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Favorable Snack Trends and Beverage Innovation Should Continue To Fuel Growth at WideFavorable Snack Trends and Beverage Innovation Should Continue To Fuel Growth at Wide-Moat PepsiCo Dan Su Equity Analyst Business Strategy and Outlook | by Dan Su Updated Mar 17, 2023 Following years of anemic growth due to operational missteps and underinvestment, management has worked to right PepsiCo’s ship, even amid COVID-19-related disruptions and inflation. But we think there is more room to go, as the firm benefits from secular tailwinds in the snack business, growth initiatives in select attractive beverage subcategories (energy drinks, for one) and regional markets (Africa, Asia-Pacific), and an integrated business model facilitating more effective commercialization. Thanks to the strong snack and beverage brands underpinning close retail relationships combined with its massive scale and bargaining edge, we rate the firm as wide-moat and don’t foresee this position as wavering. For one, we see Pepsi’s convenient snack lineup as well placed to bolster its share by leveraging unrivalled brand awareness, operational scale, and retail relations. Within its beverage mix the firm is exploring a variety of options from nascent, in-house brands to brand licensing from third-party category leaders to expand its revenue base in nonsparkling categories, adding to its distribution clout and augmenting its carbonated drinks that have struggled thus far to narrow the gap with wide-moat Coca-Cola. Demand for snacks and beverages tends to remain resilient throughout economic cycles, and a large end-to-end supply chain gives Pepsi better control over execution, helping to shield its operations from exogenous shocks. Risks and uncertainties abound, nonetheless, including inroads from e-commerce and hard discounters that introduce more competition and disrupts the pricing structure; consumption pattern shifts driven by health awareness; and cumbersome regulations and taxes that discourage the use of plastic packaging and the intake of sugar, sodium, and saturated fat. That said, a nimble and pragmatic approach, coupled with inherent brand prowess and manufacturing/distribution scale, should enable the firm to navigate the evolving competitive landscape while enhancing its returns. Economic Moat | by Dan Su Updated Mar 17, 2023 We surmise that PepsiCo has built a wide economic moat around its global snacks and beverage operations, thanks to an impressive ensemble of household brands underpinning consumer loyalty and close retailer relationships, as well as significant scale benefits ($86 billion revenue base, global manufacturing and distribution capacity) that bring bargaining power and lower operational costs. We expect the strong intangible assets and cost advantage to enable the firm to deliver investment returns that exceed its cost of capital for more than 20 years. On our estimate, PepsiCo will generate returns on invested capital, or ROICs, including goodwill, averaging in the mid-20s over our explicit 10-year forecast period, compared with our weighted average cost of capital at 7.1%. Evidencing its dominant standing, PepsiCo ranks as number one in the $200 billion global savory snacks market, controlling 22% of the market per Euromonitor through well-known brands such as Lay’s, Cheetos, and Doritos. Consistent brand investments ($5 billion, 6.0% of sales), similar to the level of spending by wide-moat peers Mondelez and Kellogg (5.2% and 5.5% of sales, respectively) have reinforced the image of these snacks as affordable treats in today’s fast-paced life, thus allowing the snack provider to fetch pricing gains above inflation while maintaining healthy volume growth. As an example, over the past five years, the Frito-Lay North America business unit (about half of PepsiCo’s snack sales) grew price/mix at an average annual rate of 2.8% excluding the extraodinary price hikes in 2022, ahead of snack price inflation at 0.9% (per U.S. Bureau of Labor Statistics), while keeping volume growth at 2%. We believe trends are similar in major international markets. As Pepsi continues to focus on innovation in areas such as ingredients and packs to meet consumers’ evolving snacking habits and preferences, we expect its snack brands will remain top of mind for a wide variety of consumer occasions and maintain pricing power. Further, as the world’s second-largest beverage provider behind Coca-Cola, PepsiCo owns a broad portfolio of strong brands in carbonated soft drink, or CSD, and nonsparkling categories and operates the bulk of bottling capacities in-house to better control the commercialization process. The company has kept a firm grip on its number two position in the CSD category—roughly half of total beverage volume sold by PepsiCo—which we believe still offers room to grow through higher penetration primarily in emerging markets. Beyond this global growth potential, we posit Pepsi has built strong brand loyalty on taste preferences and emotional connections, and when juxtaposed with the low 5% private-label penetration that categorizes the space, we think PepsiCo’s well-known CSD brands are poised to continue to extract strong investment