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Wide-Moat-Rated Coca-Cola and PepsiCo Taking Inflation in Stride, but Shares Look a Bit Expensive
Wide-Moat-Rated Coca-Cola and PepsiCo Taking Inflation in Stride, but Shares Look a Bit Expensive
Analyst Note| by Chris OwenUpdated May 12, 2022
With leading brands and stout cost advantages, we’ve long believed that Coca-Cola (the dominant player in the carbonated soft drink—CSD—space, with nearly 21% value share per Euromonitor) and PepsiCo (the top operator in global savory snacks, with nearly 22% value share, and the second-largest player in the CSD market with 10% share) have carved out wide economic moats. From our vantage point, this edge has manifest in pricing power and negotiating leverage with suppliers, which we think will persist and prove particularly valuable as inflationary headwinds show no signs of diminishing.
While we think both Coke and Pepsi are poised to navigate the challenging landscape relatively unscathed, we don’t currently see much value in shares, which trade north of our revised intrinsic valuations (by around 5%-10%).
In this context, we’ve lowered our fair value estimate for Coke by $1 per share to $58, to reflect stepped-up cost pressures that we expect will linger the next several quarters, culminating in our forecast for average gross margins through 2025 of 61.2%, versus 62.4% prior. However, we continue to believe that Coke’s data-driven approach to innovation, combined with its vast international footprint and continued brand support, should result in 5.2% average annual sales growth over our 10-year explicit forecast.
Even though Pepsi isn’t immune to these challenges, we’re raising our fair value estimate to $164, from $154, after incorporating a slightly higher average midcycle revenue growth rate (4.3% versus 3.8% prior), as we now expect recent investments in its brands, direct-store delivery, manufacturing capacity, and data analytics to bolster its top line prospects. We forecast this growth will be achieved against 16.9% operating margins by fiscal 2026 (up 250 basis points relative to fiscal 2021), as the firm funds continued investments in its brands with savings extracted from its operations.
Business Strategy and Outlook| by Chris OwenUpdated May 12, 2022
We view Pepsi’s strategy, emphasizing growth in its core snacks (number one position) and beverages (number two position) businesses through expanding its addressable market and investing to align its mix with evolving consumer preferences (such as snacking as a meal substitute), favorably.
Within snacks (55% of sales), Pepsi dominates the global competitive landscape (7 times its closest competitor, with five of the six top brands), and we believe its core brand development advantages--direct-to-store partnerships with retailers, innovation to align with consumer preferences, and data analysis--allow it to drive growth in its underlying categories. In our view, Pepsi’s market position enables it to raise price without a lasting hit to volumes (and should continue to do so), given its troves of global consumer data. But the firm doesn’t just let its fare fend for itself. Rather, it spends to support its brands in a crowded space. In addition, investments to bolster its manufacturing capacity should further entrench its standing with leading retail partners in both physical and digital outlets, in our opinion.
In its beverage business (45% of sales), Pepsi is a strong number two player in an oligopolistic industry, and we anticipate the firm can generate growth within the carbonated soft drink, or CSD, category and still beverages, such as sports (where it maintains dominant share), energy drinks (enhanced by its acquisition of Rockstar Energy), and bottled/carbonated water. We think current innovation efforts, particularly to expand in low sugar CSDs and sports drinks, aligns with consumer preferences and leverages its strong brands.
Pepsi faces risks that consumers spurn its fare in favor of healthier options and that online distribution grows, but we surmise the firm is well positioned to manage these challenges. We think investments to reformulate products (without altering the taste profile) combined with the addition of healthier brands should appeal to consumers looking for wholesome products. In our view, Pepsi’s resources should ensure its fare wins regardless of the channel in which consumers opt to shop.
Economic Moat| by Chris OwenUpdated May 12, 2022
We believe that Pepsi merits a wide moat rating on the basis of the intangible assets and cost advantages it has amassed in both its snacks and beverages businesses. In our view, the company maintains an extraordinary collection of leading global brands, as evidenced by Pepsi’s consistent ability to raise prices without a durable hit to volume. Further, with nearly $80 billion in annual sales, we believe the company has negotiating prowess in procuring key raw materials, in advertising and marketing, and in distribution costs and thereby a cost advantage as well. In this context, we expect Pepsi will earn returns on invested capital (including goodwill) in the mid-20% range on average over our explicit forecast, or well in excess of our 7% estimate of its cost of capital.
Pepsi’s brand intangible assets are particularly evident in its snacking arm, in our view, as the firm holds nearly 22% share of the global savory snacks category (per Euromonitor), roughly 7 times the next closest competitor. As a leader in a growing category, we believe Pepsi is a highly valued partner for food retailers eager to capitalize on trends such as snacking as a substitute for meals. Even when other indulgent fare is included (such as sugary snacks and ice cream), Pepsi still maintains a leading global position (at nearly 8% of the category), about a point above its closest competitor, wide-moat Mondelez.
