Why Is Coca-Cola Generating Lower Returns Than PepsiCo?

In the last three years, the average operating margin of Coca-Cola was 22% compared to PepsiCo’s 14%.  Despite this margin advantage, Coca-Cola’s ROE (return on equity) for 2014 stood at 22% (28% for 2012), lower than the 31% (29% for 2012) ROE generated by PepsiCo. Coca-Cola has higher margins than PepsiCo; however the latter seems to be using its capital more efficiently leading to higher return on invested capital for PepsiCo. Further, PepsiCo’s debt/equity mix works in favor of its equity shareholders, generating a higher ROE compared to Coca-Cola.

Lower Capital Turns Makes Coca-Cola Less Efficient, Despite High Margins

Coca-Cola’s operating margin has consistently stayed well above that of PepsiCo for the last three years. Much of this can be attributed to its higher gross margin.

However, revenues per unit of capital employed by Coca-Cola are lower than that of PepsiCo and have been declining over the past three years. These lower capital turns wipe out the margin advantage and lead to a lower return on capital employed.

* Total Capital employed is calculated as Total Equity+ Total Debt- Cash & Equivalents

ROIC is calculated as NOPAT/Average Capital employed

A significantly high NOPAT (net operating profit after tax) margin at Coca-Cola gets offset by lower capital turns, leading to a lower ROIC compared to PepsiCo. While PepsiCo has reduced its average capital employed over the past three years with increasing revenues, Coca-Cola’s capital employed has increased in the last three years, without a significant increase in its sales.  This has led to a decline in its capital turns.

With a business model of higher capital turns, PepsiCo is able to generate a higher return on capital employed, despite lower margins. PepsiCo has a relatively diversified business with a significant contribution coming from the snacks division. So the businesses are not exactly similar. PepsiCo’s snack division has higher margins and appears to be more capital efficient, which leads to a higher capital efficiency of the overall business. We looked at the asset turnover of the snacks division, which is much higher than the other segments of PepsiCo, and we use this as a proxy to arrive at its capital efficiency.

Better Debt Equity Mix Benefits PepsiCo’s Equity Shareholders

Coca-Cola’s debt-equity ratio for 2014 was 1.37, lower than 1.65 for PepsiCo. Adequate leverage works to the advantage of shareholders of businesses which generate a higher return from their operations, compared to the borrowing cost. PepsiCo uses this advantage, with a higher debt-equity ratio. PepsiCo did a share repurchase of $5 billion in 2014, reducing its total equity and increasing its debt/equity ratio. Although PepsiCo’s net income is slightly lower than Coca-Cola, its ROE is higher due to its lower equity base.