In Spite Of Lower Operating Margins, PepsiCo’s Bottom Line In 2018 Was Boosted By Significant Tax Benefits; Strong Organic Growth Expected In 2019

PepsiCo, Inc. (NYSE: PEP) announced its Q4 2018 results on February 15, 2019, followed by a conference call with analysts. The company met analysts’ expectations for revenue as well as EPS. PepsiCo reported revenue of $19.52 billion in Q4 2018, marginally lower compared to $19.53 billion in Q4 2017. Though organic revenue grew by 4.6% (y-o-y) during the quarter, unfavorable foreign exchange movements and acquisitions and divestitures had an adverse impact on reported revenue. Adjusted earnings were $1.49 per share in Q4 2018, 13.7% higher compared to $1.31 in Q4 2017. Higher earnings were mainly driven by gains from the productivity plan, tax benefits, and refranchising of a portion of its beverage business in Thailand, partially offset by lower operating profit due to higher transportation and commodity prices.

We have summarized the key takeaways from the announcement in our interactive dashboard – Refranchising And Productivity Gains Along With Tax Benefits Drive PepsiCo’s Bottom Line In 2018. In addition, here is more Consumer Staples data.

Key Factors Affecting Earnings

Growth in Frito-Lay: Frito-Lay North America (FLNA), which contributes a little over a quarter of the company’s total revenue, saw its revenue grow by about 3.5% in 2018, driven by effective net pricing and volume growth in variety packs and its trademark Doritos, partially offset by lower volume of Santitas. FLNA’s EBITDA margins saw a slight decline in 2018 due to certain operating cost increases and the impact of a bonus extended to certain U.S. employees in connection with the TCJ Act, partially offset by net revenue growth and productivity savings. We believe that the foray into new products and healthy snacks would drive segment revenue growth in 2019 and beyond. However, growth in margins is expected to be slightly subdued on the back of higher transportation costs and higher commodity costs, primarily potatoes and motor fuel.

Quaker Foods and North America Beverages proved to be a drag: Net revenue of Quaker Foods declined by 1.5% in 2018, reflecting lower volume and unfavorable net pricing and mix. The lower volume was driven by decline in trademark Gamesa and ready-to-eat cereals, partially offset by growth in oatmeal. EBITDA margin declined due to lower revenue and the impact of higher commodity costs. In the near future, we expect revenue to be around the current level, with a slight downward bias, due to declining volume. Margins are expected to slightly improve, driven by productivity savings and lower advertising and marketing expenses.

Revenue in North America Beverages segment grew by 0.6% on the back of favorable pricing mix. However, volume decreased in 2018 due to a decline in CSD (carbonated soft drinks) volume and a decrease in juice and the juice drinks portfolio. On the other hand, the water and sports drinks portfolio received a boost due to an increase in non-carbonated beverage volume and an increase in Gatorade sports drinks. EBITDA margins saw a sharp decline, driven by higher transportation and commodity costs. We expect revenue to increase in the near term, driven by higher sales of non-carbonated beverages. Margin growth is likely to remain subdued due to increasing advertising and marketing expenditure.

Refranchising: In Q2 2018, PepsiCo refranchised its beverage business in Thailand by selling a controlling interest in its Thailand bottling operations. This has led to about a 2.1% decline in revenue from Asia, Middle East and North African segment. As the revenue per unit is 3-4 times greater in the bottling business, it has a magnified effect on revenues rather than on margins. Refranchising of the low-margin bottling business along with productivity savings has led to an increase in the segment’s profitability. We expect revenues to remain flat going forward due to the loss of revenue from the bottling business being refranchised, offset by organic growth across other categories. Margins are expected to continue their  upward trend.

Outlook Remains Strong

We believe PepsiCo’s recent focus on healthy snacks – with it shifting its portfolio to a wider range termed as “Everyday Nutrition Products” – would help it cater to the health-conscious young generation. The recent announcement of the $3.2 billion acquisition of SodaStream – the number one sparkling water brand – would likely help the company grow as there is a shift in consumers’ preference away from carbonated drinks and diet sodas, thus precipitating growth of the sparkling water category. Thus, we expect revenue to grow by 3% to $66.6 billion in 2019, compared to $64.7 billion in 2018, driven by strong organic growth, rising sales of non-carbonated beverages, growth in healthy snacks and sports drinks, partially offset by foreign currency headwinds.

PepsiCo announced a new productivity plan in February 2019, which will leverage new technology and business models to further simplify, harmonize, and automate processes; re-engineer the go-to-market and information systems, including deploying the right automation for each market; simplify the organization and optimize manufacturing and supply chain footprint. This new plan is an improvement over the existing plan and is expected to boost the company’s margins over the next five years due to intended cost savings and operational efficiencies. Net income margin increased significantly in 2018, mainly due to $3.4 billion of tax benefit during the year following the implementation of Tax Cuts and Jobs Act. As this was a one-time benefit, margins in 2019 are expected to be much more subdued, though higher than in 2017. We expect net income margin of 8.5% in 2019, led by productivity savings and refranchising initiatives, slightly offset by rising commodity and transportation costs.

On February 15, 2019, PepsiCo announced a 3% increase in its annualized dividend to $3.82 per share from $3.71 per share, effective with the dividend expected to be paid in June 2019. The company expects to return a total of approximately $8 billion to shareholders in 2019 through share repurchases of approximately $3 billion and dividends of approximately $5 billion. We believe that these initiatives to enhance shareholder returns, coupled with increasing organic growth and rising margins, would provide a boost to PepsiCo’s stock price over the next one year.

We have a price estimate of $119 per share for the company, which is higher than its current market price.

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