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.

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