returns through its pricing power. Outside of the CSD category, the company has successfully diversified its reach by bringing strong brands into the fold, realizing volume share gains in structural growth areas such as sports and energy drinks. For one, the Gatorade brand dominates the sports category with a 40%-plus volume share globally per Euromonitor and continues to broaden its brand appeal and reach with smart advertising and innovation in ingredients and flavoring. In energy drinks, while its current volume share at 11% per Beverage Digest ranks the firm third after entrenched leaders Monster and Red Bull, PepsiCo is poised to narrow the gap utilizing a multi-brand approach with Rockstar and Mountain Dew at the core to score some share gains in a market increasingly segmented by lifestyle needs. Top volume shares in the ready-to-drink coffee and tea categories, under the Lipton and Starbucks brands licensed from Unilever and Starbucks, also help fortify PepsiCo’s competitive edge by augmenting its beverage lineup, adding to its distribution scale, and further deepening its relationship with retailers with extra touchpoints during delivery and shelf planning. A strong portfolio of top-selling brands that drives traffic and purchase in both the snack and beverage aisles makes PepsiCo an indispensable partner to most retailers from grocers to gas station stores. Equipped with a full suite of beverages in both CSD and nonsparkling categories, a variety of snack brands catering to different budget sizes and regional preferences, and a technology enhanced direct-to-store logistics system, PepsiCo provides an efficient, one-stop solution to retail chains for inventory planning, stocking, and replenishment that is hard to match. The reliability and flexibility of a proven distribution giant like PepsiCo should be deemed particularly valuable now, as many retailers are still reeling from logistics bottlenecks. In return for these benefits, PepsiCo earns favorable shelf allocation/placement and some liberty in designing and implementing in-store promotions that reinforce brand awareness and pricing power. Close retailer collaboration also enables PepsiCo to derive valuable insights on consumers and retail dynamics from transaction and logistics data analytics, which should inform timely and precise commercial plans and execution to keep the firm at the top of its game. We see cost advantage as a second pillar to our wide economic moat rating on PepsiCo. With a massive revenue base at $86 billion, the firm commands significant bargaining power in a wide range of procurement negotiations ranging from raw materials to advertising services. Purchases for key ingredients such as sugar, sweeteners, seasoning, and cooking oil each take only a single-digit-percent of a dispersed basket for PepsiCo, allowing the firm to tightly manage procurement costs even during periods of high inflation. We also see a cost edge stemming from its massive distribution scale, allowing the firm to reach more retailers and consumers faster and at a lower cost. The scale benefit allows PepsiCo to not only accelerate its own product commercialization to maximize profitable share gains in new and existing categories, but also attract desirable partners to license their brands to the firm’s distribution platform, adding to its scale and distribution clout. We would point to PepsiCo’s 30-years long successful distribution partnerships with wide-moats Unilever and Starbucks (both topnotch operators in and of themselves) in the tea and coffee categories as strong examples of PepsiCo’s distribution scale and prowess. Fair Value and Profit Drivers | by Dan Su Updated Mar 17, 2023 We are maintianing our fair value estimate for PepsiCo at $170 per share, which implies a 2023 EV/adjusted EBITDA multiple of 17 times. We forecast the topline to grow at 5% annually over the next 10 years. We see broad-based strength in its snack revenue growth, whereas trends are more mixed in the beverage business. We expect its strong brands, coupled with secular tailwinds in convenience food consumption, to drive solid, mid- to high-single-digit growth in snack revenue. A diverse beverage portfolio should also enable PepsiCo to garner an expanding share in the non-CSD categories such as sports, water, and ready-to-drink coffee, but its CSD business will likely remain flattish with healthy emerging market growth offsetting soft demand in the U.S. and Western Europe. We forecast overall beverage sales to grow at a low-single-digit clip over the next 10 years. Historically, PepsiCo has augmented organic growth with strategic acquisitions, and we expect the two-pronged growth strategy to continue. However, we have refrained from incorporating M&A into our explicit forecast until we gain better visibility surrounding its deal pipeline. On the profitability front, we have modeled operating margins that widen by 380 basis points to 16.9% at the end of our 10-year forecast period, relative to 2022. In addition to gross margin expansion of roughly 120 basis points over the period thanks to manufacturing efficiency gains in the snack business and a slightly higher mix of international beverage business with an outsourced model, we forecast