- The ECB stance on not expanding QE last week may have put a top in the dollar. The strong US job report couldn't rally the dollar index back to new highs.
- If the dollar continues to weaken, companies like Pepsi, with a lot to gain from dollar weakness should benefit the most.
- Frito-Lay should expand due to better healthier offerings. Company has just announced an expansion to its manufacturing facilities.
- Pepsi is fortunate in that it leads the US non-carbonated sector. I can only see Pepsi gaining market share here.
Mario Draghi's decision to hold firm in not increasing the amount of bond purchases in Europe really made the euro rally hard against the dollar. The dollar went from $1.058 to over $1.09 which is a huge move in 24 hours. Draghi's statement meant that the euro could have formed an intermediate bottom which means that the dollar could have printed its own intermediate top (see chart).
The bounce off its 50 day moving average since Draghi's comments has so far is weak. Furthermore the November jobs report although being strong still didn't ray the dollar back to new highs. I bring up the dollar because many US multi-nationals have been adversely affected over the last 18 months.
Pepsico (NYSE:PEP) is one such company which has been reporting strong organic growth in recent quarters but still has seen revenues and net incomes decrease in currency neutral US dollars. However if we can get some meaningful weakness in the dollar, it will be the companies with strong core growth like Pepsi that should flourish in the years to come.
High Relative Valuation
Firstly many analysts are neutral to bearish on Pepsi stock because of the perceived high valuation despite the company's top line and bottom lines continuing to fall. Revenues are expected to come in at $64.5 billion for 2015 which would be around $2.2 billion shy of the sales figure in 2014. The bottom line is expected to take a bigger hit with $5.05 billion expected compared to $6.51 billion or EPS of $4.27 last year.
Furthermore the company has a present p/e ratio of 29.43 and a forward p/e ratio of 20.45 which are high valuations for a company that has flat to negative top and bottom lines but stocks like Pepsi always seems to sell at a premium for a variety of reasons.
First its a dividend aristocrat, has excellent fundamentals and continues to reward shareholders through stock buybacks. Apart from these reasons, the valuation is staying elevated because of the company's growth in "core" volume and pricing. In the third quarter of this year, net effective pricing rose 6% and beverage volume grew by 1% whereas the US was the best performing market with 3% overall growth.
Furthermore core operating margins rose to 17.7% and the company raised its EPS estimated to 9% for the year. These figures are keeping Pepsi stock's valuation elevated despite the company reporting a drop in revenue by 5% which the bears are continually emphasizing. However if my US dollar trend assumption is correct, Pepsi's "core" growth should show up more in its top line numbers going forward.
Profitable Snack's Division Continues To Expand
Secondly the main area where Pepsi differs from Coca Cola (NYSE:KO) is its snack division. Frito-Lay which is the company's most profitable divisions in terms of EBIDTA is expanding and I'm not surprised. Pepsi is expanding its Aberdeen plant with an investment of $60 million to cater for the elevated demand of its snacks. The company has also been quick to adapt to changing customer habits in this area by introducing more healthy products with natural ingredients and free of gluten.
These changes are starting to affect the top line as organic volumes grew by 0.5% last quarter which means the company has had 2% revenue growth over the first 9 months of this year. Investors should watch this division closely. Why? Because the operating margins (30%+) are almost double the company's average of 17% which means that any meaningful growth here in the top line should really benefit the bottom line. Moreover Pepsi is starting to sell snacks in smaller packets which should increase profitability also. These initiatives are vital as carbonated drinks continue to soften in the US, new avenues of growth are badly needed.
In the non-carbonated side, Pepsi reported a 10% increase in volumes which is in line with what we are seeing overall in this sector across the board. Coke has been investing heavily in this sector lately as its carbonated side is over 70% of its business but Pepsi may have an advantage here as it already has a strong foothold in the still category compared to competitors with products such as Gatorade, Lipton Tea and Tropicana.
Some investors thought that the shift to still beverages would adversely impact margins but that doesn't seem to be the case. Core gross margin rose 120 points last quarter which illustrate that the company's snack and still divisions should be able to withstand declining carbonated beverage sales going forward. Furthermore the productivity savings the company is realizing at present will ensure the decline in carbonated beverages will not be felt as much as its competitors.
To sum up, I believe Pepsi has too much going for it especially when you look at its competitors. Emerging markets provide huge growth potential where consumption on a per capita basis is low compared to western economies. Investors should also remember that the barriers to entry in this sector are very high. When you include distributions networks, the brand the company has built up and its bottling operations (Pepsi will keep its bottlers whereas Coke is in the process of shedding its bottling assets), prices should be well supported going forward.
Also in the US, Pepsi leads the non-carbonated drinks market which means if the growing trend gains traction, Pepsi will grow its market share here. Its strong balance sheet and 42 year history of dividend increases will ensure that shareholders will continue to get rewarded. Nevertheless, I would wait for a pull-back to enter. Its valuation ratios such as its price to earnings and price to cash are a bit on the high side at this moment in time.