Obstacles That Could Deter Growth For PepsiCo’s Snacks Division (Part 1)

While revenues for PepsiCo‘s (NYSE:PEP) beverage business have declined in each of the last couple of years, the snacks division has consolidated consecutive years of growth. As headwinds in the carbonated soft drinks (CSD) market, primarily in the developed world, continue to stall volume expansion for PepsiCo, the company expects two-thirds of its top line growth to come from its booming snacks division this year. Sweet, savory, and dairy snacks and breakfast foods together constitute just over 62% of PepsiCo’s valuation by our estimates. The U.S., Russia and Mexico are the three largest markets for PepsiCo, constituting almost two-thirds of the net sales in 2013. Both the U.S. and Mexico have a large appetite for savory snacks, which is why PepsiCo’s snacks in these two countries witnessed around 6% sales growth last year by our estimates. But large snacking is also one of the reasons why both Mexico and the U.S. have the world’s highest obesity rates of 32.8% and 31.8% respectively. In order to improve health in the country, Mexico introduced a junk-food-tax in the beginning of this year, which negatively impacted snack volumes for PepsiCo in the first quarter. On the other hand, dairy products such as yogurt and cheese are popular in Russia. However, recent geopolitical issues in Russia led to devaluation of the Russian ruble against the U.S. dollar, and together with high inflation, dragged down revenues from the country. Despite strong sales year after year, PepsiCo’s snacks business could possibly face some obstacles in its three most crucial markets. In this article, we will highlight trends that could hurt the Frito-Lay division in the U.S., and follow it up with snack trends in Mexico and Russia in the next article.

We estimate a $86.82 price for PepsiCo, which is roughly in line with the current market price.

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Health Concerns Could Impact Sales For Frito-Lay

PepsiCo leads the U.S. savory snacks market by far with 36.6% market share as of December 2013. The next biggest manufacturers in this sector are Kellogg’s and Mondelez with 7% and 5.6% share respectively. Revenues for Frito Lay in the U.S. grew by 4% year-over-year in 2013 by our estimates, whereas beverages in the country declined by 1% in terms of sales. Despite high calorie and cholesterol levels, savory snacks, especially salty snacks, remain popular among consumers. The domestic snack food market is worth $35 billion presently, growing at a CAGR of 3.8% since 2009. ^[1] However, similar to how health and wellness concerns have stalled growth for CSDs in the U.S., salty snacks could also lose out to healthier options such as nutritional snack bars and dairy products. PepsiCo is also present in the dairy space with its Muller Quaker Dairy (MQD) products, in partnership with the Theo Muller Group. Greek yogurt taking away consumers from salty snacks could mean cannibalization of sales for PepsiCo.

However, unlike in savory snacks where PepsiCo is the runaway market leader, the company is relatively new to the yogurt segment. The U.S. yogurt and sour milk products market, which is expected to grow by 10% between 2013-2018 to $9.3 billion, is led by Danone and Chobani. ^[2] Both these companies account for more than half the value share in this market. The PepsiCo-Muller partnership is only over a year old and the MQD products are relatively unknown in the U.S. This means that if consumers choose dairy products over salty snacks, they might prefer more established makers such as Danone and Chobani. In this way, food sales for PepsiCo could decline.

High Commodity Costs Could Hurt Margins In The Long Term

Frito-Lay North America is the most profitable division for PepsiCo, with operating margins of 27.4% last year. However, rising raw material prices could increase cost of sales for the company. After hitting a three-year low at the end of last year, corn prices have been steadily rising this year. ^[3] On the other hand, sugar prices are expected to rise till 2015. PepsiCo might be hedged against the price rises in these commodities in the near term. However, if commodity prices keep rising, it would either put a downward pressure on margins or prompt PepsiCo to raise product prices. Rise in savory snack prices could hurt demand and act as another incentive for consumers to shift snack choices.

Innovative Snacking Could Add Incremental Sales

In the wake of health concerns possibly hurting savory snack sales, PepsiCo aims to achieve growth in its foods business by diversifying snacking options. 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. ^[4] 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 the Frito-Lay division. PepsiCo expanded its presence in foodservice last year by replacing Coca-Cola as the official soft drinks partner for Buffalo Wild Wings. ^[5] Apart from selling beverages, PepsiCo’s snacks will soon be used in some new menu items at Buffalo Wind Wings, which spreads across more than thousand locations in North America. This will not only add incremental sales for PepsiCo, but could also be a useful marketing tool. The company might be able to offset any possible decline in snack volumes, due to health concerns, by adding new platforms for snack consumption in the coming years. We expect the North American savory snacks market to grow at a CAGR of 3% to nearly $48 billion by 2020. However, if domestic customers start switching to healthier options in place of savory snacks, and the market only grows to $44 billion, there could by a 3.5% downside to our valuation for PepsiCo.

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1. “Snack food production in the U.S.“, April 2014, ibisworld.com [↩]
2. “Yogurt and sour milk products in the US“, November 2013, euromonitor.com [↩]
3. “Corn prices“, nasdaq.com [↩]
4. “Doritos locos tacos sales pass $1 billion“, October 2013, huffingtonpost.com [↩]
5. “Pepsi partnership presents opportunities for Buffalo Wild Wings“, March 2014, startribune.com [↩]