better leverage of marketing and advertising expense (5.7% of sales by 2032 versus 6.0% in 2022) and more efficient, technology-enabled distribution spending (15.8% of sales by 2032 versus 17.4% in 2022). Risk and Uncertainty | by Dan Su Updated Mar 17, 2023 We award a Low Morningstar Uncertainty Rating to PepsiCo. With the ubiquity of smartphones and social media, food and beverage brands are constantly under the scrutiny of consumers. Any messaging, consumer experience, social, or sustainability practice that is perceived to be inconsistent with the company’s positioning could be brought under the limelight, and without timely and appropriate response, result in brand damage, and a temporary or long-term hit to volume demand and pricing power. Exposure to international markets with divergent economic and demographic trends put to the test PepsiCo’s ability to adapt to a rapidly evolving operating environment and address issues ranging from currencies and cost inflation to labor relations and geopolitical unrest. That said, with 60 of revenues from North America, PepsiCo is more insulated compared to beverage peer Coca-Cola. With growing health awareness among consumers, PepsiCo also faces the challenge of keeping a delicate balance between taste appeal and health considerations. Reformulation and recipe modification efforts notwithstanding, consumer concerns regarding the health impact from savory snack and beverage products may persist, or PepsiCo’s efforts to assuage such concerns may become cost inefficient and weigh on margins. Capital Allocation | by Dan Su Updated Mar 17, 2023 We assign an Exemplary capital allocation rating to PepsiCo, based on our view that the company has a sound balance sheet, a good track record of investments for long-term value creation, and an appropriate shareholder distribution practice blending cash dividends and share repurchases. First, we view PepsiCo as in excellent financial health. It has a strong balance sheet, with net debt to EBITDA of 2.4 times in 2022 and projected to fall below 2 times in 2023 and onward. As such, we don’t foresee any problem for the firm to maintain its Tier 1 commercial paper access to short-term funding at competitive rates when necessary. In addition, the firm has a solid cash position and a projected strong free cash flow generation ($10.3 billion on average per year, 10.3% of sales) over the next five years. All in, we believe the company is well-equipped financially to withstand external shocks and to fund its growth plans. On the investment front, we give the company credit for heavy spending over the years behind its snack brand portfolio, distribution system, and research and development that has driven and should continue to result in solid organic growth, underpinning its global dominance in the structurally attractive snack business, where its market share is 9 times ahead of its closest competitor. While the beverage business underwent a period of underinvestment, the situation was rectified since current CEO Ramon Laguarta took the helm in 2018, as the company stepped up spending to refresh its core brands, while bringing to market versions of its classic recipes to cater to a growing health-conscious crowd. Mergers and acquisitions have always been a part of the firm’s growth roadmap, with PepsiCo scoring successes with deals such as the Quaker Oats acquisition in 2001, which gave PepsiCo dominant sports drink brand Gatorade and a long runway of growth in the nonsparkling category. Its more recent acquisitions in food (Pioneer Foods, Be & Cheery) and beverage (Rockstar), though smaller in size, fit a similar strategic profile and offer the firm exposure to attractive categories (energy drinks, nuts and seeds) and attractive emerging markets (Africa and China). The transactions for Be & Cheery and Pioneer Foods deals valued the two businesses at price/sales multiples of roughly 1 times and 1.2 times, respectively, which strikes us as reasonable. However, we view the Rockstar acquisition as richly valued, with price/sales at over 20 times. We appreciate the strategic value of Rockstar (2% global volume share in energy drinks per Euromonitor, popular in the convenience store channel) to PepsiCo (roughly 4% global volume share prior to the Rockstar deal, according to Euromonitor). Still, we believe the company overpaid in its push to refresh its sleepy energy drink lineup. In the coming years, we expect strategic M&A to remain part of PepsiCo’s long-term growth strategy. On shareholder distributions, PepsiCo has returned cash to shareholders consistently with a combination of cash dividends and share buybacks. It maintained a payout ratio averaging more than 70% over the past three years, with dividends per share growing at an average of 6% each year. Over our 10-year explicit forecast period, we forecast the payout ratio to stay above 70% on average and the dividend payment to grow 7% annually. Share buybacks have fluctuated from year to year, which we believe has been prudent, as we believe management should consider buybacks only when the stock trades below its intrinsic value, without committing to a yearly target at a fixed amount. |
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