Image Source: PepsiCo Inc – IR Presentation
By Callum Turcan
Maker of snacks and sugary beverages, PepsiCo Inc (PEP) posted second-quarter earnings for fiscal 2019 on July 9 that were positively received by the market. PepsiCo reaffirmed 2019 guidance calling for 4% annual organic revenue growth, a 1% decline in core constant EPS (3% decline when including an expected 200 basis point headwind from foreign currency movements) versus 2018 levels, and ~$4.5 billion in free cash flow generation. Shares of PEP yield 2.9% as of this writing and we like PepsiCo’s dividend coverage. However, please note that the company expects to spend $5.0 billion on dividends and $3.0 billion on share buybacks this year. Forecasted free cash flows will only cover most, but not all, of its dividend payout while buybacks are being funded by the balance sheet.
Quarter in Review
In the second quarter of fiscal 2019, which ended on June 15, PepsiCo reported $16.45 billion in net sales and $1.54 in non-GAAP core EPS. Reported GAAP sales were up over 2% year-over-year with growth experienced in every geographical category but AMENA (Asia, Middle East and North Africa), and when adjusting for negative currency movements, PepsiCo was pleased to announce 4.5% organic sales growth year-over-year.
While foreign currency headwinds, a product of a strong US dollar, are widely expected to remain a thorn in the side of international giants like PepsiCo, management wants to communicate to the market that underlying demand for its products remain strong. According to its earnings press release, negative foreign currency movements shaved ~300 basis points off of PepsiCo’s net revenue growth and ~200 basis points off of its EPS last quarter.
PepsiCo reported strong demand for its snacks in North America driven by sales of Lay’s, Doritos, Cheetos, and Ruffles. Sales growth was strong at dollar stores and convenience stores. Organic sales growth for PepsiCo’s Frito-Lay North America (“FLNA”) were up 5% year-over-year and management noted that “in addition, we posted good growth across all channels in the U.S., led by high single-digit growth in convenience and dollar stores.” This is a space we see a lot of potential in as America could see thousands of new dollar stores and similar locations open up all over the country over the next decade. Performing well in this category will be key as it relates to its North American division.
Beyond its domestic market, PepsiCo was pleased to announce 8% organic sales growth year-over-year in developing and emerging markets last quarter. Its organic Brazilian revenue spiked by 20% due to a very favorable comparison period, as transportation strikes held down sales last year. PepsiCo reported “strong” double-digit growth in China, high single-digit growth in Mexico and Russia, and mid-single-digit growth in India. Management sees affordability and local relevance as key to driving successful performance.
Marketing goods that aren’t compatible with local tastes or are viewed as “expensive” relative to other offerings doesn’t fit in with PepsiCo’s business model, as that creates inefficiencies in the logistics and distribution system as sales flounder. By tailoring its approach to each market differently while leveraging its global brand and scale, PepsiCo is seeking to gain market share in developing and emerging markets while positioning itself to capitalize on rising per capita income in those economies over the coming decades. We like this strategy.
PepsiCo’s GAAP gross margin expanded by a tad over ten basis points from the second quarter of 2018 to the second quarter of 2019, while its non-GAAP gross margin expanded by over 70 basis points during that period. Strong performance at its snacks businesses was key. The adjusted gross margin figure removed the negative impact of restructuring and impairment charges (50 basis point drag on GAAP gross margins) among other items to provide investors with a better idea of how PepsiCo is performing. Even better, PepsiCo’s CFO Hugh Johnston mentioned that going forward, the firm expects less pressure from commodity prices relative to last year during the second half of 2019.
Please note that PepsiCo’s GAAP operating margin and operating income weakened in the second quarter. The firm’s GAAP operating margin declined by over 220 basis points year-over-year, resulting in its GAAP operating income declining by almost 10% during this period. Pressure from SG&A expenses led to this contraction, as did foreign currency headwinds, but PepsiCo’s GAAP net income still expanded by almost 12% year-over-year to $2.0 billion. A 1% year-over-year decline in its outstanding diluted share count, a product of its share buyback program, boosted PepsiCo’s quarterly GAAP EPS to $1.44 (up almost 13% year-over-year).
The company exited the second quarter with $3.6 billion in cash on hand versus $31.2 billion in debt (inclusive of short-term debt), good for a net debt position of $27.6 billion. We caution that PepsiCo’s large net debt load is one big reason why we see its dividend coverage as good, but not great. Its free cash flows should enable PepsiCo to manage that burden while maintaining its dividend policy, aided by its investment grade credit rating. Moody’s Corporation (MCO) rated PepsiCo’s senior unsecured Eurobonds at A1 with a stable outlook.
Key Strengths and Potential Weaknesses
In the excerpts below we highlight our thoughts on PepsiCo as it relates to its dividend coverage, from our two-page Dividend Report;
“It is hard not to like the reliability of Pepsi’s business model, and such stability drives its impressively consistent free cash flow generating ability. Like many of its peers, management has earned the reputation of being very shareholder friendly; the firm plans to return more than 100% of its free cash flow in 2019 to shareholders through dividends and share repurchases, which has been a common practice for it in recent years. The company’s dividend hike in 2018 marked its 46th consecutive year of raising the payout [PepsiCo increased its payout again in July, marking its 47th consecutive year of dividend increases), and we’re expecting the streak to continue. Though we think dividend growth might curtail compared to previous years, management is dedicated to growing the payout. Free cash flow performance should be watched closely.
Pepsi’s fundamental strength is hard to poke holes in, and the firm’s strength in North America is augmented by its exposure to potentially higher-growth emerging markets, though higher volatility in the latter is not uncommon. We’re not fans of the firm’s rising debt load, but free cash flow generation should handle this capably.
However, free cash flow generation has declined in recent years as it is expected to fall to $5 billion in 2019 from $8.1 billion in 2015. Dividend payments have outpaced (and will again in 2019) share repurchases more recently, an adjustment we like, as shares have not been cheap for some time now, in our opinion. All things considered, investors can expect Pepsi to continue returning copious amounts of cash to shareholders.”
PepsiCo loves its shareholders, but further declines in its free cash flow heading into 2020+ would be worrisome. The company is pivoting away from share buybacks and towards greater dividend payouts, which we appreciate, but that alone won’t be enough to shore up its dividend coverage. We expect future dividend increases will be harder to come by unless PepsiCo’s free cash flows improve.
Concluding Thoughts
Shares of PEP trade well above our fair value estimate and as of this writing are trading near the top end of our fair value range. We aren’t looking to add PEP to any newsletter portfolio, but we appreciate PepsiCo’s improving operational and financial performance in the face of foreign currency headwinds, trade wars, and other exogenous events outside of its control. Members interested in reading more about PepsiCo can check out this article here from April 2019, which covered its first quarter performance as well as its energy drink strategy.
Beverages – Nonalcoholic: CCEP, KO, KDP, MNST, FIZZ, PEP
Related: PBJ
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.