Why Soda Tax Is Not A Big Problem For PepsiCo

| About: PepsiCo Inc. (PEP)

Summary

Philadelphia soda tax is unlikely to hurt PepsiCo.

The company is still struggling to stop falling Diet Pepsi sales.

Its growing snacks business is the key factor to consider while holding PepsiCo for the long run.

Changing trends in the global food & beverage industry are creating challenges as well as opportunities for multinational players such as PepsiCo (NYSE:PEP). While the U.S. food & beverage industry is steadily growing, consumers are increasingly reducing their consumption level of certain categories. This is evident from the fact that soda sales have dropped more than 25% over the past two decades. The future outlook of carbonated soft drinks market is still soft, but the expansion of natural, low-calorie snacks and growth opportunities in emerging markets bode well for PepsiCo in the longer run.

Philadelphia Soda Tax - Doesn't Matter

In the past, several cities have failed to impose a soda tax in an attempt to cap soft drinks consumption, but Philadelphia is on the verge of becoming the first major city to approve a soda tax. Will this hurt PepsiCo? I don't think so. First off, carbonated soft drinks form only 25% of the company's global sales, which means Philadelphia is nearly a fraction of PepsiCo's total soda volumes. On the other hand, the company is investing billions of dollars to boost its soft drink brands in the emerging market. PepsiCo has positioned itself in Asia-Pacific, where the soft drinks market is expected to record absolute growth of $34 billion by 2020, according to Euromonitor.

The soda tax is a new phenomenon. Thus, currently, it might be difficult to foresee the short-term as well as long-term consequences of Philadelphia soda tax. Let's take an example. Mexico's soft drinks market recorded initial declines, but volumes surged after two years as consumers returned to their favorite cola brands. Although PepsiCo's overall revenue stream from Mexico has squeezed over the past few years, primarily due to the strengthening of the U.S. dollar, its beverages volumes have remained steady despite a soda tax. Having said that, it is pretty tricky at this point in time to quantify the impact, though a price hike may reduce consumption in the short term.

Diet Pepsi Is The Problem To Solve As Soon As Possible

The major challenge for PepsiCo is to revive its Diet Pepsi brand, which is under intense pressure after last year's recipe change. Diet Pepsi recorded another 12% sales drop during the 12-week period ended 21st May, significantly worse than the industry average. Recently, PepsiCo canceled a presentation with bottling partners, which the company had planned to discuss the future course of action. It seems that the company has not found a remedy yet.

PepsiCo needs to turn around the Diet Pepsi business to avoid market share loss. The PepsiCo North America Beverages segment is not delivering satisfactory performance, as the top line has surged at a compounded annual growth rate of only 0.21% over the past five years. Thus, instead of defending the new recipe, the company must listen to consumers and come up with a recipe that can stop the falling sales.

PepsiCo is heavily advertising its beverage brands in emerging markets, as carbonated soft drinks demand is rising in the developing economies. The company's marketing efforts are driving double-digit growth in beverages business in some key Asia-Pacific markets, such as India, Pakistan, and the Philippines. Recently, the company launched Mountain Dew Game Fuel in India, which is the first variant of the Mountain Dew brand in thirteen years.

Mountain Dew Kickstart is delivering very impressive results and recorded 34% volumetric growth during the first quarter 2016. With the help of games-centric marketing campaigns and new soft drinks variants, PepsiCo is trying to benefit from the rapidly growing passion for sports in India. The company plans to invest 15-20% of its total market budget on digital media amid a booming e-commerce industry, which would enhance the effectiveness of its overall marketing strategy. PepsiCo is also expanding its snacks brands in India, which will boost snacks sales, as the Indian savory snacks market is expected to grow at a CAGR of 16.6% by 2020.

Snacks Business - Better Profit Margins

Over the years, PepsiCo has invested very smartly in the snacks business, which has become the company's primary growth segment. PepsiCo's Frito-Lay segment sales have surged at a CAGR of 3.3% between 2010 and 2015, and saw a 3% year-over-year increase during the first quarter of 2016. Although Americans are abandoning soda, their love for snacks is growing, which is evident from the fact that U.S. consumers, on average, are spending almost seven times more on savory snacks than the global average.

Market research shows that global savory snacks market will grow at a CAGR of 7% to reach $166.6 billion by 2020. As the demand for snacks is very healthy in the developed as well as emerging markets, the increasing revenue contribution from the snacks business would steadily boost the company's profit margins. Frito-Lay holds the leading position in North America, which gives PepsiCo a pricing edge due to a loyal customer base. That why Frito-Lay North America's operating margin of 32.2% is much higher than its North America Beverage segment's operating margin of 11.3%. As opposed to Diet Pepsi, the company constantly introduces new snacks with a low level of fats and sodium, which fits changing consumer requirements.

Should You Hold PepsiCo?

PepsiCo has rallied approximately 15% over the past one year, and the stock currently trades at a forward price-to-earnings of 20 times. As a result, it offers a dividend yield of 2.91%, which is decent enough but not very impressive. However, investors should consider the company's dividend growth. PepsiCo has increased dividends at a CAGR of 8.2% over the past five years. The current payout ratio of 80% and operating cash flows of just $131 million are suggesting that future dividend hikes may drop. But this is not the case, because consensus earnings per share expectation of $4.73 for 2016 and current annualized dividend of $3.01 per share mean the forward payout ratio is 69%. In addition to this, cash and cash equivalent of $8 billion at the end of first-quarter 2016, though PepsiCo's debt level is pretty high, indicates that the company still has the potential to continue increasing future dividends at a high-single digit rate in the long term.

Soft drinks may continue to disappoint, but PepsiCo is more than just a beverage company. The company's snacks portfolio is generating healthy top line growth, while sturdy profit margins are boosting the bottom line. However, expansion of organic juice brands such as Gatorade and a focus on still beverages may offset the negative impact of lackluster soda sales to some extent. Nevertheless, overall industry dynamics are good enough that PepsiCo's earnings can grow at a decent pace, thus providing a solid return to shareholders in the long run.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.