Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: PepsiCo Inc – CAGNY 2021 Presentation

By Callum Turcan

On July 13, PepsiCo Inc (PEP) reported second-quarter fiscal 2021 earnings (period ended June 12, 2021) that beat both consensus top- and bottom-line estimates. Due to its strong performance during the first half of the fiscal year, PepsiCo raised its full-year guidance for fiscal 2021 in conjunction with its latest earnings report. Now the firm expects to post 6% organic sales growth (versus a mid-single-digit range previously) and 11% core constant currency EPS growth (versus a high-single-digit range previously) in fiscal 2021 on an annual basis. Foreign currency tailwinds favorably impacted its financial performance last fiscal quarter, and for the full fiscal year, PepsiCo sees these tailwinds boosting its net revenue and core EPS performance by ~100 basis points.

Earnings Update

The reopening of the global economy is having a favorable impact on PepsiCo’s performance in the wake of coronavirus (‘COVID-19’) vaccine distribution efforts. Its Frito-Lay North America division posted 6% year-over-year organic sales growth (a non-GAAP figure) last fiscal quarter as its “convenience and gas channel delivered double-digit net revenue growth” while its “food service business delivered very strong net revenue growth as it lapped significant restrictions and closures associated with the pandemic in the previous year.” New products, including healthier options, also supported PepsiCo’s performance on this front in the fiscal second quarter.

Its PepsiCo Beverages North America division posted 21% year-over-year organic sales growth last fiscal quarter as “large format and convenience and gas channels delivered double-digit net revenue growth, while net revenue for our foodservice business doubled in the quarter as we lapped a significant decline from the previous year due to pandemic-related restrictions and closures.” PepsiCo’s ‘International beverage’ business posted 22% organic sales growth last fiscal quarter, aided by the resumption of pre-pandemic activities in portions of the world, while its ‘International snacks’ business posted 11% organic sales growth in the fiscal second quarter.

The only segment to experience a year-over-year decline in organic revenues last fiscal quarter was PepsiCo’s Quaker Foods North America division. Please note that sales at this division surged in the same period last fiscal year due to the “panic stockpiling” effect in the face of the early stages of the COVID-19 pandemic. With that in mind, management still noted this division “gained market share in the at-home breakfast, snacks, and meals categories” which is a welcome sign.

Overall, PepsiCo’s organic revenues were up 13% year-over-year in the fiscal second quarter while its GAAP net revenues were up 21% during this period. Economies of scale enabled PepsiCo to grow its GAAP operating income by 35% year-over-year last fiscal quarter. PepsiCo’s financials are clearly on the rebound.

During the first half of fiscal 2021, PepsiCo generated $1.0 billion in free cash flow, a sharp improvement from its performance the prior fiscal year when it generated $0.3 billion in free cash flow. While its free cash flows still fell well short of the $2.8 billion it spent covering its dividend obligations and $0.1 billion on share buybacks in the first half of fiscal 2021, historically PepsiCo experiences a large working capital build in the first half of the fiscal year before that dynamic reverses (the firm generated $6.4 billion in free cash flow in fiscal 2020, for example, and the lion’s share of that was generated in the second half of the fiscal year ended December 26, 2020).

PepsiCo’s share buyback program for fiscal 2021 is now complete and the firm does not intend to repurchase any more of its stock for the rest of the fiscal year. The company’s balance sheet is rather bloated with PepsiCo exiting the fiscal second quarter with a net debt load of ~$36.5 billion (inclusive of short-term debt), which is one of the reasons why the company’s Dividend Cushion ratio sits below parity at 0.7. While we still rate PepsiCo’s Dividend Safety rating as GOOD, given its stable cash flow profile and the resilience of its business, we would like to see the firm pare down that burden going forward. PepsiCo recently acquired Pioneer Foods for $1.7 billion (sells consumer staples products in Africa) and Be and Cherry for $0.7 billion (sells snacks in China), deals that were primarily funded by the balance sheet.

Looking ahead, PepsiCo’s two core capital allocation priorities include investing in the business and continuing to make good on its dividend obligations. In our view, the firm should keep easing off share buybacks going forward. Shares of PEP are trading near the top end of our fair value estimate range as of this writing, and the company needs to improve its balance sheet.

Restructuring

To bolster its cash flow generating abilities and overall profitability levels going forward, PepsiCo extended its ‘2019 Productivity Plan’ through 2026 and expects to incur about $3.15 billion in pre-tax charges (including ~$2.4 billion in capital expenditures) to implement these changes (up from its previous guidance of $2.5 billion). Within its earnings report PepsiCo noted the program “was expanded and extended through the end of 2026 to take advantage of additional opportunities within the initiatives of the plan” with an eye towards automation initiatives and simplifying both its operations and organization structure.

PepsiCo aims to generate “at least $1 billion in annual productivity savings through 2026” by “leverage[ing] new technology and business models to further simplify, harmonize and automate processes; re-engineer our go-to-market and information systems, including deploying the right automation for each market; and simplify our organization and optimize our manufacturing and supply chain footprint.” We appreciate management’s efforts to make PepsiCo a more profitable enterprise, because over the long haul, it will be hard to sustain organic revenue growth rates far north of global GDP growth (given the nature of consumer staples firms). Through the end of the second quarter of fiscal 2021, PepsiCo had incurred roughly $0.9 billion in pre-tax charges associated with this plan.

Concluding Thoughts

The biggest downside to PepsiCo’s business model is its bloated balance sheet, in our view, though we appreciate its recent guidance boost and the incredibly stable nature of its cash flow profile. We expect management will remain committed to preserving PepsiCo’s dividend payout at any cost and shares of PEP yield ~2.8% as of this writing. The top end of our fair value estimate for PepsiCo sits at $162 per share, moderately above where shares are trading as of this writing.

Recently, shares of PepsiCo have been converging towards the top end of our fair value estimate range, aided by its strong earnings report and guidance boost. Over the long haul, its productivity program should better enable PepsiCo to generate sizable free cash flows in any operating environment. We include Vanguard Consumer Staples Index Fund ETF (VDC) in the High Yield Dividend Newsletter portfolio (more here) to gain broad exposure to the relatively higher yielding consumer staples sector (as it concerns the yield on equities).

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Callum Turcan does not own shares in any of the securities mentioned above. Philip Morris International Inc (PM) and Vanguard Consumer Staples ETF (VDC) are both included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.