PepsiCo: Back on the growth track

I am generally quite bearish on the outlook for branded consumer staples businesses. Consumers are becoming more savvy and discerning with their purchases and this is making life more difficult for the makers and sellers of big consumer food and drinks brands. 

Not so long ago, many shoppers were happy to place their faith in leading brands that had gained their trust over the years and pay higher prices for the privilege of doing so. The scale of the leading companies and their huge advertising budgets made them difficult to compete against. This favourable backdrop made them firm favourites with investors who liked the dependability of the growing returns that they received.

Yet, what has become very clear in recent years is that the big consumer food and drinks giants cannot take their customers for granted. They want healthier products with less salt, sugar and fat and with fewer calories. The demand for these has been increasingly met from young, dynamic companies that market their products to a younger audience and sell directly to them over the internet.

The other change in the competitive landscape has come from the rapid growth in private-label products that are now offering increasingly premium products at much cheaper prices than the leading brands. Supermarkets are investing heavily in them as they can earn more money than they can from brands.

Once investors thought that big branded food and drinks businesses had big and defensible economic moats which would ensure that they could keep on growing with high rates of profitability. This is no longer the case. While the big players still have the inbuilt competitive advantages of scale in manufacturing, advertising and distribution if they fail to innovate and adapt their businesses will struggle to grow and shareholders will end up with disappointing returns.

Pepsi’s stable of leading food and drinks brands have given it many of the hallmarks of an outstanding business with high levels of profitability. Yet without sustainable profit growth in recent years, its shares had all the hallmarks of what I call a quality trap – a highly profitable business that cannot grow in value over the years ahead. As we shall see shortly, this missing ingredient now looks to have been restored.

The business

PepsiCo has some of the best-known food and drinks brands in the world, which it sells in more than 200 countries. It still makes most of its money from the US, which accounted for 57 per cent of total revenues in 2018. 54 per cent of revenues came from food products with the remainder coming from beverages. The company has split its business into six reportable segments:

Frito-Lays North America (FLNA), which accounts for 25.6 per cent of revenues and 39.1 per cent of operating profit. Branded snack products including Cheetos cheese snacks, Doritos tortilla chips, Lay’s and Ruffles potato chips, Bare fruit and vegetable snacks and Off the Eaten Path vegetable crisps.

Quaker Foods North America (QFNA), 3.8 per cent and 18.6 per cent. Branded cereals, rice and pasta, including Quaker oat products, Aunt Jemima mixes and syrups and Cap Crunch cereal. 

PepsiCo Beverages North America (PBNA), 32.5 per cent and 16.2 per cent. Branded soft drinks and waters including Pepsi, Gatorade, Mountain Dew, Tropicana, Aquafina, Naked Smoothies LWTR, Propel, as well as licences to make Lipton Teas and Starbucks coffee drinks.

Latin America, 11.3 per cent and 8.2 per cent – the company’s food and beverages sold in the area.

Europe and Sub-Saharan Africa (ESSA), 17.8 per cent and 10 per cent – the company’s food and beverages sold in this area. This includes very strong local brands such as Walkers Crisps in the UK and the Sodastream business bought in 2018.

Asia, Middle East and North Africa (AMENA), 9 per cent and 8 per cent – the company’s food and drinks sold in the area.

The Frito-Lays North American business is by far the biggest source of profit for the company, followed by Quaker Foods and the North American Beverages business.

PepsiCo sells its products to supermarkets, convenience stores, wholesalers, foodservice companies, distributors and independent bottling companies. Its drinks business had a 20 per cent share of the US market in 2018, just behind Coca-Cola, with 22 per cent. However, PepsiCo lags behind its major drinks competitor in many international markets, which may represent an opportunity for future growth with the right business strategy.

Its US business is dominated by five big retailer customers, which accounted for 33 per cent of its sales in 2019. Walmart accounted for 19 per cent alone.

The company is a major purchaser of food ingredients, which gives it significant exposure to commodity price inflation which it seeks to reduce through hedges. It also has significant exposure to the cost of plastics, cardboard packaging and energy. Its large international presence means that its financial results are significantly influenced by changes in the exchange rates against the US dollar.

