good potential for the company to outperform through beating the low-set bar.

When you look at peers like PepsiCo (NYSE: PEP), it becomes clear that Coca-Cola has one thing that they do not: a proven management team. Indeed PepsiCo's Chairman & CEO has come under pressure from delivering poor performance while Coca-Cola went ahead and penetrated the market. It is because of this reason that I do not see Coca-Cola's shares dipping much, if at all. Even during poor economic climate in 2007, shares quickly recovered and went on to doubling in value. All in all, reward outweighs risk for Coca-Cola.

With that said, I still do think the company is meaningfully undervalued to warrant an investment. The firm is trading above its historical 5-year average 18.5x PE multiple and profit margins have dipped downward from the average - at best, going nowhere at times. Free cash flow may be going up, but cost savings through growth has been disappointing. I thus recommend holding out for now.

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