As seems to be the case with Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP) is not presently delivering the sort of results that its premium valuation would seem to demand. Certainly some of this can be tied to investor confidence - Coca-Cola and PepsiCo may wobble from time to time, but they eventually get their affairs in order and get back to the business of wringing above-average profits from strong global brands. That said, while I do believe PepsiCo has some good things going for it, I see no reason to pay up for the stock today.
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A Quarterly Beat, but not a Great Performance
For PepsiCo, the third quarter was another one where there was some 'splainin' to do. The company did beat the bottom line estimate, but the quality of the win was a little weak (powered by below-the-line numbers) and the core North American beverage business is not firing on all cylinders.
Revenue was down 5% on a reported basis, but up 5% on an organic basis (edging out Coca-Cola's organic growth for the same quarter). Growth was heavily weighted toward pricing/mix, as volume increased 1%. The PepsiCo Americas Beverage unit saw flat organic performance, while Foods rose 6%, Europe rose 7%, and Asia, Middle East and Africa rose 10% (with emerging markets up about 11% overall).
On the profits side, gross margin did improve more than a half-point from last year. Operating income fell 8%, however, and both the Americas beverage and food segments were a little soft in terms of profit performance.
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Beverages - Mix, Competition and Promotion
PepsiCo's 4% decline in North American beverage volume jumped out at me this quarter, with carbonated beverage volume down 2% and still beverage volume down 7%. It certainly backs up the Nielsen data that indicated Coca-Cola was picking up share in water and sports beverages, and it sounds as though PepsiCo's Tropicana business was down in the double-digits.
This business flummoxes me a bit right now. On the one hand, PepsiCo is fine with losing share in the lower-margin case water business, and I don't dispute that decision at all (higher water sales didn't help Coke's margins). Likewise, getting out of less-profitable juice businesses makes sense. On the other hand, the company has been committing a lot of resources to this unit (North American beverages in general, that is), and it doesn't seem to be paying a lot of dividends. Even if companies such as Cott (NYSE:COT) are benefiting from a shift to cheaper, store-brand soda, it's not a good performance.
Good Overseas Performance
In contrast to North American results, PepsiCo is doing well overseas - seemingly better than even Coca-Cola in China. For reasons that don't always make a lot of sense, PepsiCo and Coca-Cola are frequently compared to other consumer companies such as Procter & Gamble (NYSE:PG) and Colgate Palmolive (NYSE:CL) in emerging market sales, and PepsiCo seems to be holding its own at present, with generally solid volumes across the board.
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Product Development Should Pay Off
PepsiCo has arguably been too lax in product development in recent years, and is paying for it with share weakness relative to Coca-Cola in beverages and companies such as Kraft (Nasdaq:KRFT) and Kellogg (NYSE:K) in snacks. Time will tell if the company's efforts here can pay dividends; PepsiCo has been working with ingredient/flavor developers such as Senomyx (Nasdaq:SNMX) in the hopes of developing better sweeteners, and the company's venture with Yum! Brands (NYSE:YUM) for the Doritos-flavored taco shell shows some of the benefits of thinking outside the box with flavor and brand extensions.
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The Bottom Line
Given PepsiCo's relatively long history as a performance laggard, I'm surprised by the extent to which analysts and investors give the company the benefit of the doubt with their models. Historically, PepsiCo has only delivered about 60% of the free cash flow margin of Coca-Cola and only about one-third more than packaged food players like Kraft and Kellogg.
Let's say that PepsiCo does better and lifts that free cash flow margin into the mid-teens over the next decade, while continuing to grow revenue at a low-to-mid single-digit clip. That points to roughly 10% compound annual free cash flow growth, but a fair value in the low $70s. So even if the company does meaningfully better than it has, there's not a lot of apparent upside to me in the stock. That said, I know the Street loves and believes in this name, so any real pullback would probably be an opportunity for investors who wish to bet that the love affair will continue.
At the time of writing, Stephen D. Simpson owned shares of Senomyx since 2007.