These Three Scenarios Could Significantly Change PepsiCo’s Valuation

One of the world’s largest food and beverage conglomerates, PepsiCo‘s (NYSE:PEP) stock grew 45% from 2011 to 2014, the same time in which the company’s revenues remained flat. One of the main reasons for the flat top line growth is the decline in beverage revenues, mainly as the core carbonated soft drinks (CSD) segment continues to struggle amid growing health and wellness concerns over large calorie consumption. Negative currency translations have also dragged down net sales, offsetting strong organic growth for the company.

We estimate a $102 price for PepsiCo, which is above the current market price.

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However, PepsiCo’s growth has been boosted by its thriving snacks business, which forms slightly more than half the net sales. This has also become the main point in argument for activist investors who are pushing to split the company, in a bid to allow the snacks division to realize its true potential, as an independent company. The company said last year that it expected two-thirds of its top line growth to come from snacks (division-wise) and emerging markets (geography-wise) in 2014. Snacks and emerging economies are expected to be the growth drivers again this year, and in the near term, holding the fort while beverages, in particular CSDs, hope to regain form in developed markets and recently more volatile emerging markets. However, certain scenarios could impact our growth forecasts for PepsiCo, and in turn alter the company’s valuation — in some cases drastically.

• Impact Of The Russia Downturn–

As Russia continues to struggle amid geopolitical issues with Ukraine, sanctions from western countries, and collapsing oil prices, rising prices and interest rates have negatively impacted customer sentiment. This, in turn, is expected to weigh on PepsiCo’s financials, as Russia is the second largest market for the company behind the U.S., contributing approximately 7% of the net sales last year. On the face of it, PepsiCo looks like it might have safeguarded itself from the continual depreciation of the ruble against the U.S. dollar, as 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. However, the situation could change drastically in the future.

With growing tensions between the U.S. and Russia, the two countries might impose further sanctions in the future. Further weakening of ties between the two countries might also impact the presence of PepsiCo — one of the largest American companies, in Russia. PepsiCo’s long-lived assets in Russia are roughly worth $4.5 billion, and even if we don’t consider a complete shutdown of PepsiCo’s business in the country, the company’s volume sales could decline at a rapid pace due to lower customer expenditure in the country going forward. Local production might protect the company’s margin growth for now, offsetting the depreciating ruble, but a continual fall in volumes could significantly impact PepsiCo’s revenue growth.

Considering how Russia is PepsiCo’s second largest market and assuming a possible significant disruption in the company’s business in the country in the coming years, we have created a scenario by reducing the market size and share estimates for the company’s International Snacks/Dairy Products, Soft Drinks, Tropicana and Other Juices divisions. In particular, as PepsiCo is mainly present in the dairy and juice space in Russia, the impact will mostly be felt by the Tropicana and Other Juices division. A considerable slowdown in Russia sales for the company, and negative currency translations over the longer term, could bring down PepsiCo’s price estimate by 11-12% to just over $91. These assumptions can further be tampered with on the Trefis website.

• Increasing Snack Food Consumption In Emerging Markets–

Our price estimate for PepsiCo is 6% above the current market price, and it could rise to 17% above the current market price if the demand in emerging markets for snacks grows by even more than our current estimates. At present, developing countries such as Russia, Venezuela, Ukraine, and Brazil are struggling amid volatile economic conditions, which could limit future growth for PepsiCo. In 2014, snack volume sales for PepsiCo declined by a mid single-digit percentage in Mexico due to the food tax imposed at the start of the year, and a low single-digit percentage in Brazil because of high interest rates and negative customer sentiment. On the other hand, markets such as India and Turkey offer high growth potential, especially India, where economic conditions are improving with a stable government at the center, and as PepsiCo has a dominant market share in the country’s snack food market.

If economic conditions improve in South America, along with improvement in other presently volatile developing nations, it could be a huge boost to PepsiCo, which generates approximately 9% of its net revenues from Mexico and Brazil. Latin America Foods constituted 12% of the company’s top line last year. If the market size for International Snacks/Dairy Products rises to $688 billion by the end of our forecast period, up from our current estimate of $614 billion, and PepsiCo’s market share in this market grows to 4.5%, up from the current forecasted share of 4%, the price estimate for PepsiCo would increase to $112.

• Benefit Of Splitting The Company? –

PepsiCo 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.

Investors in favor of the spin-off, argue that cost-cutting at each company, following the split, would more than make up for their current synergies. Cost-cuts resulting from the split, for example, such as a possible consolidation of PepsiCo’s four U.S. headquarters into two, could result in lower corporate overhead for each company and more than offset the present synergies. In addition, a trimmer business, especially the ailing beverage division, could potentially further expand margins and compete better with Coca-Cola.

Assuming what the investors in favor of a spin-off are saying is true, we increased our long-term forecasts for the company’s snack food EBITDA margins, particularly for the Frito-Lay North America division, which is PepsiCo’s most profitable division. This increased the valuation of PepsiCo by 12% over our base estimate, or 18% above the current market price. Our assumptions for this scenario can be viewed on the Trefis website.

Despite flat revenue growth in the last three years, and room for further margin improvement, growth in PepsiCo’s stock has outpaced that of its chief competitor Coca-Cola and the overall S&P 500 Index in the last 52 weeks. The company beat its own target of core constant currency EPS growth of 7% last year, by achieving 9% growth, and expects to deliver 7% EPS growth in 2015. Higher shareholder return should appease investors, even as the company’s core operational income could remain flat to slightly positive this year. While there are no immediate signs of strong economic recovery in South America, or negative material impact of deteriorating conditions in Russia on PepsiCo’s financials, these are two scenarios that could significantly impact the food and beverage giant’s valuation. And then there is the possibility of a split, which could change the entire structure of the company as we know it.

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