Leading beverage and snacks manufacturer, PepsiCo (NYSE:PEP), is scheduled to announce its Q4 and full-year earnings on February 13. Contracting soda sales and declining demand for hot cereals in the U.S. are expected to weigh on the company’s financials. However, the company is expected to derive growth from its booming Frito-Lay snacks division, especially in Latin America and certain emerging economies, in addition to the domestic market. Although trailing the S&P 500′s 31% rise in 2013, PepsiCo’s shares jumped 22%, beating both The Coca-Cola Company‘s (NYSE:KO) 14% and Dr Pepper Snapple‘s (NYSE:DPS) 11% advances. The impact of declining carbonated soft drink (CSD) sales on PepsiCo’s stock is less profound as compared to its chief competitors due to its strong presence in the snacks market apart from beverages. In fact, more than 60% of the company’s valuation comes from its snacks division by our estimates.
We estimate a $87 price for PepsiCo, which is around 8% above the current market price.
- Innovative Snacking To Provide Growth For Frito-Lay North America
On the back of continual strong demand for savory snacks, PepsiCo’s Frito Lay North America division witnessed 4.5% revenue growth in the nine months ending September 2013.  The sweet and savory snacks market in the U.S. had retail sales of around $40 billion in 2012, with sales of salty snacks (including potato chips, tortilla chips and corn snacks) increasing by over 4% year-on-year.  Frito-Lay holds a commanding position in this market, accounting for 42% of the market share by value. The largest segment of the salty snacks market is potato chips, which contributed sales of $9 billion in 2012.  Fueled by the introduction of baked and gluten-free chips, this segment is expected to grow at a CAGR of 3.1% through 2017.  This bodes well for PepsiCo, which boasts a market share of 58% in potato chips and could draw dollar sales of over $5.5 billion from this segment alone by 2017, given the present scenario.
We expect Frito-Lay to cap off another strong quarter, bolstered by the success of its Doritos Locos Tacos. In 2012, the company launched Doritos Locos Tacos in partnership with Taco Bell, a subsidiary of Yum! Brands, which crossed 1 billion in retail sales by October last year.  Going forward, PepsiCo aims to replicate this success by partnering with restaurant chains such as Pizza Hut, also owned by Yum! Brands, and Buffalo Wild Wings. The company is looking for innovative ways to incorporate its snacks in menus of these restaurants to boost sales of its Frito-Lay division.
- Declining Demand For Hot Cereals Could Hurt Quaker’s Sales
While PepsiCo’s Frito-Lay snacks continued to grow in the domestic market, sales of breakfast cereal brand Quaker Foods remained flat through September. This is primarily due to shifting trends in the breakfast cereal industry, where compact foods and ready-to-eat nutritional snack bars are gaining more popularity as compared to traditional hot cereals. At present, General Mills and Kellogg’s lead the U.S. breakfast cereal market with a combined share of over 55%, but Quaker Foods leads the hot cereals segment. The overall market is expected to grow at a CAGR of 3% to $10.3 billion in 2017.  However, despite the growth potential of this market, what could hurt sales of Quaker is the decline in volumes of the hot cereals segment.
Consumers, especially women who take care of the entire family’s nutritional intake form the target demographic for the breakfast cereal market. The unemployment rate for adult women (ages above 20) fell from 7.2% in January last year to 6% by the end of the year.  With increasing rates of employment, women now are more pressed for time and are likely to either skip breakfast altogether or consume packaged foods and nutrition bars. However, PepsiCo has taken some steps to keep up with recent trends and revive the Quaker Foods North America division. The company introduced its own nutritional snack bar “Quaker Real Medleys Bars” mid-last year, following mild success of the portable Quaker Real Medleys oatmeal launched in 2012.
- Emerging Countries To Provide Growth For PepsiCo’s Snacks
International foods constitute over one-fifths of PepsiCo’s valuation by our estimates. The company’s Latin America Foods division registered the highest growth rate compared to any other division in the last couple of years. This division grew by 13% through September, while the company managed 4% growth. In addition, PepsiCo’s snacks business grew by 7% in Asia, Middle East and Africa, bolstered by high single-digit percent increases in China and India. Due to the acceleration in economic development and increasing disposable incomes in these countries, we expect another strong quarter for PepsiCo’s international foods business. However, the company’s revenues from this segment might be somewhat offset by unfavorable currency translations. Strengthening of the U.S. dollar against currencies in some of PepsiCo’s crucial international markets such as Russia, India and Mexico could negatively impact the company’s top line.
- Sugary Drinks Slump Could Impede Growth For PepsiCo
Over a third of PepsiCo’s revenues in 2012 came from its CSDs and juices. Both these categories together constitute more than half of the U.S. beverage market volumes. The company has considerable market shares in both CSDs and juices owing to brands such as Pepsi cola drink and Tropicana respectively. However, heeding to the call for a healthier lifestyle, consumers are now slowly shifting from high sugar drinks to beverages such as sports drinks, ready-to-drink tea and carbonated water. This is expected to weigh on PepsiCo’s top line in the fourth quarter as well.
In the long run, we expect CSDs and juices in the U.S. to decline by 0.5% and 3% respectively through 2018, contributing less than 45% to the overall beverage market volumes at the end of the forecast period. Given the present scenario, PepsiCo’s CSD and juice volumes in the domestic market will decline by 5% from 4.6 billion gallons in 2012 to around 4.3 billion gallons in 2018 by our estimates. However, international markets such as China and Russia could provide potential growth opportunities, where fizzy drinks and juices are still popular.
- Growth Could Come From The Sports Drink Gatorade
Recent trends suggest that consumers are choosing sports drinks and carbonated water to substitute sugary drinks. Although sports drinks constitute a small 5% of the U.S. beverage industry at present, we expect this segment to grow by 7% through 2018 to over 2 billion gallons. PepsiCo could in fact gain from the shifting consumer trends as it holds three-fourths of this market with its brand Gatorade. This could mean that even if fizzy drink volumes decline at a rapid rate in the U.S., the company might gain from rising volumes in sports drinks.
We expect growth in Frito-Lay North America and beverages such as sports drinks to offset any decrease in soda volumes for PepsiCo in 2013. Going forward, the company will look to introduce its diet CSDs that use the artificial sweetener Reb D, a stevia derivative made by PureCircle. PepsiCo has already filed a patent application for the same, and will hope to recover its CSD sales by using stevia, which is considered safer.Notes:
- “PepsiCo 10-q“ [↩]
- “Sweets and snacks 2013 trends“, May 2013, cnbc.com [↩]
- “Salty snacks-US“, January 2013, marketresearch.com [↩]
- “Potato chips in the US“, September 2013, marketresearch.com [↩]
- “Doritos locos tacos sales pass $1 billion“, October 2013, huffingtonpost.com [↩]
- “Breakfast cereals in the U.S.“, March 2013, euromonitor.com [↩]
- “U.S. department of labor statistics“ [↩]