PepsiCo Earnings Review: Core Performance Remains Strong, Although Marred By Structural Changes

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PepsiCo (NYSE:PEP) has for the second time in three months raised its guidance on the full-year core constant currency EPS growth (from 7% to 8%, and then 9%), on the back of solid Q3 results, reported on October 6. [1] Shining bright among various structural shifts and the reclassification of operating units, was the strong performance in North America — the home market, which contributes over 60% to the top line, and approximately two-thirds of the core division operating profit. Although the volatile macro environment in some of the crucial emerging markets continues to be a downer, PepsiCo’s solid organic growth, especially in snacks and non-carbonated segments, reflects strength in the core business.

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

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Organic revenues were up 7.4% year-over-year in Q3, but net revenues declined 5 percent reflecting a 12-percentage-point impact of unfavorable foreign currency translations. But one of the biggest talking points after the earnings release remained the impairment charges of $1.36 billion as PepsiCo deconsolidated assets and liabilities of its wholly-owned Venezuelan subsidiaries from its consolidated balance sheet, and began accounting for its investments in the country using the cost method of accounting, citing the tough economic environment and restrictive foreign-exchange regulations in the country that make it difficult to convert the Venezuelan bolivar back into dollars.

But apart from the impact of the adverse currency translations, which continue to cloud PepsiCo’s growth as the U.S. dollar strengthens against foreign currencies, the food and beverage giant’s strong performance in the home market promises a smooth finish to the year.

pepsi q3

Snacks Growth Continues To Be Solid 

North America sales growth carries significant importance for PepsiCo not only because it’s the home market, where the company derives a substantial portion of its revenues from, but also because growth in this market is challenged by the ever-so-growing health and wellness concerns, so it becomes difficult to extract growth. Evolving customer preferences, and a shift to a healthier diet, present obstacles to growth for PepsiCo, which sells savory snacks and beverages that are often blamed for health problems and the widespread obesity concerns. However, organic volume growth seems to be holding up owing to the large American snacking habit, growing 0.5% in Q3 for the Frito-Lay North America division.

Following a 3% top line growth in 2014, PepsiCo’s Frito-Lay North America has reported 2% revenue growth through the first nine months of 2015. 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 the continual sales growth for Frito-Lay North America, but this is also PepsiCo’s most profitable division, with 30.5% operating margins this year, compared to 17% for the overall company (we have excluded the Venezuela charges from the 17% operating margins figure). This growth in Frito-Lay North America is fueled by strategic revenue management and pricing gains. A focus on small packs, which are sold for more price per weight, is driving an increase in average revenue per unit and, in turn, profitability.

Non-Carbonated Portfolio Boosts Growth In Beverages

While beverages have now long been the trailing leg in PepsiCo’s growth mobile, an impressive 10% volume growth for the non-carbonated portfolio made up for the 2% decline in carbonated soft drinks (CSD) volume, to fuel a 3% rise in organic volumes for the North America beverages division (which now doesn’t include Mexico and Latin America) in Q3. CSDs continue to bear the brunt of growing health concerns and customer skepticism regarding the usage of artificial sweeteners and/or bitter aftertastes of the diet/low calorie drinks. This caused a 1% decline in regular soft drinks and a steeper 6.5% decline in diets.

But while customers are shifting away from CSDs, what bodes well for PepsiCo is that they are shifting to other beverage segments such as sports drinks, ready-to-drink tea and bottled water, where the company has significant presence, as well. Bottom line is that consumers are not drinking less, they are just not drinking sodas as much, anymore. So a more focused approach, marketing, and media investments behind brands such as Gatorade sports drinks, Lipton teas, and Tropicana fruit juices is driving an increase in PepsiCo’s drinks volume. The question now is whether the shift in volume sales from CSDs to other segments will impact margins.

While segments such as bottled water carry narrow margins, segments such as sports and energy drinks carry broader margins. The focus on smaller bottles and packs has boded well for PepsiCo in recent times, and so has the sustained low gas prices, which have boosted customer spending and allowed food and beverage companies to operate at higher price points. This quarter, PepsiCo’s North America beverages realized 2 percentage points of effective net pricing and reported the highest growth in net revenues (4% year-over-year) of any other operating unit. This sales growth is even more than that of Frito-Lay North America, which grew by 1% in Q3. One might say that the argument that beverages are a forever second to snacks when it comes to PepsiCo, and are holding back growth, becomes weak going by the results this quarter, especially for the home market.

Another win for PepsiCo this quarter was the growth in margins. Core gross margin expanded 120 basis points, and net gross profit declined only 2.5% (excluding Venezuela impairment charges), despite the adverse effect of currency translations, which dragged down the top line by 5% compared to the year ago period. Effective revenue management strategies and productivity initiatives have helped in achieving higher profitability. The company is optimizing its manufacturing footprint, and has reduced the number of company-owned beverage plants in North America by 23% since 2010, simultaneously increasing capacity utilization by 20%. PepsiCo remains on course to derive productivity savings of $1 billion this year and through 2019, following a similarly aggressive three-year $3 billion program that was concluded last year.

2015 for America-based companies has been a year marred by unfavorable currency translations, which continue to drag down organic growth considerably, and are now expected to be an 11 percentage point headwind on the full-year core earnings per share. But the core performance of PepsiCo’s snacks and even beverages remains strong, supported by the consistent cost-cuts and operational changes which are driving profitable growth.

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Notes:
  1. PepsiCo earnings release []