In our view, Pepsi’s global leadership in snacks (a $199 billion market that accounts for 55% of company revenue) allows it to raise prices in excess of food price inflation, which in turn supports strong profitability (with operating margins averaging 30% in its domestic Frito Lay arm over the past five years). In this context, the Frito Lay segment has averaged a 2.8% price contribution to growth over the last five years, higher than corresponding food inflation, which averaged 2.3% per the Bureau of Labor Statistics. We don’t anticipate this prowess will recede. We surmise Pepsi’s ability to raise prices without compressing volumes over an extended horizon (even in times of pronounced inflation) is enhanced by the vast compilations of consumer data it has gathered from around the world, ultimately allowing Pepsi to respond to shifts at the shelf in real time.
We believe that the firm has supported its competitive edge in the snacking aisle by investing in initiatives designed to align its product offerings with evolving consumer trends (by offering differentiated and more convenient pack sizes while also expanding its lineup to include healthier fare, such as lower sodium products). The company’s investments in research and development (which we peg at around 1% of sales annually going forward, in line with history) should aid its products in continually winning at the shelf. Pepsi diligently markets its fare to ensure its products remain top of mind for consumers (regardless of channel). In this context, Pepsi directed more than 6% of sales toward advertising in 2021 (just north of $5 billion), which generally aligns with the mid-single-digit percentage levels expended by wide-moat peers, Mondelez and Kellogg.
We believe Pepsi’s competitive edge in snacking is complemented by its strong number two position in the attractive beverage industry (accounting for 45% of sales). Despite Coke’s dominance (controlling more than one fifth of the global soft drink market in 2021), Pepsi has held remarkably stable share on a retail value basis at 10% over the last decade, which is 5 times the level held by the next leading brand, Suntory at 2.2% per Euromonitor. In our view, the confluence of very strong brands (including its namesake offering, Gatorade, Aquafina, and Mountain Dew, among others) and relatively limited private-label participation (9% by volume per Euromonitor in 2021, lagging the high-teens to low-20s penetration levels that tend to characterize the U.S. food and beverage space) permits a favorable pricing environment that we expect to persist over time.
We find the re-acceleration of the carbonated soft drink, or CSD, market, which has resumed growth after several years of declines in volume terms, supportive of Pepsi’s wide moat. We believe the CSD space is likely to remain a growing category due to work from home arrangements, new products that align better with health trends supported by real time data analysis, and flavor tweaks (such as citrus at present). Euromonitor expects global carbonate off-trade volume to grow an average of 1.8% over the next five years, which seems reasonable to us. However, Pepsi’s fate in the beverage aisle isn’t exclusively tied to the CSD category. Rather, the firm has been building out its position in other attractive niches, including sports drinks (with the clear number one brand in Gatorade) and energy drinks, as well as bottled water (with the number three brand globally in Aquafina), which we believe bolsters its standing with leading retailers. However, we are well aware that private-label competition is rife in the bottled water aisle (particularly as differentiation is lacking), and thus competition is likely more pronounced (hindering Pepsi’s ability to price consistently in excess of inflation). At a low-single-digit percentage of sales (approximately 2% through the Aquafina brand), though, we don’t believe bottled water will impede the firm’s ability to generate excess returns over an extended horizon.
We believe the direct-store distribution, or DSD, network, while not necessary for retail success in today’s environment, nonetheless provides an intimate relationship with retailers, with Pepsi managing its shelf space in conjunction with its retail partner and ensuring that quality and product availability are maintained. The constant client interaction through DSD provides another avenue of real-time feedback on products and trends--and even product replenishment. As Pepsi develops its omnichannel capabilities, we expect its dominance will follow to the online channel, though we recognize any distribution shift could invite a competitive response that may eat into its returns.
From our vantage point, Pepsi, by virtue of its respective number one and number two positions in snacks and beverages, enjoys inherent cost advantages relative to smaller, less differentiated peers. The current environment provides examples of its longer-term advantages, in our view. For instance, costs for key ingredients, including vegetable oil, sugar, and aluminum, have risen dramatically, but we surmise that Pepsi has employed negotiating prowess to blunt the impact, as it draws upon multiple suppliers and makes large volume purchases. However, even against a more benign cost backdrop, we surmise the firm’s scale enables it to flex its negotiating muscle, such as within advertising, in a way that smaller peers would struggle to replicate.
Fair Value and Profit Drivers| by Chris OwenUpdated May 12, 2022
We are increasing Pepsi’s fair value estimate to $164, from $154 prior, to reflect the time value of money and our expectations for slightly higher five-year revenue growth, as we now surmise the firm is more effectively positioned to leverage recent investments in real-time data analytics to ensure its mix aligns with evolving consumer trends. Our revised valuation implies an enterprise value/adjusted EBITDA of around 17 times.
Inflationary pressures could represent a mid- to high-single-digit headwind in 2022, in our view, though we believe that Pepsi maintains multiple levers through which to blunt the hit to profits. We anticipate that the firm, in addition to raising prices, will ratchet back discretionary spending (where feasible), while also eliminating inefficiencies. Despite the near-term challenges, we’re encouraged Pepsi continues to invest to support its competitive position. We forecast, consistent with historical averages, that marketing will amount to 6%-7% of sales, and research and development will approximate 1% of sales, through fiscal 2031. In our forecast, gross margins expand around 250 basis points over the next 10 years to 55.8%% in fiscal 2031, while operating margins reach 17.5% (around a 300 basis points increase over fiscal 2021).
