PepsiCo (NYSE:PEP) is scheduled to announce its third quarter earnings on October 16. We expect the snacks business to be the primary growth driver on strong performance from its global snacks food brands as well as growing popularity of nutritional snacks in developed markets. On the other hand, PepsiCo’s underperformance in the beverage space in developed markets, where consumption of carbonated soft drinks (CSDs) has been consistently declining over the last few years, is expected to weigh on its financials.
Moreover, PepsiCo’s third quarter earnings are expected to take a hit from currency headwinds due to strengthening U.S. dollar and volatile emerging market currencies. However, the company might be able to offset the impact to some extent through savings from its ongoing productivity program targeting $900 million savings for the year.
Our $89 price estimate for the company is about 10% above its current market price.
Snacks Division To Drive Growth
PepsiCo’s snacks division, which operates brands like Lay’s, Quaker and Doritos, has been performing well in recent years, maintaining and growing its market share in both developed and emerging markets.
In the developed markets, the company has been leveraging a shift towards healthier snacks, relying largely on new, gluten-free and low fat products to drive sales. Recently, Muller Quaker Dairy, a joint venture (JV) between PepsiCo and Theo Muller Group of Germany, announced the opening of a new manufacturing facility in Batavia, New York. The companies aim to expand the distribution of Muller yogurt servings from select regional markets to cover nationwide stores, increasing their share in one of the fastest growing categories in the U.S. food and beverage industry. (See: PepsiCo Expands Yogurt Production To Target Healthier Eating Trends)
PepsiCo is also focused on diversifying its pricing mix in developed economies with new products being launched in both premium and low-priced segments. This is helping the company access a broader range of consumers. The company’s attempts at experimenting with local tastes and preferences have also helped it gain ground in emerging markets despite stiff competition from local players.
PepsiCo’s strong performance in the snacks division is highlighted by the top-line growth of Pepsi Americas Foods, which includes snacks sales in North and Latin America. During the first half of the year, sales from the division that contributed ~40% to the company’s consolidated net revenues and ~50% to its total operating income grew 5% y-o-y. We expect the snacks division to be the primary growth driver for the company during the third quarter as well. 
The Soda Slump In Developed Markets To Weigh On Earnings
As consumers continue to shift towards healthier alternatives due to obesity and diabetes concerns, the soda slump in developed markets is getting bad to worse. The situation in the U.S. is a key example of this trend – all-channel carbonated soft drink (CSD) sales volume in the U.S. declined 1.2% in 2012, slightly worse than the 1% decline in 2011 and the 0.5% decline in 2010.  Per capita consumption of CSDs peaked around 1998 at about 54 gallons a year. In 2012, the figure stood at around 44 gallons a year.  Growing consumer awareness about the negative health impact of CSDs has been a major reason behind this trend. A research paper recently published in the American Journal of Public Health concluded: “Soft drink consumption is significantly linked to overweight, obesity, and diabetes prevalent worldwide.”
The situation is also difficult in the low-calorie segment, which was once seen as a savior of the CSD lineup. A recent report from Beverage Digest, a trade publication, suggests that consumption of low-calorie or diet sodas is falling faster that the regular CSDs. It noted that while the sales of regular Coke and Pepsi declined by just 1% and 3% in 2012, their low-calorie counterparts fell by more than 3% and 6%, respectively.  This is primarily due to health concerns associated with consumption of aspartame, an artificial sweetener that contains close to zero calories and is almost 200 times sweeter than sugar. It can also be attributed to a growing shift in consumer preferences toward natural and organic ingredients in the U.S.
PepsiCo has been the worst hit by the soda slump in developed markets. The company’s CSD volume market share has eroded the most among the top three beverage players in the U.S. over the last couple of years. PepsiCo’s all-channel volume market share in the U.S. CSD market stood at 29.3% in 2010, which declined to 28.1% in 2012.  This is primarily due to the company’s price-taking strategy aimed at sustaining and expanding its value share. However, there are inherent risks associated with this strategy which are even higher than those associated with launching a new product, as the company is sacrificing its existing market share which will be difficult to regain. We do not believe that this strategy is sustainable in the long run and investors should be concerned if the trend persists over the next few quarters.
Since the developed markets still account for a majority of PepsiCo’s CSD sales, consumption growth from the emerging markets, such as China, Russia and India is currently not enough to offset the impact of the soda slump in these markets. Not only this, the growing proportion of sales from emerging markets also has a negative impact on PepsiCo’s average revenue per case, and it also increases the variability of the company’s revenues due to exchange rate fluctuations. The high volatility observed in the valuation of emerging market currencies this year on concerns over the U.S. Federal Reserve’s tapering program is a key example of this trend.  Recently, PepsiCo guided to a slightly harder impact of the volatile currency markets on its full year revenues than expected earlier. Notes:
- PepsiCo SEC Filings, sec.gov [↩]
- Special Issue: U.S. Beverage Results for 2012, beverage-digest.com [↩] [↩]
- Water becomes America’s favorite drink again, usatoday.com [↩]
- Coca-Cola ad to defend artificial sweeteners, usatoday.com [↩]
- Fed tapering a bigger risk to Asia markets than assumed, reuters.com [↩]
- PepsiCo Backs 2013 Earnings Outlook, Currency Fluctuation To Hurt Revenue Growth, nasdaq.com [↩]