Source: Pepsico

The Frito-Lays North American business is by far the biggest source of profit for the company, followed by Quaker Foods and the North American Beverages business.

Source: Pepsico

PepsiCo sells its products to supermarkets, convenience stores, wholesalers, foodservice companies, distributors and independent bottling companies. Its drinks business had a 20 per cent share of the US market in 2018, just behind Coca-Cola, with 22 per cent. However, PepsiCo lags behind its major drinks competitor in many international markets, which may represent an opportunity for future growth with the right business strategy.

Its US business is dominated by five big retailer customers, which accounted for 33 per cent of its sales in 2019. Walmart accounted for 19 per cent alone.

The company is a major purchaser of food ingredients, which gives it significant exposure to commodity price inflation which it seeks to reduce through hedges. It also has significant exposure to the cost of plastics, cardboard packaging and energy. Its large international presence means that its financial results are significantly influenced by changes in the exchange rates against the US dollar.

A closer look at business performance

Frito-Lays North America – an outstanding business

FLNA is PepsiCo’s standout business. It has been able to consistently grow its revenues, profits and market share despite already dominating the US snacks market.

FLNA: Revenues and profits ($m)

Source: Annual reports

The business is outstandingly profitable with very high profit margins. The company has proved to be very good at innovating with new products and getting consumers to trade up to more premium snacks.

One of the strongest signs that you are looking at a very high quality business is one that is able to sell more products every year and to do so by increasing prices as well. The ability to raise prices has two main advantages: the first is to pass on increases in costs, which in a business exposed to significant food ingredients costs is no bad thing. The other benefit is to persuade customers to trade up and pay more for more premium products.

We can see here that FLNA has been good at selling more and charging more to keep its sales and profits growing. 2019 saw a pick-up in pricing as there was an improvement in sales mix towards premium products, with the Bare fruit and vegetable snacks and Off the Eaten Path vegetable crisps products selling very well.

Pricing power and high margins are generally desirable characteristics in a business, but they can also be a sign of a company charging too much and inviting competition. Given FLNA’s current market share gains, this is not something to worry about at the moment, but it needs to be watched.

Quaker has been underperforming

The Quaker business has been struggling for some time. Sales volumes have been declining and so have prices. 2019 saw some price improvement, but the current annual profitability of the business is lower than it was five years ago.

Despite a lack of growth, QFNA is a highly profitable business as evidenced by its profit margins. It also remains a significant source of profit and cash flow for the business as a whole. 

QFNA: Revenues and profits ($m)

Sources: Annual reports, Investors Chronicle

Light at the end of the tunnel for North American Beverages?

PepsiCo North American Beverages: Revenues & profits ($m)

Sources: Annual reports, Investors Chronicle

PepsiCo’s North American beverages business has been struggling. Americans are drinking fewer sugary drinks, while rising competition has taken a bite out of the company’s profits. Brands such as Mountain Dew have been struggling to find favour with consumers and need to be fixed.

Yet there are signs that this business might be turning itself around. The business has shown that it has consistent pricing power in recent years despite falling volumes.

The third quarter of 2019 saw it deliver 3 per cent organic sales growth, which may not be earth-shattering but is its best performance for some time. This has come with much higher advertising spending, which has further dragged down profits.

Yet there are reasons to be upbeat. Sugar-free Pepsi (Diet Pepsi and Pepsi Max) is selling well, whereas Gatorade has been rejuvenated with the launch of the sugar-free Gatorade Zero. Its water business, along with Pure Leaf Teas and Starbucks coffee drinks, also seem to have good sales momentum. The company now has a strategy in place that its hopes will attract more purchases. More on this shortly.

International businesses held back by currency effects

PepsiCo’s overseas businesses are performing well in their local currencies and are taking market share. Profits in US dollars are being held back when they are translated due to the strength of the dollar. Profits have also been impacted by selling businesses. That said, at the moment they are not a source of profit growth for the company. Stable currencies may change this.

PepsiCo International: Revenues & profits

Sources: Annual reports, Investors Chronicle

Excellent financial performance

Despite having a few ups and downs in recent years, PepsiCo has still maintained its impressive levels of profitability and cash generation. Its profit margins, return on capital (ROCE) and free cash flow (FCF) margins are all signs of an excellent business.

