PepsiCo: Q3 Operating Margins Proof That Company’s Strategy Is Paying Off
Contributor since 2021 / 313 Followers
Summary:
- PepsiCo’s Q3 results showed strong operating margins and an 8.8% increase in organic revenues despite modest volume declines.
- The company’s strategy of selling smaller packs has helped meet consumer demand for portion control and mitigate negative consequences of price increases.
- PepsiCo’s international business, particularly in India, performed well with significant profit and revenue growth.
Joe Raedle
Investment Thesis
PepsiCo (NASDAQ:PEP) had a decent third quarter, with strong operating margins more than offsetting modest volume declines. In this article, I talk about the key highlights of the company’s third quarter, especially how the company’s strategy to sell smaller packs and the strong performance of the international business, position the company to withstand the current macroeconomic environment.
A Snapshot of PepsiCo’s Third Quarter
PepsiCo had a decent third quarter, with revenues coming in at $23.45 billion, up 7% year-over-year, and in-line with estimates. Organic revenues saw an 8.8% jump year-over-year, despite the company witnessing a moderate decline in the organic volume for the global beverage and convenient food businesses. Furthermore, despite the decline in the volumes, PepsiCo still saw a 105-bps expansion in the core gross margins and an 80-bps expansion in the core operating margins. Q3 non-GAAP EPS came in at $2.25, which represents a 16% jump on a constant currency basis, and beating estimates by $0.10.
The management, despite warning that the U.S. consumer is becoming more cautious, still offered a rosy outlook for the rest of the year, which includes a 10% organic revenue growth, and a 13% constant currency EPS growth for FY23. Management also offered some positive outlook for FY24 with organic revenues and core EPS, on a constant currency basis, now expected to come in at the higher-end of the company’s long-term target range of 4 to 6% and high single digits respectively.
Smaller Packs keep Both Cost- and Health-Conscious Consumers Engaged
One of the major takeaways from PEP’s third quarter was how the company is reacting to the changing needs of the U.S. consumer, who has become more cost- and health-conscious. The strategy involves introducing smaller pack sizes, which not only allowed the company to meet the consumer demand for portion control, but also mitigated any negative consequences of price increases.
For instance, Frito-Lay North America managed to gain market share in the macro and savory snack categories in the third quarter as a result of smaller pack sizes as well as the introduction of bite-size versions of Doritos, Cheetos, and SunChips brands.
By consciously moving the focus towards smaller packs, which are more in line with the current consumer demand, PEP was able to adjust their pricing strategy better, which subsequently contributed to the overall margin expansion despite moderate declines in volumes.
Strong Operating Margins in North America More than Offset Decline in Organic Revenue Growth
PEP’s North America business did see a decline in organic revenue growth across all of its major segments, with Frito-Lay North America seeing growth fall from 20% to 7%, Quaker Foods North America’s seeing a decline from 16% in Q3 of FY22 to just 5% in the current quarter, and PepsiCo Beverages North America registering revenue growth of 6% compared to 13%.
However, the expansion seen in the segments’ margins more than offset the declines in the organic revenues. Beverages, for example, saw core operating margins expand by 155 bps, driven by initiatives such as investments in zero sugar offerings, relaunching the BAJA BLAST franchise, and obtaining licenses to distribute the company’s alcohol offering, Hard Mtn Dew, which is a product of Boston Beer Company.
From a margin expansion perspective, the performance in North America suggests that the company has nailed its pricing strategy, especially in a challenging macro environment.
India, an Example of the Strong Performance of PEP’s International Business
PepsiCo’s International Business also did not disappoint in the quarter. While the business saw a decline in its organic revenue growth, the decline was not as bad in comparison (12% this quarter vs. 16% in the third quarter of FY22) to other regions. The bright spot within the International Expansion was the AMESA region, which registered a 17% growth in organic revenues and 13% growth in operating profits on a constant-currency basis.
The performance in India, in particular, really stood out for me in the third quarter. The company saw its profits jump multi-fold in the country, and also saw revenues and operating profits jump 29% and 115%, year-over-year, respectively.
India remains a key destination for the company, especially since it provides an ideal region to implement the small pack strategy despite cooling inflation. The process of downtrading seems to have deepened in the region as Indian consumers continue to purchase more of smaller packs, thereby implying a structural shift in consumer mentality in the region, similar to the U.S. This would greatly benefit PepsiCo in the long-run given that this shift is in line with the company’s long-term strategy.
Valuation
|
Forward P/E Approach |
|
|
Price Target |
$181.00 |
|
Projected Forward P/E Multiple |
22.5x |
|
Forward PEG Ratio |
2.35x |
|
Projected EPS Growth Rate |
9.57% |
|
Projected FY23 EPS |
$7.33 |
|
Projected FY24 EPS |
$8.03 |
Source: Refinitiv, Author’s Calculations & PEP Q3FY23 Earnings Call
The company is currently trading at a forward P/E of 20.3x, according to Refinitiv. The company’s 5-year median forward P/E is 23.6x and the 10-year median forward P/E is 21.5x, which suggests that the stock is currently cheap. I have assumed a forward P/E of 22.5x, which is the average of both the 5-year and 10-year median values.
PEP’s forward PEG ratio currently stands at 2.35x, which results in a projected EPS growth rate of 9.57%. This growth rate would imply a projected FY23 EPS of $7.33 and assuming the same growth rate, it would imply a projected FY24 EPS of $8.03.
At a forward P/E multiple of 22.5x and FY24 EPS of $8.03, the price target for PEP is $181, which represents a 14.5% increase from current levels.
Risk Factors
The main risk facing the company is the rapid adoption of weight-loss drugs in the U.S., especially Novo Nordisk’s Ozempic. While PEP’s management disclosed during the earnings call that the impact till date has been negligible, the demand for the company’s products are at the risk of being severely impacted in the coming quarters. According to a survey by Accolade, the number of U.S. employers who cover obesity medications could nearly double next year, which makes it a significant risk factor for the company.
Then there’s the issue of declining volumes. While operating margins more than offset the decline in volumes in the third quarter, this trend is far from certain in the coming quarters, especially if the U.S. ends up in a slowdown longer than anticipated.
Concluding Thoughts
PEP had a very decent third quarter, with operating margins more than offsetting the modest declines in volumes. The company’s switch to smaller packs along with a series of innovations within the Beverages division are really paying off for the company. The company’s international business is also performing well, with the AMESA region, especially being a bright spot.
From a valuation perspective, the company’s stock remains undervalued. And while the surging popularity of weight loss drugs could have an adverse impact on the company’s products, as things stand, there is nothing to suggest that PEP’s products are facing any threat from the current macroeconomic uncertainties.
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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in PEP over 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.
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