Pepsi: Should You Consider This Consumer Stock?
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PepsiCo, (NYSE: PEP) is as much of a brand management company as it is a food and beverage manufacturer. Pepsi manages no less than 80 different brands internationally. The company is best known for its soft-drinks, but also has salty snacks, breakfast cereals, juices, and even flavored water. Pepsi’s continued success is as dependent on its ability to manage this portfolio of brands as it is on traditional manufacturing goals of controlling costs and staving off competition. According to Pepsi’s recently released 2011 financials, the beverage business accounts for nearly 52% of Pepsi’s net revenues. Coca-Cola (NYSE: KO) has been the undisputed market leader in soft drinks for years; however Pepsi remains the leader in the salty snack food business with approximately 64% of U.S. market share. Leveraging these brands to generate positive shareholder return has been a challenge for Pepsi over the last three years as it has underperformed both the broader market and its arch-rival Coke. Improved focus may provide equity investors an opportunity to purchase this stable of brands at attractive valuations.
While Pepsi’s soft drink business makes up 52% of net revenues for the company, salty snacks lend heft to the bottom line with 24% of sales and a whopping 41% of operating profits. Quaker, Tropicana and Gatorade are no slouches either, which Pepsi has categorized as having strong potential for growth both domestically and internationally. Outside of the U.S., Pepsi has a vast and deep network of bottlers and distribution channels. The company reported at 2011 year end that 50% of net revenues are generated internationally. During the fiscal year 2011, Pepsi saw net sales increase by 15% globally, with 41% of this increase coming from Pepsi’s European business, 17% from its Asia, Middle East and Africa business and 13% from its Latin American Food business. Pepsi reported that 35% of European growth was due to increases in the snack business, and its acquisition of WBD in September 2011. Snack volume also grew within the Asia, Middle East and Africa market up 15% from the previous year, in part due to strong growth in China, India and the Middle East.
Pepsi’s increasing dependence on international sales opens up earnings to exchange rate risks, especially if foreign currencies weaken against the U.S. dollar and global commodity prices rise. The company’s ability to hedge this risk appears to be adequate as currency translation gains have historically been small, but investors should remain diligent to potential shenanigans should the dollar weaken. A bigger risk than currency fluctuations is Pepsi’s ability to pass along input price increases as the company attempts to maintain and potentially grow market share.
On February 9th, as Pepsi was announcing year end results, the company also announced a series of key initiatives to drive improved growth in 2012. One of these key measures is to increase its budget for advertising and marketing by $500-600 million. The advertising spend will be primarily in the U.S. to support the company’s top brands. A renewed focus on the U.S. is a reversal from past trends, given Pepsi’s increasingly important international business and the hefty margins provided by the snack food business overseas. The company has been silent on whether it believes that an equally ambitious marketing campaign internationally is not warranted or simply that a $1 billion increase in selling expenses would apply too much pressure to its margins when commodity price increases have proven difficult to pass along to consumers.
There has been a growing call to divide the beverage business from the snacks division, but CEO Nooyi remains committed to maintaining the integration of the two units. There have been rumors that Nooyi may take the helm at the World Bank. She is only 55, so unless she does move to the Bank, she is unlikely to retire anytime soon. As long as Nooyi is CEO, investors should not expect any breakup of the businesses. With that said, Pepsi will remain a challenge to value given its cacophony of brands generating widely varying returns.
There are multiple ways to value the equity of a business, but one of the simplest is discounting the firm’s dividend stream. For mature businesses like Pepsi, I like to begin any valuation with this approach to provide a baseline. Currently, Pepsi yields approximately 3.30% with a current annual dividend of approximately $2 a share. Over the long term, no company can grow faster than the gross domestic product. I elected to use the long-term average growth in the gross domestic product of the United States, which is 3%. This estimate of growth maybe a little low due to Pepsi’s international growth, but I use the dividend model to just get a baseline valuation. I assumed a cost of equity of 6%. This estimate was based on the PepsiCo’s current beta of .34 and a risk free rate of 3% along with a historical average return of 11%. Using Gordon’s growth model, Pepsi’s stock has a valuation of $71 a share using nothing more than the dividend stream.
Various multiples are used for computing valuation, but the most common remains price to earnings. In theory, this is the price multiple that an investor is willing to pay for a dollar of earnings. Mature companies such as Pepsi, tend to trade within a range of its multiple. I will warn that when businesses are undergoing structural change, this rule of thumb can lose it validity. With this warning in mind, I still usually conduct a review of the multiple and its trend as a second step in valuation.
Pepsi has had an average price to earnings ratio since 2002 of approximately 20 times and since 2007 of 17.75 times. The price to earnings ratio using the trailing twelve months earnings equates to roughly 15.5 times. I believe this downtrend is best explained by the downward trend in the growth rate of earnings per share and it is unlikely that earnings growth will return to its historical 8% level from the last five years. It is my opinion that the earnings’ estimate for the next five years is nearer to 6% when share buybacks are accounted for. Even at 6%, I believe a price to earnings multiple of 17 is not unwarranted to due to the relative stability of earnings, and the potential for earnings improvement based on the operational changes being implemented at Pepsi. Using a 17 times earnings multiple and the value of PepsiCo is approximately $68.50 or $2.50 less than our simple dividend discount model.
The best approach to determining the value of a company is a discounted cash flow. The basic discounted cash flow model requires projecting the expected cash flows along with the terminal value of the business then discounting this stream of payments by a an appropriate discount rate. As with all models, the inputs determine the validity of the model, however using my own model, I estimated a fair value of Pepsi of $70 a share.
The three approaches produce slightly different values, but point to a fair value range for PepsiCo of $68.50 to $71 a share. Pepsi’s stock currently trades near $64. I believe that to invest in a stock, an investor needs a margin of safety of 20% in order to provide enough upside to warrant investing in a relatively risky asset. With a fair value of between $68.50 and $71 a share and assuming a 20% margin of safety, then a reasonable entry point into the stock for longer-term investors would be between $54.80 and $56.80 a share.
Pepsi owns and manages one of the greatest collections of food and beverage brands in world. Unfortunately, its ability to generate excess returns on this stellar collection has been lackluster at best over the last five years. The result has been an increasing valuation premium for arch-rival Coca-Cola versus PepsiCo. The company faces significant pressure on input prices and earnings growth, but the market is likely discounting Pepsi too heavily. Improvements in operating performance and even a minor pickup in volume should allow Pepsi to beat analysts’ estimate. Should the stock decline from its current level of near $64 to the mid 50’s, I would argue that a buying opportunity maybe available for an investor with the patience to appreciate the value in Pepsi’s extraordinary portfolio of brands.
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