PepsiCo Inc. (PEP, Financial) reported financial results for the second quarter of fiscal 2019 on Tuesday.
For the quarter, organic revenue increased 4.5% (slightly below the result in the first quarter). This reflected top-line growth across each segment in the company’s North America business, as well as 8% organic revenue growth in developing and emerging markets.
In North America, growth was led by Frito-Lay, with revenues up 5%. Year to date, segment revenues and core constant currency operating income have increased 5% and 7%, with top-line growth largely driven by net pricing. As I’ve noted in previous articles, Frito-Lay North America is the company's most important segment at nearly 50% of operating income (before corporate unallocated expenses). It would be more appropriate to call the company Frito-Lay than Pepsi.
Internationally, the company benefited from 10% organic revenue growth in Latin America. However, this includes greater than 20% growth in Brazil, which largely reflects an easy comp (lapping last year's transportation strike that broadly disrupted commerce in the country). Elsewhere, revenues increased mid-single digits in India, high single digits in Mexico and double digits in China.
Despite mid-single-digit organic revenue growth, core constant currency operating income declined 3% in the second quarter (and 2% year to date). This largely reflects outsized investment in advertising and marketing, which has increased by roughly 60 basis points (measured as a percentage of revenues) through the first six months of the fiscal year.
This has been a focal point for CEO Ramon Lagurata, who took the reins from Indra Nooyi last October. As discussed on the conference call, PepsiCo is investing to drive innovation and growth across the portfolio (with the pace of investment to accelerate in the back half of 2019). A good example is the Bubly sparkling water brand, which has been on the market for 18 months. As Chief Financial Officer Hugh Johnston said during an interview on CNBC, the brand already has double-digit market share and is on pace for roughly $300 million in revenues this year. Here’s what Lagurata said about Bubly on the call:
“We're super happy with this opportunity. Sparkling water has been underdeveloped in the U.S. if you compare with some of the European markets and we thought there was a big opportunity there. I think the R&D team did an amazing job. We have a very good product and we see that by the levels of repeat and loyalty we're creating with some flavors. I think the personality of the brand is, it's fun, it's modern, it's young. The consumers are coming back to Bubly. Bubly has doubled velocity per point of distribution in the last four months after the Super Bowl. I agree with you that there is a lot of distribution opportunities yet and it takes a while for our retailer partners to give these brands that are growing so fast the right space in the store. Obviously, there is a lot of dialogue with our retail partners to expand Bubly space. We see this as a brand of the future. We're going to be innovating in this brand, not only flavors, but other occasions that I think we can attack. You're going to see mini-cans. You're going to see larger cans. It is going to be a no plastic brand. We think that is a very good positioning that we can have for this brand going forward for the modern consumer, the millennial and the younger mother that I think is adopting this brand. So, we're feeling very good about this brand. This could be one of our next a $1 billion brands. That's our goal with the NAB team and they're executing every step of the way with a lot of precision. So, we're very happy with this new brand in our portfolio.”
The company is also investing in a new sports drink brand (Bolt24), which is largely a response to the recent success of BodyArmor. As a reminder, Coca-Cola (KO, Financial) acquired a minority stake in BodyArmor last August, with the company’s North America president indicating at the time that the deal gave them “a clear path to ownership.” While Gatorade still dominates the roughly $8 billion U.S. sports drink market (with approximately 75% market share), BodyArmor now accounts for a mid-single-digit percentage of the market (with annual retail sales on track for $400 million). Presumably, some of BodyArmor’s share has come from PepsiCo’s slice of the pie. A successful launch for Bolt24, on top of the early traction for Gatorade Zero, would go a long way toward reinforcing PepsiCo’s dominant position in this space.
Year to date, core constant currency earnings per share have been roughly flat at $2.5 per share. The difference between the 2% decline in core constant currency operating income and earnings per share is accounted for by a lower share count (year to date, the company has spent $1.7 billion on repurchases, with expectations that they spend $3 billion total in 2019).
Conclusion
PepsiCo is putting up decent results, particularly relative to food and beverage peers that are struggling to produce organic revenue growth like Campbell’s (CPB, Financial), Kellogg’s (K, Financial), J.M. Smucker (SJM, Financial) and Kraft Heinz (KHC, Financial). With that said, top-line growth is coming at a cost (in terms of investments in advertising and marketing). Over the long run, balancing these two variables will be key to meeting the company’s financial targets. In the short run, management has suggested the pace of investment is unlikely to slow (“we probably need a year of additional reinvestments”).
For the year, management has guided for core constant currency earnings of roughly $5.5 per share. At $133, the stock trades at 24 times forward earnings – a significant premium to the other consumer packaged goods companies I mentioned above. Near the end of 2018, I liquidated a long-held position in PepsiCo (hopefully that doesn't prove to be a huge mistake). While I would be interested in owning the stock again, I do not believe there’s an adequate margin of safety at today’s price. For now, I’ll stay on the sidelines.
Disclosure: Long Kraft Heinz.
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