PepsiCo’s Q3 Results Beat Expectations; Emerging Economies Fuel Growth

PepsiCo (NYSE:PEP) reported better than expected third quarter results on October 9, pushing its stock to an all-time high of $96 just after the announcement. Buoyed by strong growth in emerging economies and successful pricing strategies, the beverage and snack giant realized a 3.1% year-over-year increase in organic revenues in Q3. ^[1] With both snack and beverage volumes rising 1% globally, PepsiCo reaffirmed its commitment to remaining intact, fending-off continual activist investor pressure to spin-off the beverage business. Our key takeaways from the company’s third quarter results include- higher profitability for the North American beverage unit, and sustained growth in developing markets, including Russia, where sales grew despite tough macroeconomic conditions.

We estimate a $91.26 price for PepsiCo, which is roughly 2% below the current market price.

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PepsiCo Squeezes-Out Higher Profits From The Beverage Business

As expected, headwinds in the carbonated soft drinks (CSDs) sector continued to stall growth in North America beverage volumes. PepsiCo’s CSDs in the Americas, which formed almost 15% of the net sales last year, face the threat of declining volumes as consumers continue to shift away from sugary calorie-filled sodas to other relatively healthier options such as sports drinks and ready-to-drink (RTD) teas. This trend is also reflected in PepsiCo’s Q3 results- while CSD volumes in North America fell 1.5%, the company’s Lipton RTD teas and the sports drink Gatorade witnessed volume rises in the region. Contracting consumption could result in a fall in the overall CSD volumes in the U.S. for the tenth consecutive year in 2014, but this won’t be an unexpected outcome. Sluggish performance of PepsiCo’s CSDs in the domestic market has for long cast a shadow over the company’s otherwise strong portfolio, also fueling investor pressure to spin-off the entire division. But what the company has managed to do is derive growth from this division by improving profitability, on the back of strategic packaging, revenue management and cost-cutting.

• Smaller-sized packs, even the whole-calorie options, have seen rising volume sales. This is because even though the 12-ounce bottles and mini cans contain the same calories per unit volume as the regular 20-ounce and 24-ounce bottles, the smaller packs have lesser cumulative sugar amounts. Health-conscious consumers who are wary of switching to diet versions, which allegedly alter the taste, are being swayed by beverage companies to switch to smaller-sized packs, which allow for lower one-time calorie consumption.

Why this has been fruitful for PepsiCo is because these packs have higher price per unit volume, which means that despite a fall in overall volume sales, higher proportionate sales of the mini bottles and cans has resulted in a 2% year-over-year rise in operating profits for the North America beverage division. According to the company, the 12-ounce bottle sells at more than 100% premium with the 12-ounce can. ^[2]

• Another factor that resulted in higher profits for PepsiCo’s beverage division, and the overall business, was the productivity savings initiative taken up by the company. The food and beverage giant is on course to draw an incremental $1 billion in savings this year, after saving $900 million in 2013, as part of its $3 billion savings program for the period of 2012-2014. Overall operating profit at currency neutral rose 5.5% year-over-year in Q3, as PepsiCo benefitted from its savings plan and higher pricing. Now the company looks to save another $5 billion in the next five years, as part of its productivity savings plan for 2015-2019, by optimizing global manufacturing operations and simplifying organization systems to drive efficiency.

Despite flat to negative volume growth, PepsiCo’s top line could expand by a mid-single digit percent this year due to higher pricing and revenue management. This increase in top line, coupled with cost-cutting measures, could expand the company’s operating margins, going forward. We estimate margins for PepsiCo’s soft drinks to remain relatively flat at around 16% through the end of our forecast period. However, if the margins steadily rise to 18% in the long term, our price estimate for the company would increase by 3%.

Despite Volatile Macro Conditions, Sales In Emerging Economies Grow

At the start of 2014, PepsiCo expected two-thirds of its revenue growth this year to come from developing countries, and the results so far have been positive. Despite macroeconomic and political volatility in some of the key emerging markets, organic sales in emerging countries grew 8% this quarter. PepsiCo’s revenues in India and Egypt have grown by double-digit percentages year-to-date, while China and Turkey sales have risen by high-single digit percentages. But what underpins the strong performance of PepsiCo in developing markets this year, is high growth in both Russia and Brazil, despite slowing economic activity and consumer spending in both the countries.

Beverage as well as snack volumes have declined in Russia and Brazil for PepsiCo this year, but what kept sales booming was the overall high inflationary environment in these countries. Russia and Brazil are crucial markets for PepsiCo, constituting almost 10% of the net sales, with Russia being the company’s second largest market after the U.S. What could be a problem for the food giant in Russia going forward is depreciation of the ruble against the U.S. dollar and high commodity costs. The Russian ruble has depreciated by 14% against the U.S. dollar in the last three months, and this drop in local currency could be a headwind for the company’s net revenues. ^[3] Inflation rose to 8% in Russia in September, as food prices increased, fueled by the retaliatory ban on many food imports from the U.S. and European Union imposed by the country. ^[4]

However, PepsiCo might just have these potential problems covered. The company produces most of the products sold in Russia in the country itself, sourcing a lot of the required raw materials from local suppliers. High proportion of local produce utilization could somewhat shield PepsiCo from the import bans and depreciation of the ruble. In addition, the company is mainly present in the dairy and juice space in Russia, and as these categories tend to maintain high and stable consumer demand in the country, rising product prices due to inflation fueled top-line growth in Q3 and could continue to do so. Having said this, PepsiCo’s sales in Russia could be dragged down by negative currency translations, owing to the import of some food and beverage products. It remains to be seen whether the volatility of the Russian ruble as well as other foreign currencies lowers PepsiCo’s top line by more or less than the estimated 3% this year.

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1. PepsiCo 10-q [↩]
2. PepsiCo earnings transcript [↩]
3. Ruble-U.S. dollar [↩]
4. Ruble’s fall and food import bans send inflation ever higher, themoscowtimes.com [↩]