PepsiCo: Volume Growth Continues To Strengthen The Positive Investment Case

Summary

• PEP's H1 2016 performance impressed me immensely, especially with regard to volume growth performance.
• Encouragingly, Q3 2016 appears to have continued that positive volume growth momentum.
• With strong cash flow generation and shareholder return potential combined with volume growth, PEP is looking increasingly attractive for long-term investors.

Back at H1 2016 time, snacks and beverages giant PepsiCo (NASDAQ:PEP) impressed me a great deal. I must admit to having largely overlooked the company up to that point. Yet PepsiCo was certainly thrust firmly back onto my watch list after its first-half performance.

What particularly appealed was the strength of its volume growth performances, which underpinned the more consistent appeal of its cash flow. Yet has PEP managed to stretch this attractive performance across Q3 2016 as well?

I argue that it has, and it would seem that (combined with other considerations) this leaves the increasingly positive investment case for this consumer defensive giant stronger than ever. Let me explain why here.

Top and Bottom Line Strength

A pleasant surprise to begin with. PepsiCo managed some very robust looking figures both from a reported and organic basis:

Needless to say, the practically doubled operating income catches anyone's eye quite quickly. Unsurprisingly, there was an extraordinary catalyst to this particular leap: Venezuela. Operating income was lifted massively, courtesy of the Venezuela write-down last year. Indeed, 91% of the lift in Q3 2016 was due to this.

Of course, it is the organic figures that are really of interest. Cutting out the effect of acquisitions, divestitures, currency fluctuations etc. shows that PepsiCo was able to put together some pretty robust underlying growth. Sure, it has run a little behind that seen in recent years:

Nonetheless, Q3's acceleration over H1 2016 suggests it is entering H2 2016 with some more promising momentum. Indeed, PepsiCo is anticipating that it will leave 2016 with 4% organic revenue growth. For me, that is a good set of results and the predictions seem more than fair with the possibility of being, in fact, a little conservative.

Volume Growth also Robust

What impressed me most in H1, however, had been the strong volume performance at PepsiCo. Was this replicated in Q3? Well, certainly outside North America volume growth remained healthy indeed in the third quarter:

Indeed, all except for Latin America beverages (where we saw a decline from 0% to -1%) improved upon the performances chalked up in H1 2016. The comparisons look all the more impressive when you realize that they represented a hefty hike on FY2015's results:

Although Latin American beverages still lagged behind, performance has been in line with FY2015. Speaking more generally at the Q3 earnings call about Latin America, PepsiCo's CEO, Indra Nooyi, explained that:

... we have good businesses there. And there's no question, Argentina had a troubled year. Brazil is having its share of troubles. But I'd say that, overall, the economy seemed to be holding up. But, more importantly, our businesses seemed to be performing quite well because retailers turn to us to deliver more of the growth because we have high velocity categories.

Overall, she remained "cautiously optimistic" about the emerging markets and I am with her here. Although conditions are still tough (especially in certain core Latin American markets) performance was robust and Q3 2016 suggested that improvements are coming through.

North America

The all-important North American market also showed a generally improving or consistent volume performance compared to H1 2016. Beverages managed to improve volume growth, whilst Frito Lay retained a 2% growth. Quaker Foods, in contrast, saw volume drop from 0.5% in H1 2016 to down 2% in Q3 2016:

Now, of course, healthy growth in the North American market matters. Its home market represents by far the largest part of PepsiCo's business at over 63% of revenue and 75% of operating income:

Seeing Quaker Foods drop quite so significantly is, therefore, hardly welcomed. Fortunately, the underperforming Quaker Foods division is only a very small part of that North American business. Consequently, the strong rebound in performance from beverages to a 2% volume lift is far more significant. And from this perspective, again, it is hard not to be encouraged by its performance.

Indeed, looking at recent volume performance at company level shows just how good these results are:

This leaves me very encouraged indeed. Whilst 2014 and 2015 saw all parts of the business struggling to find volume growth and relying much more heavily on pricing hikes, 2016 has so far been marked by an acceleration in volume growth. This is great news not only for Q4 and FY2016 but also into 2017.

