Why I Believe PepsiCo Is The Best Choice In The Beverage Industry: Part 1

| About: PepsiCo Inc. (PEP)

Summary

PepsiCo's diverse product portfolio and international growth prove lucrative for investors.

CSD sales continue to fall, but are supported by overall growth in the PAB division.

Consumer spending may offset currency exchange issues in the near term, but it remains to be seen.

I have been a long-term investor in PepsiCo (NYSE:PEP), and given the company's strong and consistent earnings results, the stock has risen steadily through 2014. Having purchased shares at $78 earlier in the year and witnessing this investment reach the Capital Ladder Advisory Group (CLAG), for whom I am employed) price target objective of $100, I eliminated my position in the beverage company. My intention all along was to repurchase shares on a pullback in the share price, and that is exactly what has occurred in recent weeks. In this article, I aim to outline why I believe PepsiCo to be a sound investment going forward and with consideration of longer-term investing strategies.

From the perspective of CLAG, what makes PepsiCo the standout company among other beverage companies is the diversity of its product portfolio and its snack division. For example, Mountain Dew and Doritos. These are two iconic brands in the PepsiCo portfolio, and they have extremely high co-purchase incidences. In the U.S., over 60% of Mountain Dew households buy Doritos, according to PepsiCo's reported results. Unfortunately, if we analyze the Coca-Cola (NYSE:KO) product portfolio, this type of purchase activity isn't present in the business. While I can admire the strength of the Coca-Cola business, as a decision-based investor, I'm forced to recognize where there is the greatest diversity of product, there is often the greatest opportunity for profitability. Among other capital deployment reasoning and analysis, this weighs heavily on my decision-making between taking an investment in PepsiCo versus Coca-Cola.

It is important to recognize that PepsiCo is not just a beverage industry titan, but also a snack company through its prolific Frito-Lay division of products. The co-purchase incidences give the total PepsiCo business its strength and consistent cash flow generation that is beneficial to investors. While the company has seen activist investor sentiment tied to the separating of the beverage and snack businesses, PepsiCo has stood strong in the face of scrutiny and kept these two businesses under the PepsiCo umbrella.

If we look at the snacks division, the results continue to show improvement and positive sales performance quarter after quarter. In North America and during the 3rd quarter, Frito-Lay led the company's performance with 3% organic revenue growth in the quarter and year-to-date. Core gross and operating margins both expanded by 45 basis points in the quarter, aided by the benefits of PepsiCo's global productivity initiatives. Year-to-date, core gross margin expanded 50 basis points and core operating margin expanded 35 basis points. Not bad for a secondary portion of the total PepsiCo business, right?

Co-purchase activities growth on the part of the consumer is of key importance to PepsiCo. In order to enhance these activities, the company remains focused on driving greater co-purchase incidence of Lays and Pepsi with joint packaging graphics, sports properties, point-of-sale material, ad copy and promotions. These cross-branding activations are now taking place in many of PepsiCo's key markets across the globe. Below are some examples of how the company is proliferating co-purchase incidences:

  • In Poland, the company created excitement for the Lays brand by hiding coupons for 100,000 free Pepsis in bags. The promotion was supported by ads and point-of-sale material featuring the soccer great Lionel Messi.
  • In Colombia, the company ran joint Lays, Pepsi and Tropicana Quaker soccer team promotions, offering discounts and prizes for joint purchases in the organized way.
  • Across the Middle East, the company had great success of joint Lays-Pepsi promotions during the Ramadan season.

PepsiCo's global scale initiatives and capabilities are strong and growing in strength. Examples of this characterization can be witnessed by way of the company's continued product development/innovation and its global distribution footprint. For example, within snacks, since its initial U.S. introduction in 2012, Doritos Jacked has been launched in 10 international markets. The company also lifted and shifted a larger and thicker cut chip with deep ridges, which originated from the company's Ruffles brand and lunched it into several key countries such as Russia, Brazil, the Middle East and India under the Lays Max brand. And in the UK, PepsiCo launched a new range of premium potato, tortilla and pita chips under the Market Deli brand. The Market Deli brand caters to local taste preferences with flavors such as balsamic vinegar of Modena and Wiltshire cured ham, mature cheddar and farmhouse chutney. These product launches and innovations in existing and new markets give PepsiCo the opportunity to grow its revenues and earnings for years to come, if proven successful. In the event of slowing growth or no growth in the company's beverage division, the snack division acts, at the very least, as a buffer against potential system-wide declines. To reiterate, this is just one of the many examples of why I believe the snack business of PepsiCo is quite relevant for investor consideration.

