PepsiCo: Shares Look Tempting At These Levels

| About: PepsiCo Inc. (PEP)

Summary

PEP has an attractive margin expansion story, which will support long-term EPS growth.

Stock is trading at a forward P/E of 20x, below KO’s forward P/E of 23x.

Strong cash flow generation and solid organic revenue growth which will support long term growth.

PepsiCo (NYSE:PEP) stays an attractive long-term investment prospect for investors. The stock is trading at a forward P/E of 21x, as compared to its peers average forward P/E of 23x; however, PEP is trading at a premium as compared to its five-year historical average forward P/E of 19x. I believe the stock valuations are attractive and justified, and the valuation will expand because of the company's aggressive productivity improvement initiatives, robust cash returns to shareholders and strong organic revenue growth. Also, the company's absolute earnings will improve in the upcoming quarters as currency headwinds will ease, which will positively affect PEP's cash flows and dividend growth rate; PEP offers a solid yield of 2.2%.

Financial Performance and Growth Catalysts

The company has been delivering healthy financial results, and the trend will continue in upcoming quarters. It reported EPS of $1.35, ahead of consensus of $1.31 for 2Q16, driven by favorable interest expense and lower selling, general and administrative (SG&A) expenses. Moreover, organic revenue growth remained robust at 3.3% for 2Q16, and the company expects organic revenue growth to accelerate to 4% in the second half of 2016. The company's efforts to strengthen its product portfolio through new product launches remain important revenue growth driver. PEP now plans to accelerate product launches in 4Q16, due to which the management increased full-year 2016 EPS target to $4.71, representing an increase of 9%, up from a prior target of 8%.

Moreover, the company increased focus on improving its cost structure will support its long-term EPS growth; it is targeting $1 billion in cost savings per annum through its multi-year productivity improvement plan. The cost savings and margin expansion will mainly be driven by productivity improvement in PEP's North America Beverages segment and Frito-Lay North America segment, which contributes 33% and 24% towards total revenues of the company. Small package sizes and product innovation will support margin expansion for North America Beverages segment, while supply chain efficiencies and shift towards premium-priced products will support Frito-Lay North America segment's margin expansion. Moreover, relatively stable input cost inflation will support margin expansion in 2016. In 2Q16, the company's gross margin increased by 80bps YoY, which led to gross margin expansion for the 16th consecutive quarter.

The productivity improvement efforts will not only allow the company to expand profit margins but will also enable it to reinvest savings in the business to support long-term growth through product innovation and productivity improvement. The company has long-term CAPEX target of 5% of total revenues. In 2015, PEP's CAPEX as a percentage of total revenues was 4.5%, as compared to Coca-Cola (NYSE:KO)'s and Kellogg (NYSE:K)'s CAPEX as a percentage of total revenues of 5.9% and 4%.

On the other side, new food labels for packaged foods by the FDA could put pressure on the company's sales volume. The new food labels include more focus on Vitamin D deficiency, focus on added sugar and modifying serving size to better reflect what consumer eat. However, the company's strong position in the snacks category and product innovation measures will allow it to offset any sales volume pressure as a result of new food labels. PEP has the leading market share of almost 30% in the sweet and savoury snacks category, and the rest of the market is fragmented, as Kellogg has the second highest market share of 2.5% in the category.

Furthermore, the company's earnings and cash flows will improve in the upcoming quarters as foreign currency headwinds are likely to stabilize. The company has a target to generate $7 billion in free cash flows and expects to return cash to shareholders through dividends and share buybacks. The company's cash flows will improve because of better operational performance and less severe currency headwinds, which will not only support dividend growth but also allow PEP to look for strategic acquisitions, to strengthen its product portfolio.

Summation

The company's performance will be positively affected in the upcoming quarters because of its correct strategic decisions. PEP has an attractive margin expansion story, which will support its long-term EPS growth. Also, the cost saving efforts will allow it to reinvest savings in business which will augur well for its market position and growth. Moreover, the stock's current relative valuation remains compelling as it is trading at a forward P/E of 20x, below KO's forward P/E of 23x. However, the stock is trading at premium valuation in comparison to its five-year average forward P/E of 19x; I believe, the premium valuations are justified given its attractive margin expansion story, strong cash flow generation, and solid organic revenue growth.

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.