Cash Flow

Nor are we to find anything to worry about on the cash flow front. Certainly, operating cash flow did decline. Consequently, with CapEx also growing, FCF was modestly down on the year to Q3 2015:

Fluctuations of this sort are, however, to be expected with cash flow. Nonetheless, there is little doubt that PepsiCo's cash flow remains stubbornly impressive. This underpins its remarkable appeal to investors both from a growth and income perspective. As we shall see, PepsiCo continues to generate this FCF very efficiently indeed.

Debt and CROIC

First let's take a quick look at debt which has increasingly attracted my attention (for instance, in my recent Brown-Forman (BF.B) analysis).

PepsiCo, like many others, has lifted its debt levels in recent years. Yet PepsiCo has done so at a slower pace than its more drink-focused peer Coca-Cola (KO) (which I reviewed more thoroughly earlier). Whilst Coca-Cola has seen each $100 of debt in 2011 grow to over $155 in 2015, PepsiCo has seen each $100 of its debt grow to just $124:

The net result is that whereas they both ended 2011 with debt levels fairly similar ($26.7 billion for PepsiCo and $28.5 billion for Coca-Cola) PepsiCo now has considerably less in contrast to its peer (£33.2 billion as opposed to $44.2 billion). What is more, Coca-Cola continued its outpaced debt growth compared to PepsiCo in FY2016 too. By Q2 2016, Coca-Cola had added another $4 billion to its total. In contrast, PepsiCo's Q3 2016 results show that it added a considerably smaller $2.4 billion.

This has helped support its cash-generating efficiency. PEP's CROIC-cash return on invested capital-is calculated by dividing its FCF by the sum of the total debt and shareholders' equity. Clearly, growing debt and a slightly weaker FCF performance to Q3 2016 has meant that PepsiCo is likely to see a weaker CROIC come the end of 2016. Assuming a similar proportion of CROIC is provided by Q4 as in 2015, it looks as though it could generate a CROIC of about 15%:

This remains a compellingly efficient level of FCF generation suggesting that for every $100 of invested capital, PepsiCo produces over $15 in FCF. Happily, this strong cash generating efficiency also leaves it with very healthy looking FCF to debt ratios. In recent history, it has sat around the 20% to 26% mark:

With current FCF and debt indications, it would appear that 2016 will likely see its FCF to Debt ratio fall down to around the 20% mark again. Yet that is still a very good coverage. It would suggest that, in theory at least, PEP could repay its entire debt load in just five years using FCF alone. All in all, this leaves me very happy indeed with how the company is looking.

Healthy Income Play

That happiness grows further when you realize that PepsiCo remains an attractive income stock despite its yield having dipped noticeably with recent share price gains:

A 2.6% yield produced by a modest 51% FCF payout ratio is very attractive indeed. Certainly, the yield has fallen in recent years. Yet what is clear is that combined with strong share buyback programs, investors have come away with a strong total yield:

What is more, the current yield is far closer to its historic average than many other consumer defensive peers.

Conclusion

PepsiCo's 2016 so far has continued to impress me immensely. In recent years, it has continued to generate strong organic growth. Yet this had largely been maintained through the less attractive means of price hikes. 2016 has, so far, proven to be a much more encouraging story for long-term investors with volume growth across its North American and global markets looking far more generous. This is great news.

What is more, PepsiCo remains an incredible cash generator. This has and is set to continue to underpin the attractive shareholder returns PEP has generated for investors. Similarly, PepsiCo's more conservative attitude towards debt growth is comforting and leaves it with a strong book to support the strong business. For me, this has increased the attractions of PepsiCo as an investment.

Nor does PepsiCo look outrageously priced right now. Using 10-year data and plugging it into my three-part valuation method suggests a fair value around the $100 to $105 mark. At $106, clearly PepsiCo is a little ahead of its fair value yet not too far. With global uncertainty as high as it is at present, the kind of dependable cash flow generators like PepsiCo continue to hold massive appeal and thus quite understandably trade at a premium.

With volume performance also improving in FY2016 so far, this premium at PepsiCo appears even more justified. The temptation to build a position in this consumer defensive giant is growing and growing at present for me. If PEP can keep this volume momentum going, I would be very keen right now to start nudging capital in its direction sooner rather than later.

Notes

Unless otherwise stated, all graphs and the calculations contained within were produced by the author. Creative Commons images reproduced from Flickr user aakanayev (cropped).

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.