The Year That Was: PepsiCo

In the last year, PepsiCo‘s (NYSE:PEP) stock has outperformed both its chief competitor,The Coca-Cola Company (NYSE:KO), and the overall S&P 500 Index’s stocks. While Coca-Cola reported only a 2% year-over-year organic growth through the first three quarters, organic growth for PepsiCo stood at 3.5%. But this growth for PepsiCo is mainly on the back of a strong showing for its snacks business, which constitutes more than half of the company’s annual revenues. Drinks, and especially carbonated drinks and juices, continue to underperform in the developed world. The company’s soft drink sales, which form around 17% of the net valuation, fell by 8% between 2011-2013, as CSD sales in developed markets continued to decline on the back of growing health and wellness concerns. And then there is the impact of negative currency translations, which is weighing on PepsiCo’s financials. Despite higher organic growth for PepsiCo compared to Coca-Cola, net sales for both the companies have remained flat this year, hurt by depreciating currencies.

We estimate a $91 price for PepsiCo, which is roughly 6% below the current market price.

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According to analyst estimates, PepsiCo’s revenue growth for 2015 is pegged at 2.2%, bolstered by the expected growth in snacks and emerging markets. Sales for the snacks division, which forms 62.5% of PepsiCo’s valuation by our estimates, grew by 8% between 2011-2013. Snacks are also more profitable than drinks; EBITDA margins for snacks and beverages stood at 24% and 16% respectively last year. Snacks could continue to fuel volume and revenue growth for PepsiCo as the demand remains strong, and owing to the company’s dominance in most markets in this segment. However, in this article, we will take a look at what hasn’t been working for PepsiCo this year, and could potentially stall sales-growth next year as well. In particular, the ailing soft drink business, and the negative impact of the currency depreciation in Russia could be detrimental to PepsiCo’s sales-growth targets.

Carbonates Continue To Decline

While the combined revenue for Frito-Lay and Quaker Foods, the snack divisions of PepsiCo, has grown in each of the last couple of years in North America (excluding Mexico), revenue for beverages in the region has sequentially declined. Some of the headwinds in beverages are industry related, as customers look to reduce unnecessary calorie consumption. But in addition to being hurt by stagnant customer demand, PepsiCo is also losing share to both Coca-Coca and Dr Pepper Snapple (NYSE:DPS) in North America. According to our estimates, while Coca-Cola and Dr. Pepper’s value shares in the U.S. CSD market rose each year between 2011-2013 to 42.4% and 17.5% respectively, PepsiCo’s market share fell each year to 28.7% in 2013. The CSD market has declined for nine consecutive years in the country, with volumes falling 3.2% year-over-year to below 13 billion gallons in 2013, and a further drop in volumes is expected this year. Revenues remained flat for the Pepsi America Beverages business unit through September, and despite the company’s efforts to introduce new products, soft drink volumes are expected to continue declining in the near term.

The underlying problem for PepsiCo might just be its failure in introducing an effective low/mid-calorie soda. The company launched Pepsi True, a naturally sweetened drink containing 60 calories in a 7.5 ounce can (as opposed to 150 calories in a 12 ounce can), in the U.S. this year, selling the drink on Amazon. However, PepsiCo’s efforts to lift its mid-calorie soda sales, which fell by high mid-single percentages in 2013 and in the first nine months of this year, didn’t meet a positive initial customer response. Pepsi True received many negative reviews on Amazon following its launch last month, reflecting how PepsiCo’s attempt to launch a Stevia-sweetened low-calorie drink might have gone awry. Come 2015, PepsiCo will look to introduce more diet drinks, in a bid to reverse the trend of falling carbonate sales.

Earlier in the year, the U.S. Food and Drug Administration (FDA)  approved a sixth artificial sweetener and flavor modifier called Advantame, for use in non-alcoholic beverages (including CSDs), apart from other foods. In addition, the Flavor and Extract Manufacturer Association cleared the use of “Sweetmyx” in diet soft drinks. Sweetmyx, made by Senomyx Inc., is essentially an ingredient that will modify flavor characteristics within the drink mix to increase sweetness. This means that while Sweetmyx will reduce the amount of sugar required, it is not a sweetener in itself. This bodes well for PepsiCo, which holds exclusive rights to use this flavor enhancer in its soft drinks. In the coming years, the company will look to introduce diet variants of sodas, and hope to recover lost customer demand.

Exchange Rate Problems For PepsiCo

Apart from ailing sales of sodas, volatile macro conditions in some of the key emerging markets such as Russia, Mexico, and Brazil, have dragged down PepsiCo’s volume sales this year. Around 7% of PepsiCo’s revenues this year have come from Russia, the company’s second largest market. In Q1, Russia sales grew by a double-digit percent over the previous year for PepsiCo, representing the highest growth in any of the company’s operating units. However, tepid economic activity and negative consumer sentiment in Russia caught up with the company’s sales in the country in Q2, with both beverage and snack volumes falling by high-single digit percentages. The trend of falling volumes continued in Q3. The Russian economy has been struggling this year amid geopolitical issues with Ukraine and collapsing oil prices. Economic weakness in the region, with the ruble depreciating by over 50% against the U.S. dollar this year is expected to weigh on PepsiCo’s financials.

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. A 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.

According to PepsiCo, around two-thirds of its top line growth this year is expected to come from emerging markets. But continued macroeconomic volatility in some of the developing economies, low consumer spending, and negative currency translations could play spoilsport. In addition, much of PepsiCo’s growth has been contributed by the flourishing snacks business, while the beverages division has struggled. Come 2015, the company will aim to introduce new products, preferably a much-needed diet soft drink, to spur growth in beverages and shake-off some of the investor pressure to spin-off the drinks business.

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