PepsiCo Pre-Earnings: Snacking On Emerging Markets Growth

PepsiCo’s (NYSE:PEP) drive towards emerging markets gained momentum in the last few months of 2012, and we expect this to translate into improved organic sales growth for the company when it releases its Q4 2012 results on February 13. The growth in emerging markets should help the company fight off the economic headwinds that have prevailed over the course of  2012. The company witnessed decline in soda consumption in developed economies and decline in the bottom line as the company incurs incremental costs due to restructuring and productivity improvement plans.

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Snacks To Lead Growth

PepsiCo’s s snacks division, which operates through brands such as Lay’s and Quaker’s, has been performing well in recent years – maintaining and growing its market share in both developed and emerging markets.

In developed markets, the company has been focusing on a shift towards healthier snacks, relying largely on new gluten-free and low fat products to drive sales. PepsiCo is also focused on diversifying its pricing mix in developed economies with new products being launched in both the premium and low-priced segment. This is helping the company access a broader range of consumers.

Meanwhile, PepsiCo’s attempts at experimenting with local tastes and preferences has helped it gain ground in emerging markets despite stiff competition from local players. The company has been raising the stakes in key regions such as India and China over the third quarter, with a wide spectrum of investments, from establishing new R&D facilities to sponsoring major sporting events.

The company’s strong performance in the snack division is highlighted by the the top line growth of Pepsi America Foods, which includes snacks sales in North and Latin America. Over the first nine months of 2012, sales in the segment stood at $16.3 billion, 4% higher than the previous year’s. We expect the coming results to continue this rising trend.

Beverages To Battle Flagging Demand And Increasing Competition

On the other hand, PepsiCo’s performance in the beverages department over 2012, has largely been a disappointment for investors. The company’s performance in the segment was largely hampered by declining consumption of carbonated beverages in developed economies. For example, the sales volumes of soda drinks in the U.S. dipped in 2012, by as much as 1.8% over the last year. With fewer dollars to chase in the traditional soda market, competition is heating up between the cola majors and competitors such as Dr Pepper Snapple (NYSE:DPS) and Coca-Cola (NYSE:KO) have been edging PepsiCo in the recent past. PepsiCo responded in its traditional way to this threat focusing on stronger pricing while playing the marketing card through the company’s Superbowl sponsorship and its ‘Live For Now’ campaign, also highlighting a $600 million dollar bump in company-wide marketing spend.

Meanwhile, in international markets, the company is trying hard to snatch market share from Coca-Cola, which continues to dominate most emerging markets. PepsiCo’s partnership with Chinese beverage company Tingyi is helping it scale up operations in China and with the integration successfully completed in mid-2012, we should see more sales coming in from the region in the final few months. However, we expect PepsiCo’s beverage performance to remain tepid over the fourth quarter with Coca-Cola continuing to remain the dominant force.

Bottom Line To Face Further Pressure

PepsiCo was in a transition through much 2012, with operational changes such as the Tingyi deal and exit from Mexican bottling operations, leading to increased reintegration and restructuring costs. The company is also expected to incur upwards of $200 million in costs as part of its ‘productivity plan’ put in place during 2012. Moreover, the company has also pumped up its advertising focus in recent months. All these factors should take a significant toll on the company’s operating margins over Q4.

Investors, however, should look forward to higher gross margins for Q4 2012, compared to the same period in 2011. With the commodity cost environment easing towards the end of 2012, PepsiCo should realize lower cost of raw materials for the final quarter. This change was also largely evident during Q3 2012, when lower commodity prices and stronger pricing helped PepsiCo realize gross margins of 53.0%, compared to 51.9%  in Q3 2011.

We currently have a price estimate of $79 for PepsiCo, which is about 9% higher than the current market price.

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