Why Pepsi May Not Be Cheap Enough

We highlighted Coca-Cola (KO) October 10th as a fantastic entry point.

Down over 10% in a matter of weeks, we felt reasons like a recession, inflation, and even Ozempic made little sense.

Today, shares are up almost 5%, a decent move for the slow moving stock.

Yet, the stock is still cheap by many accounts, as are many consumer staples, but not all.

That’s why we wanted to continue down the top five searches by financial pros in the non-alcoholic beverage space, bringing us to today’s company – Pepsico (PEP).

Pepsico’s Business

From Ray Charles to Britney Spears, Pepsi marketing put out some of the most memorable campaigns of our lives.

Once a pure soda company, Pepsi took a different approach than Coca-Cola, expanding into snack foods with brands like Frio-Lay and Doritos.

Source: Pepsi Website

The business is divided by vertical and region:

• PepsiCo Beverages North America (32% of total revenues) – Focused on beverage sales within North America, including brands like Pepsi, Mountain Dew, and Tropicana.
• Frito-Lay North America (25% of total revenues) – Primarily deals with snack foods such as chips and dips under brands like Lay’s, Doritos, and Ruffles.
• Quaker Foods North America (7% of total revenues) – Involves cereal and other food products under the Quaker brand.
• Europe (18% of total revenues) – Covers both beverage and food sales across European countries.
• Latin America (8% of total revenues) – Encompasses beverage, food, and snack sales across Latin American countries.
• Africa, Middle East, and South Asia (5% of total revenues) – This segment covers a range of beverage and snack sales across these regions.
• Asia Pacific, Australia, New Zealand, and China Region (5% of total revenues) – Covers beverage and snack sales within the specified regions.

Notably, Pepsi is far more concentrated in North America than Coca-Cola, which has advantages and disadvantages.

The company’s latest quarterly results reflect the strength and resilience of its diversified portfolio.

However, cost pressures continue to hammer the supply chain along with labor and raw materials shortages.

Financials

Source: Stock Analysis

Pepsi has done remarkably well over the last 5-7 years, pushing revenues up by high single to low double-digits at times.

However, operating margins contracted slightly over the past year, largely attributable to December 2022’s poor performance.

Otherwise, profitability is better than ever.

After a sizable increase in total debt during COVID-19, Pepsi has begun to work down its $44.8 billion debt, which stood at $33.6 billion in 2019.

We are concerned about the use of cash flow.

Pepsi generates $12.1 billion in cash from operations and spends $5.2 billion on CAPEX, leaving $6.9 billion for distributions.

In the last twelve months, Pepsi paid out $6.5 billion in dividends and spent $1.2 billion buying back shares, exceeding cash generation by $800 million.

Management forecast total cash returns of $7.7 billion for 2023, $6.7 billion of dividends, and $1.0 billion in buybacks.

Given Pepsi’s size, it can easily afford these. However, we’d like to see them keep some cash to start paying down their debt.

Valuation

Source: Seeking Alpha

21.5x earnings might seem expensive, as would 18.6x cash.

However, if we combine the share buyback program with the dividend discount model, then the current share price implies a sustainable growth rate of ~2.5%, which is reasonable.

In fact, most of these companies trade on roughly the same growth assumptions.

Growth

Source: Seeking Alpha

Pepsi’s free cash flow growth might look tiny, but it’s the best of this group. Plus, it grew revenues at 7.2% per year over the last five years, beating out Coca-Cola.

Celsius Holdings (CELH) and Monster (MNST) grow revenues and a much faster clip. Yet, only Monster translates that into actual profitability.

Profitability

Source: Seeking Alpha

While Pepsi’s gross margins are high, they’re not the highest. And when it comes down to EBIT and net income margin, they’re second to last.

More concerning is their free cash flow margin, which is half that of Coca-Cola and Monster.

Our Opinion 6/10

Pepsi isn’t as good as Coca-Cola, to say nothing of the sodas.

It simply spends all its cash and then some, which is a bit troubling.

Plus, we expect margin pressure to continue, reducing free cash flow.

While they might ultimately come out stronger, and they are a great company, the stock isn’t at the right price for us to want to play.

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