Beverage Growth Impresses For PepsiCo, But Margin Drop Disappoints

by Trefis Team
-0.78%
Downside
138
Market
137
Trefis
PEP
PepsiCo
Rate   |   votes   |   Share

PepsiCo (NYSE:PEP) reported its third quarter earnings on October 2, wherein it beat consensus expectations on revenue and earnings, on the back of a strong performance of its Frito-Lay (FLNA) business, a return to growth in its North America Beverages (NAB) segment, and a reduced tax rate. However, mounting commodity pressure, increased marketing expenditure, higher transportation costs, and foreign currency headwinds resulted in a decline in core gross and operating margins. These headwinds are expected to continue through the remainder of the year, with the company now projecting core earnings per share to come in at $5.65, versus an expectation of $5.70 earlier. On the other hand, solid performance and outlook of the FLNA and NAB segments prompted the company to improve its organic revenue guidance for the year to at least 3%, up from a prior forecast of 2.3%.

We have a $122 price estimate for PepsiCo, which is higher than the current market price. We are in the process of updating our model to reflect the new guidance provided by the company. The charts have been made using our new, interactive platform. If you don’t agree with our analysis, you can modify the different driver assumptions by clicking here for our interactive dashboard on PepsiCo’s Performance In Q3 2018, to gauge their impact on the revenue, earnings, and price per share metrics.

Factors That May Impact Future Performance 

1. Lower Tax Rate: As a result of the reduction in the corporate tax rate in the U.S., from 35% to 21%, PepsiCo believes its effective tax rate for FY 2018 will be between 19% and 20%. This is a significant drop from the 48.9% tax rate recorded in FY 2017. This factor will help drive the net income margin improvement.

2. Increased Marketing Spend For Core Beverages: While PepsiCo moderately increased media spend over the past three years, its biggest competitor – Coca-Cola – has done so by a substantial margin. While this benefited the latter, PepsiCo had struggled as a result. In response to this, the company allocated increased media to trademark Pepsi and Mountain Dew. It also launched a new “Pepsi Generations” campaign, with PepsiCo improving sales and market share as an outcome. This factor played a big role in the return to positive growth for the NAB segment in Q3. On the other hand, this step has pressured the operating margins of the company, offsetting any benefit received from the productivity initiatives implemented by the company to induce cost savings. Moreover, the company faced higher transportation and commodity costs, which were other factors that resulted in the core operating margin falling to 17.6% in the third quarter. To counter this, the company is undertaking price hikes, which should begin to show any meaningful impact from the fourth quarter onward.

3. Focus On Healthy Snacks: In order to meet the evolving needs of customers globally, PepsiCo is shifting its portfolio to a wider range termed as “Everyday Nutrition Products.” The company now derives approximately 45% of its revenues from these “Guilt Free Products” indicating that it has transformed its portfolio toward healthier products according to the new customer preferences. These products include “diet and other beverages that contain 70 calories or less from added sugar per 12-ounce serving and snacks with low levels of sodium and saturated fat” as well as “everyday nutrition products” – products with nutrients like grains, fruits and vegetables, protein, unsweetened tea, and water. Frito-Lay is also pushing toward a premiumization of its products to fuel its revenue and margin growth. Consumers have been moving away from eating unhealthy products, which has put pressure on the volumes. Hence, by concentrating on premium brands, there can be a shift from low-priced, high-volume products to the high-priced, low-volume range, which may result in top and bottom line growth.

4. Acquisition Of Brands Such As Bare Foods: The acquisition of Bare Foods fits perfectly with PepsiCo’s plan of focusing on its ‘Better For You’ portfolio. Moreover, it also provides the company with a line of products that are already doing well. Consequently, PepsiCo would not have to undertake the considerable investment needed to build the products from scratch, as well as the marketing dollars needed to establish a customer base. On the other hand, for Bare Foods, it could not have been a better offer. The brand gets to operate independently, while having access to PepsiCo’s immense distribution network, and vast coffers needed to increase production and the marketing of its products.

