PepsiCo’s Snacks More Crucial To Overall Growth

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Revenues for one of the world’s largest food and beverage conglomerates might be split half between drinks and snacks, but the latter is shouldering more responsibility than it is typically assumed. The foods business, comprising the likes of Frito-Lay and Quaker Foods, formed 53% of the net revenues last year for PepsiCo (NYSE:PEP). While sales for the snacks division have risen at a CAGR of 3.5% over the last three years, sales for the drinks division have declined at a CAGR of 3.2%.

We estimate a $98 price for PepsiCo, which is above the current market price.

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Drink segments such as carbonated soft drinks (CSD) and juices have fallen out of favor with customers over the last few years, due to the growing health concerns regarding the high amounts of sugar and other preservatives in these drinks. For example, CSDs and juices together form approximately half the net volumes in the U.S. liquid refreshment beverages market, and with continually waning demand for these segments, drinks such as Pepsi, Diet Pepsi, Mountain Dew, and Tropicana have suffered declining volume sales. According to our estimates, CSDs and juices combined form 21.6% of PepsiCo’s valuation.

On the other hand, even while health concerns have impacted soft drink sales in most developed nations, snacks, even the salty snacks with high cholesterol levels, continue to command a solid fan following. Case in point — the strengthening Frito-Lay North America division.

Pepsico annual report1

Following a 3% top line growth in 2014, PepsiCo’s Frito-Lay North America reported 2.5% revenue growth through the first half of 2015, on 2% growth in organic volume. This division alone constitutes 36.5% of PepsiCo’s valuation by our estimates, and the broader foods business forms roughly 65% of the net valuation. Not only is this because of continual sales growth for Frito-Lay North America, but this is also PepsiCo’s most profitable division, with 28.5% operating margins this year, compared to 18% for the overall company.

Even though Frito-Lay North America has earned 31% lesser revenues than the Americas Beverages division this year, its operating profit is 40% more than that for the latter, and continues to grow. 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 gain value. ((Snack food production in the U.S.))

What works for PepsiCo is that the overall demand for snacks remains strong, and the company is the dominant player in this market. 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. 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. [1] The next biggest manufacturers in this sector are Kellogg’s and Mondelez with much smaller 6.8% and 5.3% shares, respectively. Americans have a large snacking habit, which is expected to continue to bolster growth in the salty snacks market for PepsiCo going forward.

What also makes growth in the Frito-Lay North America division crucial for the overall group is the increased volatility in international markets. Despite the strong organic growth, the company reported a 6% fall in its top line in the last quarter, due to a 10% negative effect of currency translations. Considering that markets outside the U.S. form ~50% of PepsiCo’s top line, the continually strengthening U.S. dollar has dented the reported earnings this year. Performing well in the domestic market will bode well for PepsiCo, which is losing money to unfavorable currency translations. In foreign markets too, the core performance of snacks remains stronger than that of drinks. In Europe, while PepsiCo’s drinks have witnessed a 6% organic volume decline in the first half, snacks volume has remained even. On the other hand, while drinks volume has grown 1% in Asia, Middle East, and Africa, snacks volume has increased 6%.

The performance of PepsiCo’s drinks business has picked up more recently, with growth in North America in the last quarter, which is important, especially as the U.S. contributes more than half of the company’s net sales, and slowing drink sales in developed markets has for long plagued sales of beverage manufacturers. Organic volume sales for PepsiCo Americas Beverages rose 1% year-over-year in Q2, and effective pricing increased 4%. But PepsiCo’s foods business continues to easily outperform drinks.

The black sheep of the foods business remains Quaker Foods North America. It seems like PepsiCo’s efforts to stick with the Quaker brand– which carries a more wholesome and healthier image — have gone awry. Quaker Foods North America had adjusted EBITDA margins of around 35% a few years ago, but the continually falling sales, hurt by falling demand for traditional breakfast segments, have resulted in a gradual decline in margins to approximately 29% last year. Quaker’s sales growth remains sluggish, with sales declining in each of the last three years. The brand considerably trails its competitors — General Mills and Kellogg’s. Weak performance of Quaker, which forms around 4% of PepsiCo’s annual revenues, is weighing down PepsiCo’s profitability.

However, except for the Quaker division, PepsiCo’s foods division seems to be in great shape. Despite lagging Coca-Cola in beverage sales in almost every significant market, PepsiCo’s strong snacks business has kept the overall growth better than that of Coca-Cola.  In the last six months, Coca-Cola’s stock has declined by more than the S&P 500 Index, whereas PepsiCo’s stock has, although lower, performed better than both Coca-Cola’s stock and the S&P 500 Index.

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Notes:
  1. U.S. beverage business results for 2014 []