The Spin-off Does not Seem to be Helpful
While the $820 billion global soft drink industry saw continued steady growth in 2013, with sales increasing by around 5% compared to the previous year, the competitive pressure continues to intensify. The continuous weakening demand for carbonated soft drinks in the developed markets is a big concern for PepsiCo (NYSE:PEP). About a month ago the activist investor Nelson Peltz suggested spinning-off the beverages business and acquiring Mondelez International (NASDAQ:MDLZ). Nelson Peltz suggested that because of the slow-down in the growth of the beverage business focusing on billion-dollar snacks brands such as Lays, Cheetos, and Doritos and combining with Mondelez will boost the company's growth. However the chief executive officer, Indra Nooyi, rejected the suggestion by arguing that splitting the beverage and snacks business in North America would significantly reduce customer relevance. This argument is very justified due to customers' preferences; beverages and snacks sales are supportive of one another. Despite of slowdown in growth, the beverage business is cash cow for PepsiCo. Even though PepsiCo decided not to split up Peltz's presence will keep management under pressure to improve the beverage business.
The Snacks Business did the job for PepsiCo
The U.S remained the largest soft drink market in terms of volume and revenues during 2013. The markets of China, Mexico, and Brazil are growing rapidly. PepsiCo is mainly focusing on China, India and Mexico. In the fourth quarter the carbonated soft drink volume fell by 2% in the Americas region and in Europe the sales declined by 2%. However, the snacks business did well as snacks volume improved by 3% in the Americas and 2% in Europe. The soft drink sales remained challenging and to deal with the softening demand in North America, Europe, and the Americas PepsiCo has initiated significant investment plans for the emerging markets to revive its growth. The emerging markets are less saturated and the potential for growth is an appealing opportunity for soft drink companies. In the emerging markets the economic growth is supporting consumer income levels and is driving urban lifestyles. This in turn is increasing demand for convenience food and drinks.
Mexican Carbonated Soft Drink Market will Ignite the Earnings Growth
Mexico is very important for PepsiCo as it the third largest market behind the U.S. and Russia. Mexico has the largest per capita consumption of carbonated soft drinks and the world's highest per capita bottled water consumption of around 260 liters. This makes it an attractive soft drink market and recently PepsiCo has announced it would invest $5 billion over the next five years. For fiscal year 2013 the revenues from Mexico increased by around 10% to $4.35 billion and this figure accounts for 6% of total revenues. PepsiCo holds roughly 14% of the carbonated soft drink market compared to the 71% market share of Coca-Cola (NYSE:KO). PepsiCo's solid hold in the snacks market combined with the $5 billion investment and $3 billion investment in 2009 will go towards expanding production lines and bolstering research and development to fuel the earnings growth.
In 2013 the retail soft drink market in Mexico reached $28.3 billion with a growth rate of 8.2%. The savory snacks market has grown to $5.17 billion in 2012 reflecting a CAGR of 7.4% between 2008 and 2012. The market will continue to grow at a CAGR of 6% between 2012 and 2017 and reach $6.93 billion by the end of 2017. Sabritas is the brand under which the company sells its Frito-Lay snacks such as Doritos, Tostitos, Cheetos and other products specific to the Mexican market. Sabritas dominates the country's salty snack market with an 80% market share followed by Barcel, a maker of tortilla chips and other snack brands, with a 12% market share.
The $5.5 billion Investment Plan in India
Over the past five years the revenue has tripled from emerging markets. Recently the company announced an expansion plan worth $5.5 billion to be put in place in India by the end of 2020. The money will be spent on new products, agriculture programs, selling infrastructure, and manufacturing capabilities. For fiscal year 2013 snacks and beverages sales volume experienced healthy growth in the Indian market. There are 8 million FMCG retail outlets in India and the company has an extensive distribution network across India through which PepsiCo is sold through more than 2 million outlets. This investment plan will increase the market reach to a greater number of outlets and ultimately the improved sales volume will result in earnings growth and more market share. PepsiCo experienced a snack volume growth of 7% and beverage volume growth of 12% in the Asia, Middle East and Africa region.
Pepsi Deal with Shanghai Disney Resorts
In China PepsiCo has been successful through its Lay's, Tropicana and Quaker brands. In addition to that, PepsiCo recently has broken a quarter century monopoly over beverage supply to the U.S. theme park operators by singing a deal to supply beverages to the Shanghai Disney resort. This deal has secured beverage sales to more than 7 million visitors. Although this deal represents a very small portion of the total soft drink market of $68.7 billion it is a win for PepsiCo over Coke in the highly competitive market and sales from this deal will help the beverage business to some extent. Although Coca Cola holds 15.7% of the market compared to PepsiCo's share of 4.5%, Pepsi's partner in the market, Taiwanese Tingyi, raised its market share from 9.9% in 2007 to 12.8% in 2012 and has captured further market share during 2013.
Cost-Cutting Program, More Share Buybacks, and Dividend Increase
To improve profitability PepsiCo has enacted cost cutting measures in recent years. The company was on track to save $3 billion by the end of 2014 under its previous cost-cutting program. The strong sale of Frito-Lay's products and savings from the cost-cutting program helped the recent quarter profits grow by 5%. This productivity plan will be extended for another 5 years, from 2015 through 2019. Under the plan, PepsiCo will increase investments in manufacturing automation, close some manufacturing facilities, and reengineer its distribution network in developed markets to be more efficient. The plan will result in cost savings of $1 billion per year. PepsiCo also intends to increase returns of $8.7 billion to shareholders through buybacks and dividends, $2.3 billion more from last year. This increase is quite aggressive and reflects its commitment to shareholders. In 2014 the annual dividend will increase to $2.62 per share from $2.27.
Although PepsiCo is facing sluggish demand from the developed market there is still steady growth potential in the U.S. soft drink market. The diversified product portfolio in the snack industry and strong industry growth will help the company to maintain its growth. In the developed market the energy drinks market has the potential and sales increased by 10% in 2013. This segment also offers an opportunity to stabilize the profits. However the emerging markets are the primary target to accelerate significant growth and the recent major investment plans along with the cost cutting program and product innovation will help the company to increase its revenues and earnings. PepsiCo is slightly cheap with a P/E of 18.96X compared to Coca Cola's P/E of 20.21X. The stock is trading at a forwards P/E of 16.74X with a 5 year forecasted growth of 8%. The current price of $81.89 gives an upside potential of around 8% for the average target price of $88.25. PepsiCo holds promising long-term prospects and I give this stock a buy rating.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.