Second-quarter results released recently by PepsiCo (PEP, Financial) were largely in line with management guidance. The company’s revenue increased by 2.4% to $16.09 billion, with organic revenue being 2.6% higher than in the same quarter of the previous year. Its performance was driven higher by the Frito-Lay North America (FLNA) business, achieving volume growth of 2% and operating profit growth of 5%.
Sales in the North America Beverages (NAB) division declined by 1% to $5.19 billion. Operating profit in the segment was hit by higher freight transportation costs and higher commodity input costs, however. This pushed its operating profit down by 16%. Since it is the company’s largest division, this contributed to a group fall in earnings per share of 13% for the quarter.
Changing strategy
Since the release of its second-quarter results, PepsiCo's stock price has risen by around 2%. But doubts surrounding the growth prospects of its NAB segment have contributed to a flat performance over the last year. In the same time period, the S&P 500 has risen by 13%.
One reason for the declining performance of its NAB segment in recent quarters has been the company’s lack of marketing spend versus rivals. Notably, Coca-Cola (KO, Financial) has increased its marketing spend on its main soda beverages. For example, it has re-launched Diet Coke as it seeks to improve its visibility among millennials via five different flavor variants and re-designed packaging.
With the NAB segment providing 32% of PepsiCo’s net revenue in the second quarter of the year, this remains its most important division. Therefore, it is investing more heavily in marketing its Pepsi brands. In the second quarter, the company reported an improvement in a number of key brand health metrics, which is set to lead to improved net revenue performance as the fiscal year progresses. This could act as a catalyst on the overall performance of the group and may lead to improving stock price performance.
Innovation
PepsiCo is also seeking to introduce new products into its range. Innovation in this area could lead to improving financial performance over the medium term. For example, in the second quarter, its FLNA segment delivered balanced volume growth and net price realization through innovation, releasing a 20-count family fun mix that addresses consumer demands for greater product variety and more flavors.
Similarly, the launch of Bubly provides the company with access to the fast-growing sparkling water segment. It is performing relatively well alongside further innovation in other beverage products. For example, Gatorade Zero is the company’s latest hydration innovation, containing zero sugar and all the electrolytes of Gatorade, as the company seeks to appeal to changing consumer tastes. Limited-time products such as Mountain Dew Baja Blast are also expected to deliver improved sales and profit performance in the third quarter for the NAB segment.
Consumer tastes
Of course, PepsiCo’s performance continues to be threatened by changing consumer tastes. Consumers are becoming more demanding in terms of desiring "clean label" products that contain natural ingredients. This is particularly the case among millennials, who are expected to account for around 30% of total retail spending in the U.S. by 2020.
The impact of this shift is being seen in the snack segment, with healthy snacks driving overall sales higher. Retail sales in the industry are expected to rise by 5% per annum between now and 2022, driven largely by millennials’ demand for breakfast biscuits and healthy snack bars. At the same time, demand for soda as a beverage of choice is expected to continue to fall over the medium term. This means that with the NAB segment being PepsiCo’s largest division by net sales, there could be further pressure on its medium-term performance.
In response, the company continues to diversify its product range through acquisitions. For example, it recently acquired Bare Foods, which produces healthy snacks. The purchase should fit with PepsiCo’s wider ambitions, with the company offering clean-labeled products that could help it to capitalize on the future growth of the segment.
With PepsiCo having widespread distribution channels, it has the capacity to expand its reach into new markets. In the future, the acquisition of new brands that are successful in a particular territory, alongside the company’s scope to provide scalability, could help it to adapt to changing consumer tastes more quickly.
In addition, the business is seeking to expand its "lift and shift" operation. This is where it takes a brand or product that is successful in one region and begins selling it in other regions. It has already taken its Sunbites brand from the U.S. to Australia, with new variations of the product added to the range. It has also launched one of its most successful brands in Australia, Red Rock Deli, in the U.S. By "lifting and shifting" quickly, the company could become more flexible and nimble, which could help it to keep up with fast-changing consumer tastes.
Verdict
PepsiCo has experienced mixed performance in recent quarters. Its NAB segment has disappointed, while its FLNA division has delivered strong growth. The decision to increase marketing for the former seems to be a sensible move and is expected to deliver improving financial performance in future quarters.
The company continues to diversify its offering through new product launches and acquisitions. They could help it to become less dependent on its traditional soda brands, as well as capitalize on changing consumer tastes.
Ultimately, this process is likely to take time. In the meantime, the stock may underperform the S&P 500, but in the long run it appears to offer investment potential.
