PepsiCo (NYSE:PEP) reported strong third quarter results backed by 3.3% organic growth (adjusted for structural changes and foreign exchange translation) in consolidated net revenues and core EPS growth of 5% y-o-y. The company’s core operating margins improved over last year despite an 8% increase in advertising and marketing expenses, primarily due to higher net pricing and savings from its ongoing productivity improvement program.
PepsiCo’s Americas Foods division posted strong 7% organic revenue growth on higher sales volume in North America and better pricing in Latin America. However, the company’s Americas beverage unit posted a 1.5% decline in revenues as lower volumes more that offset higher net pricing. 
We currently have $89 price estimate for PepsiCo, which we will soon update based on the third quarter earnings announcement.
Snacks Drive Growth
According to our estimates, PepsiCo’s global snacks business accounts for ~60% of its total value. The business contributed 53% to its total revenues during the first nine months of the year. We believe Frito-Lay North America is the most valuable division of PepsiCo and makes up more than one-third of our valuation for the company. This is primarily due to consistent outperformance of its popular brands such as Lay’s, Doritos, Tostitos and Cheetos.
During the third quarter, Frito-Lay’s organic net revenue increased 5% y-o-y driven by 3% organic volume growth and 2 point benefit from effective net pricing. The company was also able to offset its sluggish performance in the North American nutritional snacks market where it operates under the popular Quaker brand. The Quaker Foods North America division’s operating income declined more than 10% y-o-y as it suffered from unfavorable volume mix and higher commodity costs. 
PepsiCo already sells more brands in the North America snacks market than any other player, occupying a majority of the shelf space in retail outlets.  Strong revenue growth in the snacks category backed by higher volume as well as better pricing reinforces the company’s leading position in the marketplace. PepsiCo’s snacks business in North America was also able to expand its core operating margins despite higher marketing and advertising expense. This further bolsters our faith in the business’ capability to more than offset the persistent weakness in PepsiCo’s beverage business in the region.
The company’s snacks business also flourished in international markets, especially Latin America. PepsiCo was able to grow its organic sales volume by 3% in Latin America despite a 12% hike in effective net pricing. This coupled with productivity improvements boosted Latin America Foods’ operating profits by ~25%. The snacks business also grew strongly in Europe, Asia, Africa and the Middle East.  Overall, with snacks outgrowing beverages across its geographically diverse portfolio, PepsiCo might be slowly transitioning to a bite driven company predominantly.
Beverages Continue To Drag
PepsiCo’s beverage operations in the Americas posted a 1.5% decline in organic net revenues for the third quarter as lower volumes more than offset higher net pricing. The division reported lower volumes in both carbonated as well as non-carbonated beverage categories in North America. However, the company was able to sustain operating income from the division at last year levels, as higher net pricing and productivity gains helped in margin expansion. 
PepsiCo’s beverage volume also declined 1% in Europe. The only region where the company posted volume gains in the beverage category was Asia, the Middle East and Africa (AMEA), which contributes just 10% to its total revenues from both snacks and beverages.  Since developed markets still account for a majority of PepsiCo’s beverage 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. 
PepsiCo played down the decline in beverage sales volume in developed markets by pointing to higher value creation through pricing and innovation. We believe that while this strategy may work well for the company in some still beverage categories like energy and sports drinks where it operates leading brands, like Gatorade, it may face intense competition in other categories from pure beverage players such as Coca-Cola (NYSE:KO) and Dr Pepper Snapple (NYSE:DPS). Moreover, there are inherent risks associated with the company’s price-taking strategy aimed at sustaining and expanding its value share, 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 therefore do not believe that this strategy is sustainable in the long run.Notes: