PepsiCo Pre-Earnings: All Eyes On Margin Expansion And Growth In Developing Markets

PepsiCo (NYSE:PEP) is scheduled to announce its Q4 and full-year results on February 11. The company’s stock has outperformed both its chief competitor, The Coca-Cola Company (NYSE:KO), and the overall S&P 500 Index’s stocks over the last 52 weeks. 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. Net revenues remained flat for the company through the first three quarters, with currency headwinds dragging down the figure by 2 percentage points. At the beginning of 2014, PepsiCo stated how it expects two-thirds of its top line growth for the year to come from snacks (division-wise) and emerging markets (geography wise). Increased volatility in some of the key emerging economies, especially Russia, should have a direct bearing on PepsiCo’s full-year results.

The past year also saw PepsiCo’s stock rise on rumors of a possible split. The food and beverage giant has for nearly two years now battled activist investor pressure to spin-off its ailing beverage division, in order to, theoretically, allow the snacks division to unlock its true potential. Leading the push for separating the company’s two businesses was the activist investor Nelson Peltz, CEO of Trian Partners hedge fund, which holds a 1.19% stake in PepsiCo. Last year, Peltz said that the company’s stock could be worth $144 a share following a hypothetical spin-off. On the other hand, PepsiCo remained committed to deriving cost benefits from synergies between the two businesses, which the company says range between $800 million and $1 billion annually. In this respect, it will be interesting to see if PepsiCo managed to squeeze-out higher profits this quarter, despite the threat of slower organic business growth in beverages, and tepid economic activity in certain developing markets.

Our key points of discussion in the wake of PepsiCo’s full-year results are profitability, particularly in North America, and the possible impact of slower growth in foreign markets.

We estimate a $91 price for PepsiCo, which is roughly 4% below the current market price.

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More Margin Growth This Quarter?

While revenues are expected to remain flat for PepsiCo over 2013 levels, there might be room for further margin growth, which could in turn boost cash flow. The company’s operating margins stood at only 16.15% through Q3, lagging Coca-Cola’s margins of 23.5% during the same period. This might not seem like a valid comparison as Coca-Cola is a drinks-only business, while PepsiCo derives approximately 52% of its revenues from snacks. If we remove the snacks business from PepsiCo, operating margins for the company would in fact fall even further. Through September, margins for the Pepsi Americas Beverages (formed 32.2% of the net revenues through Q3) stood at 14.3%, whereas margins for Frito-Lay and Quaker Foods North America and Latin America Foods combined (37.5% of the net revenues) were 23.7%.

Investors in favor of segregating PepsiCo into separate beverage and snacks businesses argue how the cost-cutting at each company, following the split, would more than make up for their current synergies. In this respect, an improvement in margins, especially in beverages, could be crucial in warding off further activist pressure to spin-off the drinks segment, and also assert PepsiCo’s ability to derive growth in an otherwise struggling business. Carbonated soft drinks (CSDs) form 17% of the company’s valuation, and as customers continue to move away from these sugar and calorie-fueled drinks, the U.S. CSD market declined for the tenth consecutive year in 2014. Just for reference, 52% of PepsiCo’s revenues through September came from the U.S., but this figure also includes the food revenues. While volume growth for the company’s CSDs in North America might remain flat to negative yet again in Q4, profitability might improve, and here’s why:

• Higher Retail Prices Of Beverages- Improving economic conditions in the U.S., with falling oil prices and historically low unemployment rates, have boosted customer purchasing power in the country. As a result, beverage makers such as PepsiCo have been able to raise their product prices. According to Citi Research, the consumer-price index for nonalcoholic beverages grew in each of the months through September-December, after remaining flat for two years. Despite tepid volume sales, CSD sales in the U.S. increased 1.2% year-over-year in the twelve weeks ended December 28, mainly on a 3.8% rise in prices during the same period. ((Coke, Pepsi feeling drained overseas, wsj.com)) Higher retail prices this quarter should have boosted PepsiCo’s top line growth, subsequently bolstering margin growth.

In addition, PepsiCo is also emphasizing more on sales of small packages, which could have also contributed to higher profitability this quarter. 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. As small bottles and cans have higher price per unit, larger proportionate sales of these packs could have had a positive impact on product mix in Q4. PepsiCo’s Pepsi True was also launched only in 7.5 ounce cans late last year, and going forward, the company might focus on smaller packages to drive margin expansion.

• Productivity Savings Plan- Another reason why PepsiCo’s margins are expected to expand this quarter is the company’s productivity savings initiative. 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 benefited 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.

Could Volatile Emerging Economies Slow Growth?

Approximately 48% of PepsiCo’s revenues through the first three quarters came from outside the U.S., of which 23% was from Russia, Mexico, Canada, the U.K., and Brazil. Despite macroeconomic and political volatility in some of the key emerging markets, organic sales in emerging countries grew 8% in Q3. PepsiCo’s revenues in India and Egypt grew double-digit percentages through September, while China and Turkey sales rose by high-single digit percentages. But what underpins the strong performance of PepsiCo in developing markets through 2014, 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 declined in Russia and Brazil for PepsiCo through Q3, 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.

The Russian economy has been struggling 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 last 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.

PepsiCo’s thriving snacks unit could report another quarter of robust growth, even organically, but we will keep a close eye on the company’s margin growth, especially in the North America Beverages unit, and the impact of increased emerging market volatility on the net results.

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