So let's take a look at PepsiCo's most recent quarterly reported results that proved favorable to investors of record:

  • Organic revenue grew 3%. On a reported basis, net revenue was 2% versus year-ago, reflecting 1 point of unfavorable foreign exchange translation.
  • Core gross margin and core operating margin each rose 45 basis points.
  • Core constant currency operating profit grew 5.5%.
  • Core EPS was $1.36 and reported EPS was $1.32. This was a beat by $.07 per share against analysts' estimates. Core EPS excludes a negative net impact of $0.01 per share related to mark-to-market net losses on commodity hedges, and a $0.03 per share negative impact from restructuring and impairment charges.

Latin America Foods (LAF): Organic revenue grew 9 percent, reflecting 12 percentage points of effective net pricing, partially offset by a 2.5 percent organic volume decline.

Quaker Foods North America (QFNA): Organic revenue declined 2 percent, reflecting volume declines. Reported net revenue declined 3 percent.

PepsiCo Americas Beverages (PAB): Organic and reported net revenue were even, reflecting even organic volume. During the quarter, PAB maintained its liquid refreshment beverage value market share position in the U.S. in measured channels. In North America, non-carbonated beverage volume grew slightly and carbonated soft drink volume declined 1.5 percent. Latin America organic beverage volume increased 2.5 percent.

Europe: Organic revenue grew 1 percent, reflecting 2 percentage points of effective net pricing and volume growth of 2 percent in snacks, partially offset by a 2 percent volume decline in beverages.

Asia, Middle East & Africa (AMEA): Organic and reported net revenue grew 11 percent, driven by 11 percent volume growth in snacks and 3 percent volume growth in beverages.

As one can easily assess, while the results have been strong for PepsiCo, the company does have some work to do in key markets, especially as it pertains to its carbonated soft drinks (CSD) business. Additionally, emerging markets demand both investment and quality execution from management over the coming years.

The company's biggest hurdle presently may be its declining carbonated soft drinks division that contributes greatly to both revenues and earnings. As a whole, the PAB business that consists of both LRB and CSD beverage categories makes up the largest portion of PepsiCo's business. In the latest quarter, this segment of the PepsiCo business contributed roughly $5.38Bn in sales. As noted above, this was a basically flat performance year-over-year. Not impressive, but with consideration of the shift in consumption habits from soft drinks to healthier alternative beverages, the company has been managing this trend shift well. Unfortunately, it has not been handling it as well as Coca-Cola, which reported a flat performance in its CSD business for the same reporting period.

I know what most investors are thinking right about now: "So the company's highest revenue generating business is declining"? So what is PepsiCo doing to address the underlying issues with its declining CSD beverage business segment?

Innovation is a key driver for any business, and PepsiCo has taken many steps in this area in order to improve CSD sales. The biggest impact to traditional soft drink consumption has been the growing demand by the consumer for a achieving a healthier lifestyle. Soft drinks like those offered by Pepsi and Coke are inherently unhealthy due to their high sodium and sugar content. These two ingredients only brush the surface of the harmful ingredients in traditional store-bought sodas. Diet sodas, even with less sugar, have seen a greater volume decline in recent years, as reported by Beverage Digest and the major beverage producers themselves. The artificial sweetener, aspartame, in diet sodas has garnered a lot of negative sentiment in recent years, as studies show that the artificial sweetener has adverse side-effects on the body. But what is lesser known to the majority of diet soda consumers is that the studies suggest the sweetener is safe for consumption under normal use. The acceptable daily intake (ADI) recommendations are:

  • FDA: 50 milligrams per kilogram of body weight
  • EFSA: 40 milligrams per kilogram of body weight

A can of diet soda contains about 185 milligrams of aspartame. A 150-pound (68 kilograms) person would have to drink more than 18 cans of soda a day to exceed the FDA daily intake. Alternatively, they would need nearly 15 cans to exceed the EFSA recommendation. As anyone can clearly see, it would be very difficult to "overdose" on aspartame. Nonetheless, the sentiment is that the necessary limit requirements insinuate in favor of eliminating the sweetener from one's diet altogether. This is the choice thousands of former diet soda drinkers have chosen.

PepsiCo has partnered with Senomyx (NASDAQ:SNMX) in recent years to develop and use the company's "Sweetmyx" product exclusively in its core non-alcoholic beverages. While it's not a sweetener itself, Sweetmyx works by altering flavor characteristics to enhance sweetness. That allows less sugar to be used. Senomyx said late last year it expected PepsiCo to start selling products with Sweetmyx this year. PepsiCo hasn't said what drinks it's planning, and to-date, none of its core products use the ingredient. I would be of the opinion there will be more news regarding PepsiCo and Sensomyx in the near future.