In our view, brand support should enable Pepsi’s products to continue winning with consumers, even as competitive pressures rise. As such, we expect Pepsi to post 4.8% average annual organic revenue growth through 2031 (after excluding the Tropicana business), driven by a nearly 2% increase in volumes and a roughly 3% benefit from higher price and favorable mix. We continue to believe Pepsi is advantaged because of its enormous set of customer interactions, which should enable it to adapt to changing consumer trends (such as broadening its reach within the health and wellness sphere and new flavor profiles like citrus) in real time. While we expect healthy snacking growth (approximately 5% each year over the next 10 years), we also anticipate nearly 4% annual top line growth from the beverage aisle (including carbonated soft drinks but excluding Tropicana) through fiscal 2031.
Risk and Uncertainty| by Chris OwenUpdated May 12, 2022
We view Pepsi’s uncertainty rating as low. We believe the greatest threats to Pepsi’s fundamentals relate to the potential for declining volumes in response to heightened inflation, an uptick in health-conscious consumer behavior (potentially reinforced by government regulation), and industry distribution shifts that may permit increased competition.
Despite our expectation for continued growth in carbonated soft drinks, we believe that the category faces challenges related to pricing (particularly in an inflationary environment). Consumers face a plethora of beverage alternatives, and if the firm’s innovation (including packaging designed to lower the price point) fails to win at the shelf, consumers may find favor elsewhere, including with a less expensive product.
We regard the trend toward more health-conscious beverage and snack options and governmental efforts to reduce sugary soft drink and high sodium snack consumption, as the most pressing environmental, social, and governance risk facing Pepsi. Sales haven’t been constrained because of consumers’ increasing penchant for healthy fare yet, but this could change if the implementation of sugar taxes becomes more widespread. Further, governmental mandates restricting advertising or requiring an improved health profile for its products could limit Pepsi’s ability to tout the value of its fare to consumers and/or prompt a need for higher spending on innovation. In addition, restrictions on water use in geographies where this resource is scarce could hamper Pepsi’s beverage production.
We anticipate that the competitive landscape will become more intense (with additional players entering the fold), as the adoption of the online channel for purchasing consumer products grows. To counter competition and burnish its brand, the firm will need to continue investing in research, development, and marketing, in our view.
Capital Allocation| by Chris OwenUpdated May 12, 2022
We regard Pepsi’s capital allocation as Exemplary, as we believe that its balance sheet is sound, its investment track record is favorable, and its shareholder distributions are appropriate. With manageable near-term debt maturities and a history of making acquisitions without straining its balance sheet, Pepsi should be able to support investments in capacity, supply chain, and omnichannel capabilities, as well as return excess cash to shareholders, in our view.
Pepsi has historically maintained solid leverage ratios, and we believe that episodic acquisitions and investments are unlikely to impair its financial flexibility. In this context, the firm averaged a 1.9 times net debt/EBITDA over the last 10 years, despite reaching 2.7 times in 2020 post the acquisitions of Rockstar Energy, Be & Cheery, and Pioneer Foods, which were purchased for a total consideration of $6.7 billion. However, we believe the company is prioritizing debt paydown, as leverage declined to 2.5 times in 2021, and we expect it to fall below the historical average again by the end of 2022, absent further deals.
From our vantage point, Pepsi’s acquisitions have enhanced its product reach (including Rockstar Energy and SodaStream) in attractive enclaves, and we anticipate that it will remain a consolidator. However, we don’t believe that the firm has overpaid for its targets, expending around 5 times revenue by our estimates for each of the two larger deals it consummated over the past few years, Rockstar Energy and SodaStream, consistent with recent deals in the high-growth beverage space according to Pitchbook. But given its dominant position, we surmise its future pursuits will generally be smaller targets that are unlikely to impair its financial flexibility, though we don’t model unannounced deals, due to the uncertainties surrounding timing and valuation.
As consumer shopping patterns bifurcate again, now that concerns surrounding the pandemic are fading, we believe Pepsi’s omnichannel reinvestment efforts (particularly as it relates to digital technology, expanded DSD capabilities, improved packaging, and enhanced manufacturing capacity) are judicious and will support Pepsi’s growth trajectory. With global tensions and inflation tangling supply chains, Pepsi’s ability to enhance its fulfillment strengths through investment stands to reinforce its brand standing and ultimately its competitive position by ensuring timely availability across all physical and digital retail channels.
We surmise that returning excess cash to shareholders (through both its dividend and share repurchases) is likely to remain a capital allocation priority for Pepsi, which we view as prudent. In 2022, management targets a $7.7 billion return of capital, with roughly 80% allocated to dividend payout and 20% to share repurchase. We anticipate the firm will raise its dividend at a high-single-digit annual clip (maintaining a payout ratio of around 70%) over our 10-year forecast horizon. We also expect repurchases of nearly 1% of shares outstanding on an annual basis, coinciding with its recent historical track record; we view this as a prudent use of cash when the stock trades below our assessment of its intrinsic value.