These are trying times for food and beverage companies, as managements try to find the right balance between offsetting cost inflation through price increases and maintaining stable volumes. While volumes were a little challenged at PepsiCo (PEP) this quarter, that's not the major challenge in front of the company. The real key to the stock breaking out of a five-year funk may have less to do with matching Coca-Cola (KO) or extending its lead over Kraft (KFT) as it does improving upon margins and free cash flow.
Should Analysts Really Celebrate Q1 Numbers?
Reactions to PepsiCo's earnings have been pretty supportive from the sell-side. Reported revenue growth of 4% and slightly higher organic growth were consistent with expectations, and the only real surprise would seem to be the weak volume seen at Quaker.
Even still, negative 2% revenue growth in North American beverages doesn't impress me much in a quarter where Coca-Cola grew and Nestle (NSRGY.PK) picked up some share as well. Frito-Lay was a better story, though, at least relative to comparables like Kellogg (K). International results also looked pretty solid, with 3% snack volume growth in Europe, nearly 5% growth in Latin America, and 16% growth in Asia.
Margins are still not very good, though. Gross margin dropped two points, due in part to an incremental $300 million in commodity costs. Operating income fell 6% and operating margin slipped another 140 basis points, though SG&A only increased 1% despite 25% higher U.S. ad spending. Still, while analysts seemed pleased with this (and it was better than expected), margins dropped in every reporting segment.
Threats And Opportunities Seem Pretty Balanced
With the pending break-up of Kraft, the new Mondelez snack food business is likely to be focused on validating the split with strong growth. Elsewhere, Kellogg will be bringing Procter & Gamble's (PG) Pringles into the fold (and paying a lot to do so) and certainly looking to boost its market share - which happens to be less than some individual chip lines at PepsiCo's Frito-Lay.
Should PepsiCo be worried? Well, the company has nearly 40% of the broadly-defined U.S. snack market, and nearly two-thirds of the salty snack market, not to mention strong (and growing) share in European and Latin American markets like the U.K. and Brazil. By comparison, Kraft has 10% share and post-Pringles Kellogg will have maybe 7% or 8% share.
With that in mind, I don't think PepsiCo needs to be too worried here. Stilll, PepsiCo does deserve credit for actually doing what a lot of other companies say they will do - making real money off of healthier/more nutritious snacks - and management seems to be raising the bar here again.
Beverages is a different story, though. The company's flagship line doesn't seem to be gaining ground on its major rival, and I'm a little concerned about share movement in the non-soda beverages as well. PepsiCo is moving aggressively to boost its overseas business, though, and closing the gap with Coca-Cola in emerging markets should help.
But What About The Margins?
While I understand the decisions of PepsiCo management to accelerate revenue growth through a greater focus on emerging markets and more promotional spending, it has to be balanced with some concern for long-term margins. I'm not sure the company has really reaped a lot of benefits from the acquisitions of the Pepsi Bottling Group and PepsiAmericas, though the fact that Coca-Cola matched the move suggests that there's something to it.
To be fair, PepsiCo's operating margins and free cash flow production aren't bad by the standards of the food/beverage sector, but they need to get better for this stock to work.
The Bottom Line
Sell-side analysts aren't expecting much improvement in margins anytime soon, so that may be the best potential source of upside in this stock. At nearly 10x trailing EBTIDA, the stock is not a huge bargain. Looking at a broader range of food and beverage stocks, though, PepsiCo is at least just as good (if not better) than Coca-Cola, ConAgra (CAG), Campbell's Soup (CPB), General Mills (GIS), Kellogg, or Nestle from a risk/reward/value perspective.
I still have issues with the fundamental valuation. Even if the company can grow free cash flow at a high single-digit clip, the stock still looks more or less fairly-valued today. So while it may be the best of an over-valued group, and it does sport a respectable dividend, it's still not a compelling stock to me today.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