For the consumer, it's all about the healthier alternative, and the major beverage providers are doing all they can, as quickly as they can, to address the consumer's wants and needs. A mid-calorie sweetener for soft drinks that has growing appeal with no harmful side-affects to the human body has been hard to come by. PepsiCo's latest attempt to address the consumer shift away from soft drinks and to lure them back into the category is through the use of Stevia, a sweetener extracted from plant leaves. Stevia was used in Pepsi Next, which was first sold in Australia and has since expanded to France and Canada. The problems surrounding the use of Stevia comes down to taste. Stevia's bitter aftertaste is widely polarizing, and as a result, many analysts have predicted it will ultimately fail.

We believe stevia-sweetened Coke Life may not see a launch in the US, as we do not believe it has performed well in tests and consumers have not responded to mid-calorie colas (as shown by failures of Pepsi NEXT and Dr. Pepper TEN)," analysts wrote in a July 2014 report by CLSA, an Asia-based independent brokerage and investment group.

It's quite obvious that while the analysts were incorrect in predicting Coke Life won't launch in the U.S., they may still be proven accurate in that these mid-calorie product offerings may be destined to fail. The response has been less-than-spectacular for Coke Life, as reported by Nielsen Homescan Data.

In regions where Coca-Cola has launched Coke Life, the consumer response has been quite mixed. Britain launched Coke Life in August of this year. The data suggests the sentiment from Brits was slightly skewed toward negative reactions from the beverage (51% negative to 49% positive). Moreover, PepsiCo hasn't let the early results from Coke Life deter its launch of a new Stevia-based soft drink from the company. Pepsi True launched in the U.S. during the month of October. Like Coke Life, the reviews have been mixed for Pepsi True, and the backlash from environmentalists has been even worse. Pepsi True was launched exclusively on Amazon.com.

Thousands of shoppers - led by campaign group SumOfUs.org - taking to the site to leave negative reviews, and blasting the company for its unsustainable use of palm oil. The product was removed briefly, but such was the media storm around the debacle that the damage had already been done, and Pepsi reinstated the drink on Amazon - presumably some sales and bad publicity are better than no sales and bad publicity. Pepsi then responded to the sabotage with a fairly aggressive public relations campaign, claiming that it had been a victim of "an orchestrated effort to post inaccurate information" about the product.

The bottom line seems to be that PepsiCo and Coca-Cola are going to have to address their growing problems in the CSD space through alternative measures. I think the actions to find a mid-calorie cola winner is going to be fruitless for either company. The health-conscious and the traditional soda consumer want zero-calorie or full-calorie beverages. It's got to be one way or the other, no in-between. The in-between formulas just don't seem to be working well.

I'll leave this portion of the CSD conversation here for the time being so as to develop it further in a "Part 2" publication. Both PepsiCo and Coca-Cola have other tricks up their respective sleeves to address the issues concerning the CSD category.

Like any other company, when considering an investment, one should analyze both the past and the potential for the company's future. We have already seen the company beat estimates in each of the last several quarters, including the most recently reported 3rd quarter of 2014. Additionally, the company raised its 2014 EPS guidance from 8% growth to 9% growth in the most recently reported quarter. PepsiCo's emerging market growth is also considerably higher than its peers, which bode well for the company going forward. Keep in mind, it does have a smaller footprint in international markets.

While PepsiCo certainly has its share of opportunity, it will also face hurdles like the issues surrounding the CSD category. Some other near-term issues the company faces surround the volatile situation in the currency market, which may prove to dilute earnings in the coming quarters. Nothing is certain when it comes to the currency markets, and with the recent strength from the consumer in PepsiCo's largest North American markets, additional consumer spending could potentially offset negative impact from unfavorable currency exchange rates. In a recent article by Bill Maurer, Seeking Alpha contributor, he discusses the potential impact from lower gasoline prices on the consumer in North America.

As you have probably heard by now, the price of oil is plunging and so are gas prices. US consumers are going to have a lot more money in their pockets as we get into the new year. In the chart below, you can see how far gas prices have fallen, and they are expected to continue lower in the short-term.

While it remains to be seen whether or not consumer spending in North America can offset, to some degree, PepsiCo's potential currency issues in the near term, the logic is certainly formidable to suggest it has the potential.

For Part 2, go here.

Disclosure: The author is long PEP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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