PepsiCo Is Worth Buying For Its Snacks Business
PepsiCo Inc. (PEP) is adopting mega trends rather quickly in the transforming packaged food and beverage industry. In the recent past, PepsiCo has taken much-needed initiatives to sustain profitable growth, including a sharp reduction of sodium and sugar content and continued expansion of wellness focused food and beverage brands. But more importantly, PepsiCo is increasingly focusing on premium brands to fuel revenue and margins even if volumetric growth remains modest in the developed markets.
The dilation of its portfolio of healthier products will generate long-term revenue growth. Furthermore, PepsiCo’s increased advertising spending and development of e-commerce channels across the globe will strengthen long-term growth prospects. The agility and much deeper distribution penetration make PepsiCo comparatively less vulnerable online shopping boom, but enhanced communication with consumers and use of big data analytics will enable the management to execute a more polished e-commerce strategy to boost impulse buy.
PepsiCo’s carbonated soft drinks business is witnessing slower-than-expected growth in C-stores across the U.S., but the continuation of reformulation and innovation efforts will help stabilize falling volume sales. However, revenue contribution from carbonated soft drink brands is likely to shrink as PepsiCo continues to release new products in premium bottled water, value-added dairy, and ready-to-drink tea and coffee categories. The latest rollout of premium Tea House Collection has strengthened its tea business and will help gain more market share in the coming quarter. On the other hand, its newly released premium bottled water brand LIFEWTR has gained a lot of customer interest and is on track to reach $200 million sales during its first year.
However, the future growth story is dependent on its snacks business as PepsiCo drives more than 40% of total operating income from Frito-Lay North America. During the second quarter of 2017, Frito-Lay North America recorded 2% revenue growth on the back of a steady recovery in volume sales and net price realization. PepsiCo is one of the top performing packaged food companies despite the dramatic change in eating habits around the world, but the continuity of winning streak depends on further solidification of its Good for You and Better for You snacks portfolios.
According to Euromonitor, healthy snacks segment will grow at a CAGR of 3% by 2021 while traditional snacks sales will record 2% growth over the same period. The strengthening of wellness trends and a greater desire for a healthy lifestyle will fuel demand for healthy and organic snacks in North America and Western Europe. The extensive distribution channels and robust brand recognition in these regions will help PepsiCo capture growth potential. The introduction of convenient and portable options like breakfast squares and overnight oats cups and expansion of expansion of breakfast flats will play a role in sustaining top-line growth.
North American savory snacks market is on track to achieve 2.2% growth this year and will sustain similar growth rates in the coming years. While the overall industry offers long-term growth potential, those categories focused on convenience and wellness trends will outperform. The market for nuts, seeds, and trail mixes will reach $24.92 billion this year, up from $21.9 billion in 2015, which significantly outpaces the overall industry growth rates. Thus, PepsiCo should tap opportunities in growth categories, including trail mixes, nut bars, and high protein vegetable snacks. However, PepsiCo will face intense resistance from competing firms, including Planters, Emerald, and Larabar, and particularly smaller players that focused on differentiation. For instance, meat snacks maker Oberto is marketing Oberto trail mix which also contains small pieces of chicken jerky. On the other hand, Sargento has released its trail mix brand with cheese called Balanced Breaks.
The solid performance of snacks business outside North America reaffirms that PepsiCo is a stock to hold for the long-term gains. While Frito-Lay North America has seen 0.5% decline in volume sales during the first half of 2017, the company’s ESSA and AMENA segments have posted 4% and 7% increase in volumes, respectively.
PepsiCo has consistently gained market share in India over the past years, which makes it the largest savory snacks player with 31% share. The extension of distribution channels in rural areas and expansion of its product offering will help accelerate top-line growth as Indian savory snacks industry is expected to grow at a compounded annual growth of 12%between 2016 and 2021. The rationalization of Kurkure brand in India will positively impact sales and margins. PepsiCo is experiencing robust demand for its Doritos brand, and recent capacity expansion will enable PepsiCo to further expand its third rapidly growing brand throughout India.
The long-term growth prospects are also bright in China where savory snacks market is expected to reach $16.6 billion by 2021, reflecting a value CAGR of 6%. The resilience of China’s savory snacks industry despite economic weakness will bode well for PepsiCo, but intensifying competition from regional companies could disrupt the progress. PepsiCo is the second-largest player and holds 5.1% market share, but Want Want Holdings with its diverse portfolio and an extensive distribution reach continues to challenge PepsiCo. However, the collaboration with Alibaba (BABA) to leverage its big data and other digital capabilities will help PepsiCo expand its digital footprints and stay ahead of the competition in China.
During the first half of 2017, PepsiCo’s sales were up 6% in Europe and Sub-Saharan Africa region despite challenging industry dynamics. The snacks sales growth rate is Western Europe is falling behind the global average. The mature industry will create growth headwinds, but releasing new innovative products in right distribution channels will improve long-term growth prospects in Western Europe. On average, Europeans spend $47 on savory snacks, which is double the size of global average. The significantly higher consumers spending level will support PepsiCo pricing strategy and will its boost sales. The rollout of more premium chips brands, including vegetable and pulse chips and nut bars, in the U.K., France, and Turkey will accelerate sales growth in the coming years.
Several packaged food companies are aggressive slashing operational costs in the context of stagnant organic sales growth. PepsiCo is also making encouraging progress with its multi-year productivity program to optimize its cost structure and boost profit margins. But more importantly, PepsiCo is reinvesting its savings in product innovation and marketing efforts to accelerate sustainable top-line growth. PepsiCo has steadily increased its marketing spending over the years, and this trend will continue as PepsiCo expands its portfolio of better for you products. On the other hand, the continuous increase in research and development investments will significantly boost PepsiCo’s innovation capabilities in the coming years and will enable the company to meet consumer preferences in highly dynamic market conditions.
Although its current yield of 2.8% is considerably less than what Coca-Cola (KO) offers, PepsiCo is a safe option for dividend investors due to better top-line and bottom-line growth prospects. In a recent announcement, PepsiCo has increased the annualized dividend by 7% to $3.22 per share. In my opinion, PepsiCo will increase the future dividend payouts at a similar pace due to 61% payout ratio, steady earnings growth over the next five years, and stable cash flow position.
PepsiCo’s operating and cash flows have remained quite stable over the past few years. The cash flow stream is likely to remain flat this year as PepsiCo is expecting $10 billion in operating cash. Despite that, the cash flow stream will be good enough to fund CapEx and cash reward to shareholders. The debt burden, however, has increased by $11.1 billion since 2012, though the total debt/EBITDA ratio of 3.12x is still hovering at a reasonable level. The debt level could grow further, but the estimated 7.4% compounded annual growth in bottom-line over the next five years will keep the risk in balance.
PepsiCo’s one-year forward PE multiple of 21.6x is in line with the soft drinks industry average of 22.4x. The stock is a bit expensive as compared to packaged foods industry multiple of 18.2x as PepsiCo earns most of its profits from snacks business. However, as opposed to several struggling packaged food companies, PepsiCo is well-positioned to continue to its resilient performance in the future. Thus, PepsiCo is still worth buying for the long-term gains.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.