I remember the Pepsi (PEP) commercial in the early nineties featuring Gloria Estefan. At the age of around 15 the commercial really made me want to try a Pepsi. For the past 20 years Pepsi has evolved into a company which derives almost half of its revenue from processed foods or snacks and the rest from beverages. This evolution has had its ups and downs but mostly ups. According to Yahoo, as of April 1st, 2012, the stock has returned 258% for the past 20 years compared to 260% for its closest competitor Coca-Cola (KO), 240% for the unmanaged S&P 500 index and 78% for Kellogg (K), the maker of cereal and other processed foods.
While clearly the beverage business is more profitable than snacks (or Kellogg is poorly managed), Pepsi is investing in the snacks business. Pepsico management expects the company to receive 55% of its revenues from snacks in ten years compared to 48% today. In addition, on February 8, 2012 Pepsico announced a restructuring program which would reduce costs, increase marketing expenses and increase dividends to $2.15 per share. Is this the right time to invest in Pepsico for the next twenty years? Below are some insights which should help you decide.
Pepsico has 1.65 billion shares outstanding, a market capitalization of slightly over $100 billion, and an enterprise value of $125 billion which includes $4 billion of cash and $21 billion of long-term debt among other items. In 2011, the company had revenue of $66.5 billion and earned $4.03 per share for an enterprise value to sales ratio of nearly two and a trailing twelve months price to earnings ratio of 16.1. This price to earnings is at a premium compared to Kellogg's and Dr Pepper Snapple's (DPS) price to earnings ratios of 15.7 and 14.3, respectively but at a discount compared to Coke's price to earnings ratio of 19.5. On an enterprise value to sales basis the situation is similar. It appears that Pepsico is slightly overvalued compared to Kellogg and Dr Pepper, with its enterprise value to sales ratios of 1.9 and 1.8, respectively. Compared to Coke's enterprise value to sales ratio of 3.8, Pepsico is significantly undervalued. From a current stand point, it appears that Pepsico, with its dividend yield of 3.3%, is a good investment.
Looking into the near to medium term, Pepsico is well positioned to reward shareholders. In 2010 the company gained a significant advantage into the Russian market by acquiring the soft drinks and milk producer Wimm-Bill-Dann. From an investment standpoint, I think this was not a good investment as Pepsico paid $5.7 billion in this purchase for a company with sales of $2 billion in 2009, or almost three times sales. Russians are not known as big soft-drink consumers as they prefer alcohol and they even dilute their hard liquor drinks with beer instead of soft-drinks. Also, Russia is currently experiencing the worst negative population growth in the world. From a strategic stand point, the acquisition allowed Pepsico to place its foot in an emerging region and I believe it will use this leverage to cross-sell its own products such as potato chips and other snacks, which have been traditionally strong in Russia and the region around it. Russia still has an enormous influence in the European/Asian regions and over time there will be intangible benefits to this acquisition. Overall, Pepsico expects 50% of its revenues to be derived from emerging and developing markets compared to 34% today. The Wimm-Bill-Dann acquisition is a major step towards this goal.
From a profitability stand-point, Pepsico is facing headwinds as it was impacted by raw material inflation more than Coca-Cola since Coke does not have a snack's business which is more sensitive to inflation pressures. On the other hand, consumers will always chose a snack to a drink if they cannot afford both and the first substitute a consumer makes at a fast-food place is to order water instead of soda. The recently announced restructuring should offset some of this disadvantage. Pepsico will eliminate about 8,700 positions or 3% of its work force and I believe there is room for further elimination in 2013 and beyond as Pepsico had $224 thousand of revenue per employee compared to over $300 thousand for Coke and Dr Pepper, a 30% difference. Also, Pepsico operating margin is about 14.5% compared to over 17.4% for Dr Pepper and Coke of 20% and also below Kellogg's 15%. Over time, I believe Pepsico should be able to bring its operating margins to high teens after the benefit of the restructuring program begin to surface in 2013 and beyond. I estimate that Pepsico will finish the year with $4.10 of earnings per share helped by the $3 billion share repurchase program the company instituted in the beginning of 2011 and a significantly higher earnings per share in 2013 of $4.40. Assuming a price to earnings ratio of 17, the 2013 price target is 75, a 15% capital appreciation for about two years and a dividend payout of about 6% for a total return of over 20% by 2014.
In conclusion, Pepsico is taking the necessary steps to grow and improve profitability. Pepsico should be able to outperform the market in the next twenty years due to its global position (especially in emerging and developing markets), its strong brands, and capable management in the face of its Indian born CEO, Indra Nooyi. When I read Pepsico's 2011 letter to shareholders, I agree with Ms. Nooyi's words that the "greatest challenge in business today is to renew a successful company - positioning it for long-term growth and profitability while performing in the current marketplace. This is a challenge we embrace." I think shareholders should rest assured for the next 20+ years that Pepsico has the resources, skills, and motivation to overcome this challenge.