5. Growth Of Healthier Beverages: With the growth of its beverage business slowing down, as a result of sluggish soda sales, the healthy products segment will be a focus for the company in the future to drive its sales. PepsiCo’s tea portfolio, with brands including Lipton and Pure Leaf, has grown retail sales in the range of mid-single digits to as high as 21% over the past 18 quarters. In enhanced water, LIFWTR is on track to achieve more $200 million in measured retail sales in 2018, while Bubly (launched in February 2018) is projected to exceed a $100 million in measured retail sales in its first year. KeVita, PepsiCo’s line of premium organic live probiotic beverages, has continued its strong performance, following 66% growth for the full year 2017. The growth of these brands is highly important for the company, as significant growth here may help to offset some of the weakness in the core portfolio.

6. Purchase Of SodaStream: PepsiCo recently announced the $3.2 billion acquisition of SodaStream, the number one sparkling water brand by volume in the world, and the leading manufacturer and distributor of Sparkling Water Makers, with the deal expected to close in January 2019. The shift away from carbonated drinks and diet sodas has precipitated the growth of the sparkling water category. Given that nationally, sparkling water has been growing at a much higher rate than the overall bottled water segment, 38% growth last year, compared to 7% for the whole category, it is definitely a significant market for PepsiCo to ply its trade. This tremendous growth is expected to continue in the future as well, as the soda sales contract, and consumers look toward sparkling water to satisfy their cravings for carbonation. Moreover, the introduction of new and innovative flavors, as well as its image as a healthy alternative to carbonated drinks, should also help to drive the sales. For PepsiCo, SodaStream can be expected to form only a small portion of the North American Beverage revenues, once the acquisition is complete, given the fact that the latter has a very small presence in the U.S. This will result in a lower level of cannibalization for PepsiCo given the similar products offered by both companies. Looking ahead, SodaStream will be able to leverage PepsiCo’s massive distribution network to expand its presence in North America.

7. Importance Of Frito-Lay: While Frito-Lay North America (FLNA) contributes to roughly a quarter of the company’s revenues, its share of the total operating profit is about 42%. We expect the strong growth rates of FLNA to continue in the future, boosted by the segment’s foray into new products and healthy snacks. For example, due to the success of Lay’s Poppables, launched in 2017, FLNA extended the Poppables product line-up with the introduction of new Lay’s Poppables Honey Barbecue and a 12-count multipack of Poppables Sea Salt. The company has also extended the Simply sub-line (which offers natural and organic versions of popular snack brands) by introducing new package varieties with the Simply variety pack and a three-flavor lineup of single-serve packages for Simply Lay’s, Cheetos, and Doritos offerings. To address consumers’ desire for greater flavor and product variety in single-serve multi-packs, PepsiCo launched a 20-count Family Fun mix that includes a variety of products, including Lay’s, Cheetos, and Ruffles, with an expanded mix of flavors, which helped drive strong revenue growth in the overall variety pack business.

8. Focus On The E-Commerce Space: With online grocery shopping rising at a phenomenal pace, PepsiCo is placing a big bet on the online space. The company is making an increasing effort to address the growth opportunities across eGrocery, pureplay, urban grocery delivery, direct-to-business, and direct-to-consumer models. Keeping this in mind, the cola giant has developed a team of roughly 200 e-commerce professionals which has been tasked with capturing growth in this rapidly growing segment.  PepsiCo’s efforts seem to be working well, as the company has witnessed tremendous growth through its e-commerce channels, with its digital business garnering approximately $1 billion in annualized retail sales.

See Our Complete Analysis For PepsiCo Here

 

What’s behind Trefis? See How It’s Powering New Collaboration and What-Ifs

For CFOs and Finance Teams | Product, R&D, and Marketing Teams

More Trefis Research

Like our charts? Explore example interactive dashboards and create your own.

Rate   |   votes   |   Share

Comments

Name (Required)
Email (Required, but never displayed)
Be the first to comment!