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Stock Strategist

This Wide-Moat Firm Hit 5 Stars for the First Time in 2008

This stock offers 15% expected returns.

Mentioned:

Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

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PepsiCo, Inc.
Moat: Wide | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.84 | Three-Year Expected Annual Return*: 15.0%

What It Does: PepsiCo (PEP) is a global food and beverage producer. The company manufactures and distributes a wide variety of salty, sweet, and grain-based snacks, carbonated and noncarbonated beverages, and other foods. The firm conducts its business through three major divisions: PepsiCo Americas Foods, PepsiCo Americas Beverages, and PepsiCo International. Major brands include Fritos, Lay's, Ruffles, Doritos, Cheetos, Quaker, Pepsi, Mountain Dew, Sierra Mist, Gatorade, and Tropicana.

What Gives It an Edge: Morningstar analyst Greggory Warren credits PepsiCo with a wide economic moat owing to its portfolio full of strong brands, solid track record of product innovation and differentiation, and direct-store-delivery network, all of which make PepsiCo the gold standard in the consumer products industry. Despite the head winds created this year by rising commodity costs and economic weakness in its core market, Warren continues to believe that PepsiCo will weather the storm much better than many of its peers. Not just a beverage company, PepsiCo generates more than half of its sales and operating profits from its food operations--made up primarily of Frito-Lay and Quaker Oats. Better yet, according to Warren, the operating margins in those businesses have been higher than what PepsiCo has been able to generate with its beverage operations. Warren expects the company to continue to tap into the generous cash flows generated by its food and beverage businesses to expand its operations outside of North America.

What the Risks Are: As a global manufacturer and distributor of food and beverages, PepsiCo can be affected by commodity price volatility, especially for raw ingredients (such as corn, wheat, sugar, and oranges), as well as packaging materials. With more than 40% of sales generated outside the United States, the firm is exposed to foreign currency risk. PepsiCo is also expanding more aggressively into emerging and developing markets around the globe, which come with their own cultural, economic, and political risks.

What the Market Is Missing: With prices for raw ingredients and packaging materials continuing to skyrocket, and the domestic economy on life support, Warren believes investors have been extremely wary of any company (including PepsiCo) that produces goods that are dependent upon commodities such as wheat, corn, or dairy products, and that face significant private-label competition. While PepsiCo is now forecasting 9%-10% input cost inflation for 2008 (versus prior expectations of 6% for the year), Warren points out that the company believes that it has adequately hedged its commodity exposure for the remainder of the year. In Warren's view, the firm also faces much less private-label competition in its food operations than most other packaged food companies, while private label (or own-store) soft drink sales have done little to dent the positioning of PepsiCo's own branded products. Having already assumed a more conservative stance on the company coming into 2008, Warren feels that today's share price represents an excellent opportunity to invest in the long-term success that has been the story at PepsiCo over much of the past decade.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.