PepsiCo Really Close Now

By Stephen D. Simpson, CFA | October 14, 2011 AAA

If there's anything good about widespread market routes, it's that they can often bring expensive stocks back to a more palatable price. That's perhaps the most significant takeaway from PepsiCo's (NYSE:PEP) third quarter earnings; while business continues to move along apace, the stock is finally at a point where long-term investors may see some real value.

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A Decent Fiscal Third Quarter
The market seemed to be girding itself for a bad performance, but PepsiCo did alright. Revenue rose more than 13% as reported, with organic growth in excess of 5%. With worldwide organic snack volume growth of 3%, and beverage volume growth of 1%. It's clear that Pepsi products are still finding their way into shopping carts, but the company hasn't really pushed as hard on pricing as other food and beverage companies.

Organic growth was strongest in the company's emerging markets (Asia, Africa and the Middle East), while the food and beverage businesses in the Western hemisphere grew at single digit rates. Investors should also note that reported results were boosted by the inclusion of the Wimm-Bill-Dann (WBD) deal.

PepsiCo came up a little short on profits, but not to a worrisome degree. The company did take a hit on gross margins (down three full points), as the company absorbs not only higher input costs, but the impact of currency and the different margin structure of WBD. Adjusted operating income rose just about 5% this quarter as the company's efforts to restrain selling, general and administrative expenses spending couldn't recapture that lost gross profitability. (For related reading on SG&A, see Understanding The Income Statement.)

Should PepsiCo Get Involved In the Food Industry Shuffling?
Recently, there have been more than a few tremors in the food business. From small companies like Diamond Foods (Nasdaq:DMND) looking to boost its roster of snack foods to larger (albeit failed) deals like ConAgra (NYSE:CAG) and Ralcorp (NYSE:RAH), to transactions like those at Sara Lee (NYSE:SLE), there is certainly some interest out there in food and beverage mergers and acquisitions.

Where might PepsiCo go? I have to wonder if PepsiCo will take a look at Post Foods once it's free of Ralcorp. PepsiCo has a small dry cereal business (well behind Kellogg (NYSE:K) and General Mills (NYSE:GIS) in market shares) but a larger hot cereal business. At the same time, the company has low shares in the snack bar business, and maybe Abbott (NYSE:ABT) will think of selling its ZonePerfect line to PepsiCo.

Is Innovation the Answer?
Food and beverage companies don't get a lot of credit for innovation. There's a cottage industry in writing columns about famous failures, and Coca-Cola's (NYSE:KO) New Coke and PepsiCo's Pepsi Clear are frequent fliers on those lists. But, the fact is that companies like PepsiCo and Nestle (Nasdaq:NSRGY) are more innovative than people think. In the case of Pepsi, maybe products like Tostitos Artisan chips don't strike readers as "innovative," but they do drive increased sales (often at a premium), and the company has done well moving healthier snack foods into the market. Moreover, the company has a collaboration underway for a new sweetener that could be a share-shifter in the beverage industry.

The Bottom Line
Absent of a big innovation, like a better sweetener, salt substitute or a major new hit product, the North American snack and beverage business "is what it is" - a low-growth but high-profit business that PepsiCo investors can count on for reliable performance. Overseas, though, there is still much more potential - not only in businesses like bottled water, but in snack foods and flavored beverages as well.

PepsiCo's stocks have rarely ever been cheap in recent years (and the same is true for Nestle), but circumstances have changed a bit with this market pullback. Even allowing for the probability that poor consumer sentiment may send some shoppers back to tap water and store brand colas. The long-term outlook for PepsiCo is strong, and the stock is much more appealing now as a long-term prospect. (For related reading, see Why Consumer Confidence Matters.)

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