Negative Currency Translations Overshadow PepsiCo’s Strong Organic Growth In Q1

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As expectedPepsiCo‘s (NYSE:PEP) strong organic growth was countered by negative currency translations in Q1. The company announced its quarterly results on April 23, and since, the stock is down approximately 1.6%. PepsiCo’s strong organic growth of 4.4% came on the back of a continued strong showing by the snacks division, which forms slightly more than half the revenues for the company, and 64% of the company’s valuation, according to our estimates. [1] The key takeaway from PepsiCo’s Q1 results is that while organic volume for beverages declined 1%, volume for snacks grew 2%. Snacks continue to outperform beverages in almost all markets for the food and beverage giant, and this, again, could prompt activist investors to pursue a split of the company into separate food and beverage businesses, in order to allow the snacks division to unlock its true potential.

We estimate a $102 price for PepsiCo, which is 7% above the current market price. However, we are currently in the process of incorporating the recent quarterly results into our forecasts, and revising our price estimate.

See Our Complete Analysis For PepsiCo

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PepsiCo’s revenue is almost evenly split between the U.S. and countries outside the U.S., and as the dollar has surged about 8.5% against a basket of major currencies this year, the impact of negative currency translations had a major bearing on the company’s Q1 results. Net revenues declined 3% this quarter, hurt by an 8-percentage-point unfavorable impact of foreign currency depreciation. PepsiCo now expects a 10 to 11 percentage point negative effect of currency translations on its full-year net sales and core earnings per share, which could cast a shadow over future growth, and considerably drag down return to shareholders. However, the company remains committed to deriving productivity savings of $1 billion this year and through 2019, and return approximately $8.5-$9 billion to shareholders this year, including a 7% dividend per share rise, which will commence with the June payment. [2]

The strengthening U.S. dollar against foreign currencies marred an otherwise impressive start to the year by PepsiCo. The snacks business continues to deliver strong results, and despite continual headwinds in the carbonated soft drinks (CSD) category, effective net pricing increased net revenues for the company’s beverage division.

Frito-Lay North America Delivers Yet Again

Following a 3% top line growth in 2014, PepsiCo’s Frito-Lay North America reported 3% revenue growth in Q1 as well, on 3% growth in organic volume. This division alone constitutes 36.4% of PepsiCo’s valuation by our estimates, compared to only 15.3% constituted by the entire CSD portfolio, which forms roughly 25% of the company’s top line. This is because of continual sales growth for Frito-Lay North America, which is also PepsiCo’s most profitable division, with 27.7% operating margins this quarter, compared to 16.6% for the overall company. While CSDs continue to bear the brunt of widespread health and wellness concerns, the snack food market has managed to grow at a steady pace. The U.S. snack food market worth $35 billion grew at a CAGR of 4.2% between 2009-2014, and continues to grow. ((Snack food production in the U.S.))

PepsiCo, which holds around 25.4% volume share in the U.S. liquid refreshment beverage market, second behind Coca-Cola’s 33.6% share, dominates the savory snacks market in the country with a 36.4% market share. [3] The next biggest manufacturers in this sector are Kellogg’s and Mondelez with much smaller 6.8% and 5.3% shares, respectively. According to research by Nielsen, 63% of North Americans said that they ate chips/crisps as a snack in the last 30 days, a segment which is dominated by PepsiCo’s brands such as Lays, Doritos, and Cheetos. Americans have a large snacking habit, which is expected to continue to bolster growth in the salty snacks market for PepsiCo going forward.

Although PepsiCo achieved 3 points of effective net pricing in global beverages, organic revenues were up only 1.5% for this division, due to a decline in volume sales, compared to a larger 7% increase in organic revenues for snacks. Strategic pricing strategies such as an increase in retail prices of beverages, aided by the improving economic environment in the U.S., and more emphasis on the higher-price-per-unit smaller packs, have bolstered growth in sales for the beverage division. However, as the company looked to cover losses due to negative currency translations through raising product prices in international markets, volume sales suffered. Beverage volumes in the Americas and Europe declined 1% and 5% respectively in Q1, and grew only 1% in the Asia, Middle East and Africa (AMEA) region. Little to no organic volume growth in beverages across all operating units yet again represents how the drinks division might be pulling down the snacks division.

FX Translations Hurt PepsiCo’s Overseas Business

Markets outside the U.S. formed 49% of PepsiCo’s revenues in 2014, with over 22% of the net revenues coming 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 10% year-over-year this quarter. However, this strong growth didn’t translate into top line growth for PepsiCo, as net revenues from developing markets fell 12% over 2014 levels on massive negative currency translations. In particular, depreciation of the Russian ruble, Brazilian real, Canadian dollar, Mexican peso, and Venezuelan bolivar were detrimental to the company’s realized sales growth.

PepsiCo has tried to minimize the negative impact of depreciation of foreign currencies against the U.S. dollar through local sourcing of materials, negotiating contracts in local currencies with overseas suppliers, and by using derivatives, primarily forward contracts. PepsiCo’s foreign currency derivatives had a total notional value of$2.7 billion at the end of last year, but based on current spot rates and the company’s existing hedge positions, negative currency translations are still expected to be a massive 10 to 11 percentage points headwind on the net sales in 2015, as aforementioned. There is scope to grow in emerging economies for the food and beverage giant, but as these economies continue to battle weak economic conditions, lower volume sales due to inflation and negative customer sentiment, and depreciation of local currencies against the U.S. dollar– all these are expected to have a significant bearing on PepsiCo’s financials going forward.

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Notes:
  1. PepsiCo 10-q []
  2. PepsiCo earnings transcript []
  3. U.S. beverage business results for 2014 []