Investors have certainly been willing to pay more for the relatively predictable streams of earnings from packaged food companies recently, and that has left scant value in the sector. That PepsiCo (PEP) still seems to have some value in it is likely a product of the fact that not all analysts are completely sold on the idea that the benefits of the company's recent restructuring will last over the long term. While wasteful acquisitions and unsuccessful marketing initiatives may loom as ongoing threats, these shares do seem to over some relative value in the sector today.
Q4 Numbers Look Ugly At First, But Get Better With Some Explanation
On first blush, PepsiCo's fourth quarter earnings didn't look so hot, with revenue down 1% and operating profit down about 2%. Underlying results were quite a bit better, though.
Reported revenue fell 1%, due in part to an extra week in the year-ago period, but organic revenue was up 5%. While the company added back 3% from refranchisings in China and Mexico that I'm not certain really should have been added back, organic growth would have been positive either way. Importantly, volumes were no worse than stable across the business, and positive in several areas.
Margin performance was more mixed. Gross margin improved very slightly from the year-ago level, but missed the average analyst estimate by about half a point. Adjusted operating income fell 10% on substantial marketing investments, and operating margin fell more than a point, but that was still meaningfully better than what the Street had expected.
Weak Beverages Not A Surprise, Solid Food Results A Positive
PepsiCo's North American beverage business was pretty soft, with organic revenue growth of less than 3% and flat volume, but that was not much of a surprise after seeing the results from Coca-Cola (KO) and Dr Pepper Snapple (DPS). On a more positive note, looking at the results in North America and around the world, it looks like PepsiCo has at least stabilized this business.
Food performance was definitely more positive. Frito-Lay North America saw 5% organic revenue growth on 5% volume growth, and Quaker Foods reported 6% volume growth. Adding in the solid snack volume growth from Europe, Latin America, and Asia, it's pretty clear that PepsiCo more than held its own in the global snack market against Mondelez (MDLZ), Kellogg (K), ConAgra (CAG), and Nestle (NSRGY.PK).
Marketing, Innovation, And Infrastructure Investments Need To Start Paying Off
For some time now, PepsiCo has been a great snack food business soldered to a mediocre beverage business (which, in turn, has been a pretty decent juice and sports drink business attached to an underperforming soda franchise). Clearly that needs to change if PepsiCo is going to close some of the valuation gap with peers like Coca-Cola.
On the soda side, PepsiCo has been investing in infrastructure and rebuilding its brand through smarter marketing efforts. Now they need to deliver the market share gains. Coca-Cola is a pretty rational competitor, and that certainly helps, but they seldom drop the ball on product promotion and PepsiCo can ill-afford any backsliding. Elsewhere, local rivals in markets like China are competing less rationally, but PepsiCo has the opportunity to out-execute.
It's also worth noting that PepsiCo seems pretty excited about what they have in their product pipeline. The company has referred to some new projects that they will be submitting to the FDA, and apparently they have already begun to get some of the commercialization process underway. While PepsiCo may well be referring to other projects, I believe this is likely a reference to the company's work with Senomyx (SNMX) on sweetness enhancers, and this may ultimately give PepsiCo a strong product to market against Coca-Cola's Diet Coke and Coke Zero.
On the snack food side, PepsiCo basically needs to avoid mistakes like value-corrosive acquisitions and letting rivals like Mondelez or Kellogg build real momentum with new product introductions and promotions. Here too, though, there is an opportunity to leverage recent investments in the business, though I suspect higher grain prices could limit some of the margin leverage for the next year.
The Bottom Line
With scanner data improving and the migration from branded packaged food to private label seemingly easing up, PepsiCo's growth prospects are looking better. Over the long term, I think PepsiCo can grow its revenue at a mid-single-digit rate, with definite upside to that number if the company can really turn around its carbonated beverage business and regain market share.
At the same time, while I think the nature of the company's business puts some limits on margin/free cash flow improvement (it takes capital and ongoing SG&A spending to support a global food business), I do believe that PepsiCo could deliver as much as 10% compound free cash flow growth if these improvements stick and volumes improve.
Pushing those numbers through a cash flow model, I believe PepsiCo shares are worth about $80 today. While that represents better appreciation potential than packaged food companies like Coca-Cola or Nestle offer, that potential is counter-balanced by weaker demonstrated operational performance. If you believe PepsiCo management has learned its lessons, though, these shares could be priced for decent performance at today's prices.