PepsiCo (PEP)is the steward of many iconic brands that are easily recognizable in any grocery store, convenience store, pharmacy or anywhere else the world goes to eat. Pepsi’s brands include the well-known beverages as well as snack foods through Frito-Lay (Doritos, Cheetos, Lays and others) and breakfast and other items through Quaker Oats (E.g. Cap’n Crunch and Life cereal, Rice-A-Roni and of course oatmeal).
Pepsi and Coca-Cola (KO) are part of a competitive beverage duopoly that has spanned the ages. Coke is the clear leader in many international markets, but Pepsi leads the U.S. in non-carbonated beverages with brands like Gatorade and Tropicana. Through its Frito-Lay division, Pepsi is the world’s largest snack food company. Frito-Lay accounts for 21% of Pepsi’s revenue, but 35% of profits.
The Power of One
Upon pressure from activist shareholder Nelson Petz, Pepsi went through a review of the business to determine if it would be better for shareholders if Pepsi split the company apart, with one part being the slow-growing beverage business and the other the food and snacks business. The review concluded that a combined company would best maximize shareholder value.
To appease activist investors at the beginning of 2014, Pepsi announced a five-year $5 billion productivity program and committed to increase the cash return to shareholders by 35% through share repurchase and higher dividends.
Pepsi’s Earnings Improve
To fend off activist investors, Pepsi needs to show growth in its anemic beverage business. In the first quarter, Pepsi’s drink revenue remained flat, but snack volume rose 2%. After taking into account currency swings and divestments, snack revenues were up 5% and drink revenue was up a respectable 3%. With overall soda volume declining 3% in 2013 and continuing industry decline in 2014, any growth in the drinks business is good. Net income for the first quarter increased to $1.22 billion from $1.08 billion the previous year driven by price increase and efficiency gains.
Pepsi’s second quarter continued the improvement with snack food revenue growing 5% and beverage revenue growing 2%, but net income declined 2% due to weaker foreign currencies. The strong results prompted Pepsi to raise its full year profit forecast growth estimate from 7% to 8%.
Pepsi Stock Performance
Although not always beneficial for investors, the attention of an activist investor can spark stock price of previously low-return businesses. Better financial results combined with stock buy-back have propelled Pepsi’s stock up nearly 13% this year.
Pepsi also boasts an annual dividend yield of 2.9% at about a 50% payout ratio. Analysts are expecting earnings to grow at an average annual rate of about 8%. Assuming the same payout structure, dividends will continue to increase at the same pace.
With a P/E of 21.1 and forward P/E of 18.9 compared to an industry average of 21.6, PEP stock appears close to fair value. The consensus Analyst 12-month price target is $99.5 and it is currently trading at about $93, which confirms my assumptions that the stock appears close to its full price, but I am still bullish on Pepsi.
Pepsi has potential for additional growth in its non-carbonated beverage brands that will offset loss in the carbonated sector. In addition, increased efficiency will drive profits higher and a better focus on shareholder value will benefit investors.
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As of this writing, Kenneth Fick did not hold a position in any of the aforementioned securities. Write him at kfick@piercethefog.com or follow him on his blog at www.piercethefog.com.