PepsiCo: Key performance indicators

Sources: Annual reports, Investors Chronicle

Despite its difficulty in growing its operating profits, PepsiCo has used its FCF generation to keep shareholders happy with a sizeable share buyback programme and a significant increase in dividend payments. While buybacks and dividends have slightly exceeded FCF before disposals and investment sales, the company’s debts are at very manageable levels, with interest cover currently 8.6 times on a trailing twelve-month (TTM) basis.

PepsiCo: Buybacks and dividends

Source: Annual reports

How will PepsiCo grow its future profits?

Having high rates of profitability and FCF generation is all well and good, but without the ability to grow revenues and profits it is difficult for a company’s shares to be a good long-term investment.

PepsiCo shares delivered total returns of 27 per cent in 2019 on the expectation that the company is capable of growing again. Third-quarter results released in October 2019 saw the company saying that it would exceed its organic revenue growth target of 4 per cent for the year. In the longer term, its ambition is to grow its organic revenues at a growth rate of 4-6 per cent a year.

This represents a step change compared with recent years, but the company, under the guidance of a relatively new chief executive, seems to have a better platform to grow than it has for a while. It has a portfolio of products that are able to exploit current consumer trends of more premium and more healthy snacks and drinks.

It is a fair criticism of PepsiCo that it has not been as proactive in engaging with consumers as some of its rivals have. A key example is in its beverages business. There is now a big focus on increasing the number of locations where people can buy its drinks and there has been significant investment in in-store displays and coolers to help achieve this.

A lot of attention is being placed on packaging and getting the right sized drink product for the right occasion in the right market. This is leading to the sale of more smaller sizes of drink, which depress sales volumes in terms of serving sizes but sell for a higher price per litre and are more profitable.

Elsewhere in beverages, the company’s launch of Gatorade Zero along with Bolt 24 and Propel have given it a major boost in the hydration segment, along with its existing water business. Its tea and coffee drinks, which it makes and sells under licence, are also doing well and fit in with the strategy for the company’s non-carbonated drinks.

Sodastream will get a major boost this year with the launch of Pepsi and 7-UP concentrates in Europe. The company intends to use Sodastream as another route to market with customers and sell the environmental benefits of making soda drinks at home and the resulting reduction in plastic waste.

Frito-Lay North America continues to fire on all cylinders with new products such as fruit and vegetable snacks. Its manufacturing capacity was becoming overstretched and fresh investment here has given more scope for growth.

Quaker is also showing signs of improvement, with PepsiCo looking to use its Quaker oat products to target the breakfast on-the-go market.

The growth plans have seen a step up in advertising and marketing spending, which had increased by 12 per cent in the year to September 2019. This is being funded by the savings generated by a $1bn efficiency plan between 2019 and 2023. These extra costs have held back profits in 2019, but should start to bear fruit in 2020.

Wall Street analysts seem to be broadly optimistic that the company’s revenue targets are doable, but at the lower end of the 4-6 per cent target (excluding currency effects). 2019 is expected to see no growth in EPS due to higher costs, but consensus forecasts are for just over 4 per cent revenue growth in 2020 and 2021, which is expected to feed through to EPS growth in the 7-8 per cent range.

PepsiCo forecasts

Source: SharePad

Is there any upside in the share price?

If forecasts are met, then PepsiCo will offer a combination of quality, predictability and, crucially, some growth. This is something that investors are currently prepared to pay high valuations for.

PepsiCo is no exception to this. At $141.86, the shares trade on a 2020F PE of 23.8 times, falling to 22.1 times in 2021. They offer a 2020F dividend yield of 2.8 per cent, rising to 3 per cent in 2021.

This is no bargain valuation and it’s fair to say that a lot of the improved outlook is factored into the share price, but it’s not excessively expensive either. In a low-interest-rate world where quality shares have thrived, there’s a lot to like about PepsiCo right now, with the possibility that its fortunes might still improve further. For UK investors looking for some US equity exposure the shares are worth considering in my view.