Is Pepsi's Turnaround For Real?

By Will Ashworth | April 19, 2013 AAA

Pepsico (NYSE:PEP) announced first quarter earnings April 18. Better than expected, its stock jumped more than 3% on the news. The soda pop and snack food conglomerate is in the midst of a revitalization that's getting a lot of attention from investors. With its stock up 20% year-to-date, I question whether its good performance will continue. Read on and I'll look at the pros and cons of Pepsi's latest results.

Earnings - The Good
Pepsico originally set a goal of $1.5 billion in annual productivity savings between 2012 and 2014. By the end of 2012 it had taken enough positive steps to double its goal to $3 billion by 2015. As a result of these productivity savings, its Q1 core constant currency operating profit increased 9% year-over-year with its core operating margin up 80 basis points to 14.3%. It's definitely a big positive.

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In terms of volume, snacks have been the big winner with 4% organic growth in the quarter versus a 1% increase for beverages. Its PepsiCo Americas Foods (PAF) business unit, its biggest, grew organic revenue by 6% in the quarter led by a 14% increase in its Latin America Foods segment. PepsiCo Americas Beverages (PAB) unit generated organic revenue that was flat. Its Europe and AMEA (Africa, Middle East, and Asia) business units, which combine snacks and beverages, both had healthy growth with 4% and 15% organic revenue growth, respectively.

Until PepsiCo makes further inroads outside the Western Hemisphere, its two business units in the Americas (PAF&PAB) are the key to its success. In the first quarter their revenues were 76% of its overall global business and 87% of operating profit. Its two biggest units combined achieved revenue growth in the quarter increase of 2.4% to $9.54 billion with a 4.6% increase in operating profits. Meanwhile, Coca-Cola's (NYSE:KO) first quarter revenue in the Western Hemisphere (Latin and North America) grew by 1.6% on a constant currency basis to $6.2 billion with operating income (constant currency) basically flat at $1.25 billion. On a comparable basis, PepsiCo's business in the Western Hemisphere grew more than Coke's both in terms of revenue and operating profit. However, Coke's operating margin was better at 20.2%, 590 basis points higher than PepsiCo.

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While some of the cost savings will be reinvested in its business, the remainder will likely go towards additional share repurchases. In its 2013 outlook Pepsico projected it will make $3 billion in share repurchases this year, slightly less than in 2012. In addition, it will pay out $3.4 billion in dividends returning a total of $6.4 billion to shareholders. Its capital allocation is definitely tilted toward rewarding investors.

Earnings - The Bad
Because its Americas business is such a huge piece of its overall revenue, it would be nice if it delivered significantly higher operating margins. Trailing Coke by almost 30%, it's leaving a lot of money on the table. Shareholders better hope its $3 billion in cost cuts are permanent because if they're not, Coke's stock is going to continue outperforming PepsiCo's.

Wells Fargo analyst Bonnie Herzog pointed out April 18 that the PepsiCo Americas Beverage unit saw volume shrink by 3% in the first quarter. Only price increases helped limit the damage. Herzog stated, "A 1% global volume growth in beverages reflects continued underperformance versus Coca-Cola." At the end of the day, Coke's global volume in beverages was four times higher than PepsiCo's. Worse still, Coca-Cola Americas' volume growth was 200% higher at 3%. PepsiCo Americas Beverages really brought down its Western Hemisphere numbers.

Lastly, and this has little to do with PepsiCo's financial performance in the quarter, is its valuation. Virtually anyone writing about PepsiCo agrees its stock is very frothy at 17 times its 2014 earnings. Considering its operating margins are much lower than Coca-Cola, Dr. Pepper Snapple (NYSE:DPS) and Monster Beverage (Nasdaq:MNST), its stock price is probably about 15% too high.

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Verdict
In my opinion, Pepsico never seems to know whether it's a beverage or snack food company. In recent years the idea of a split has come into play because several other key players have done precisely that; the most notable being Kraft, which split into two last October. With the beverage business growing in emerging markets, I think it makes a good deal of sense to split the businesses.

If PepsiCo were to split the two businesses I could see the current valuation. But since that's unlikely to happen, I'd wait to buy in the high 60s.

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