Pepsi's dominant snack food operations are underappreciated by the market.

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by Thomas Mullarkey, CFA

PepsiCo has built a wide economic moat, thanks to its economies of scale, dominance in the snack category, and efficient distribution network. The direct store delivery system allows the firm to leverage its portfolio of brands, and should ensure that PepsiCo maintains its strong returns on invested capital over the long haul. Although Coca-Cola KO is the global cola leader, PepsiCo is the dominant force in the global snack market. Pepsi controls around 64% of the U.S. salty snack market, 60% of the market in Brazil, and 46% of the U.K. market. The North American snack business is Pepsi's most profitable segment, generating 24% of the firm's total revenue in 2011, but 41% of its operating profits.Additionally, PepsiCo has an impressive record of creating or acquiring products that are aligned with emerging consumer trends. Over the past decade, Pepsi's Good-For-You portfolio has grown to $13 billion in annual sales from $2.2 billion, as consumers increasingly demand tasty and nutritional foods and drinks. We expect that future growth in the health and wellness segment will primarily be organic (via increased focus on the firm's Tropicana, Quaker and Gatorade brands) but will be supplemented through select acquisitions, such as the firm's 2011 acquisition of Wimm-Bill-Dann for $4 billion, which helped PepsiCo to enter the Russian dairy market.From our perspective, PepsiCo's direct store delivery system is one of the key attributes driving the firm’s wide economic moat, given that replicating such a system would be prohibitively expensive for an upstart competitor. Pepsi's distribution system allows the firm to deliver merchandise and stock the company's beverages and snacks to retailers across the globe, and garner market share from the firm's smaller peers.Pepsi's relationships with retailers have become even more direct since the firm took control of its two anchor bottlers, Pepsi Bottling Group and Pepsi Americas, Inc. The transactions, which closed in 2010, have already delivered over $550 million of annual synergies, and have allowed Pepsi to more nimbly experiment with packaging formats and to incubate niche products. It is important to note that the bottling operations are much more asset-intensive than the beverage concentrate business, and Pepsi's asset-base has swelled to $73 billion at year-end 2011 from $40 billion at year-end 2009 as a result. This surge in assets is the primary reason why we forecast that Pepsi's return on invested capital will pull back to the upper-teens percentage range over the next five years, versus the loftier mid-30% range the company enjoyed during the last decade.Given Pepsi's competitive advantages, we think the company's stock should trade at a high-teens multiple. Currently, the market appears fixated on problems in the company's beverage business, and is ignoring its dominant position in snacks.  Overall, while we believe that Coke should trade at a richer multiple--given that it dominates the on-premise channel, and is outspending Pepsi in emerging markets--we believe that the valuation gap between these beverage and snack giants has grown too wide.
ValuationWe are reducing our fair value estimate for PepsiCo to $72 per share from $76, largely as a result of reduced outlook for the company's 2012 performance. We expect in 2012, Pepsi's core EPS will drop by about 8% versus what it earned in 2011 as its efficiency programs are more than offset by higher marketing costs, increased raw material costs, and a strengthening U.S. dollar. Longer term, we expect Pepsi's top line and EPS to grow around 5% and 7% per year, respectively. Our new fair value estimate implies an 11 times EV/EBITDA valuation, 5% free cash flow yield, and a 2.8% dividend yield.Volume and pricing are key drivers of our valuation model. We forecast Pepsi's top line to grow roughly 5% per year over the next decade, driven by roughly 3% to 4% volume growth and 1% to 2% pricing growth.  Additionally we believe that the company's operating margins should be around 15% to 16%. We believe that, in the coming years, EPS growth should outpace top-line growth as the firm utilizes the substantial free cash flow it generates to reduce debt and repurchase shares. For 2012, we expect Pepsi to earn roughly $4.08 per share on $68.5 billion in revenue.
RiskVolatility in commodity prices, particularly for raw materials such as corn, juices, wheat, aluminum and plastic resins, could pinch PepsiCo's sales and profitability. PepsiCo is only able to hedge approximately three-quarters of its raw material costs, constantly leaving it somewhat exposed to commodities fluctuations. Approximately half of Pepsi's revenue is generated from international markets, exposing it to various currency and geopolitical risks. Finally, sales of PepsiCo's carbonated drinks and snacks are vulnerable to the impact of shifting consumer tastes that might favor healthier options, or by governments looking to tax sweets and snacks.
Management & StewardshipPepsiCo has an above-average standard of corporate governance. Chairman and CEO Indra Nooyi, who has been at the helm since 2006, has been instrumental in shepherding some bold strategic moves, including the firm's increased focus on Good-For-You products and the acquisition of Pepsi's North American bottlers. While we would like to see the roles of chairman and CEO separated, we note that with Nooyi's ownership of over 1.5 million shares, combined with her incentive-heavy compensation package, her interests are likely aligned with those of shareholders. We further applaud the firm for its adoption of majority voting, allowing shareholders to vote against the election of a director, but we think allowing cumulative voting would further enhance the rights of the small shareholder.
Overview
Financial Health: Although the acquisition of Pepsi's North American bottlers measurably increased the company's debt (to $26.8 billion in 2011 from $8 billion in 2009), we view the firm as financially healthy, with the prospect of default remote. Even with its increased debt load, we expect the company's debt/EBITDA ratio to remain below 2, and EBITDA to cover interest expense by about 15 times on average during the next five years. We currently assign Pepsi an issuer rating of AA-, implying very low default risk.
Profile: PepsiCo manufactures, markets, and sells a variety of salty, convenient, sweet, and grain-based snacks, as well as carbonated and noncarbonated beverages. The company's broad portfolio of brands includes: Pepsi, Mountain Dew, Gatorade, Tropicana, Lay's, Doritos, and Quaker. Pepsi owns most of its bottling infrastructure in North America, but typically utilizes independent bottlers in international markets. Food accounts for approximately 50% of Pepsi's revenue. Additionally, 53% of Pepsi's top line comes from the United States.