Even though PepsiCo (NYSE:PEP) is routinely lashed for not being Coca-Cola (NYSE:KO), I wrote earlier in this year that I thought the stock's relative undervaluation to the increasingly overvalued packaged food sector seemed out of line. Since then, PepsiCo has closed the gap with the likes of Coca-Cola, Mondelez (Nasdaq:MDLZ), and Kellogg (NYSE:K) as the shares have underperformed the S&P 500 by a smaller amount.

SEE: Even When Coca-Cola Stumbles, It Does Okay
Now how much of this performance is due to the ongoing drumbeat that PepsiCo should make a big move like separating the beverage and snack businesses and/or acquire Mondelez, how much is due to an unusual spate of sell-side coverage initiations, and how much is due to bargain-hunting, I don't know. What I do know, though, is that the valuation looks much fairer today and PepsiCo management needs to start outlining some definitive moves to improve operating performance on a long-term basis.
Q2 Was Good, But Not That Good
PepsiCo did indeed have a good second quarter, but it wasn't as strong as the reported beat versus the average sell-side EPS estimate would suggest. Netting out a refranchising in Vietnam and a lower tax rate, the company was just slightly ahead of expectations.
Revenue rose 2% as reported (very slightly higher than expected), though organic revenue growth was more on the order of 4%, as volumes were okay in snacks (up 3%) and slightly better than Coca-Cola in beverages (up 1.5%). The Pepsi Americas Foods business led the way with 6% organic growth, as both Frito-Lay and Latin America did well despite weakness in Quaker Foods. The Americas beverage business saw a 1% organic decline (close to Coca-Cola's performance), while Europe and Asia/Mideast/Africa were both up on an organic basis (4% and 14%, respectively).
Margins are still an issue at PepsiCo, but this was a pretty good quarter compared to expectations. The company not only saw a 110bp reported improvement in gross margin (against expectations for a roughly half-point increase), but operating income rose almost 10% and the company built on the gross margin leverage with slightly lower SG&A spending as a percentage of revenue.
SEE: A Look At Corporate Profit Margins

Mondelez May Not Solve PepsiCo's Problems, And Could Increase Them
Pressure continues to grow for management to consider splitting the business (turning the beverage and snack/food operations into separate businesses) and/or acquiring Mondelez. Not only do sell-side analysts continue to run their analyses on these moves, but Trian Partners published a white paper outlining the case for these transactions.
Call me skeptical about the benefits of such a combination. I don't necessarily agree with PepsiCo management that owning Mondelez could shift volumes from more lucrative salty snacks to less lucrative sweet snacks. My issue is one of execution. Although PepsiCo's snack and food operations are better-run and more dominant than the beverage business (including almost 40% of the U.S. snack food market and almost two-thirds of the salty snack food market), the execution risk from such a deal would be quite large, particularly as Mondelez isn't as well-run as people seem to want to believe.
Blocking And Tackling, Brewery-Style
As I outlined in a piece on Coca-Cola a little while ago, I think the soda companies have an opportunity to take some lessons from the large brewery operators (like Anheuser-Busch InBev (NYSE:BUD)) in terms of manufacturing and distribution. I don't know whether it's a legacy/tradition issue or not, but carbonated beverage bottling has long been a very local/regional business, leading to significant dis-economies of scale. Given that PepsiCo still hasn't outlined its plans for the U.S. bottling operations it acquired (or re-acquired as the case may be), I think significant consolidation could be a meaningful margin leverage opportunity for the company. After all, there are about twice as many Pepsi bottling plants in the country as Frito Lay plants, but the revenue and profits are not twice as large.
The Bottom Line
PepsiCo's strong snack food business is a crown jewel, and I'm not ready to write off the possibility that the company could do better with its healthy foods initiatives (the company's joint venture with the Theo Muller Group in yogurt is now running heavy national advertising) and its beverage business. The latter is particularly important, and I believe the company needs to do better on both product development and manufacturing/logistics.
All of that said, I think the shares trade as they ought to today. Nearly 10% long-term free cash flow growth assumes that the company starts executing better, but doesn't generate a fair value above the low-to-mid $80s. Likewise, the fair P/BV implied by the company's ROE is more or less in line with today's multiple. Consequently, PepsiCo looks like a good enough hold for now, but management really needs to realize some of the underlying potential in the business for the shares to outperform the group over the long term.

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  9. Stock Analysis

    3 Reasons to Continue to Own Monster Beverage

    Learn more about the Monster Beverage Corporation and some of the primary reasons why investors and market analysts like the stock.
  10. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  5. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  6. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!