The Secret Problem PepsiCo (PEP) is Trying to Hide

Last week, PepsiCo (PEP) reported earnings that appeared solid on the surface.

The company beat bottom-line estimates while sales missed.

Management trimmed its organic growth outlook amid economic uncertainty.

Institutional investors began searching out the stock, though at a tepid pace, according to our TrackStar data.

Yet, when we dug into the financials, we found a significant concern buried in the company’s cash flow.

While most of Wall Street has ignored this problem, we think it’s worth pointing out so you can make an informed decision.

PepsiCo’s Business

Did you know that PepsiCo sells products in over 200 countries and territories? 

This beverage and snack giant’s reach extends far beyond its namesake cola, encompassing a diverse portfolio of brands that billions of consumers enjoy daily.

PepsiCo’s product lineup includes Pepsi and Gatorade, Doritos, and Quaker Oats. Its global distribution network and marketing expertise have cemented its status as a consumer staples powerhouse across varied markets.

The company segments its business into the following areas:

• Frito-Lay North America (27% of revenues) – Snack foods in North America
• PepsiCo Beverages North America (31% of revenues) – Beverages in North America
• Quaker Foods North America (3% of revenues) – Cereals, rice, and pasta in North America
• Latin America (12% of revenues) – Beverages and snacks in Latin America
• Europe (19% of revenues) – Beverages and snacks in Europe
• Africa, Middle East and South Asia (7% of revenues) – Beverages and snacks in these regions
• Asia Pacific, Australia and New Zealand and China Region (5% of revenues) – Beverages and snacks in these regions

PepsiCo faces a health-conscious consumer shift away from sugary drinks and snacks. 

Inflation has also squeezed consumer wallets, particularly impacting North American sales.

To counter these trends, management is:

• Healthier options: Launched Pepsi Zero Sugar and expanded baked snack lines like Popchips
• Efficiency boost: Implementing AI-driven demand forecasting and automated warehousing systems
• Sustainability: Introduced 100% recycled plastic bottles for Pepsi in select markets and increased use of renewable energy in manufacturing
• E-commerce growth: Partnered with major online retailers and developed direct-to-consumer platforms like PantryShop.com
• High-growth focus: Invested in plant-based protein products and expanded presence in emerging markets like India and Africa

Q3 2024 saw a 0.6% revenue dip, reflecting these challenges. Yet PepsiCo remains steadfast in its long-term strategy, betting on innovation and operational improvements to drive future growth.

Financials

Source: Stock Analysis

Inflation and external factors largely offset price hikes that increased revenues over the last few years.

For example, PepsiCo reported 1.3% organic revenue growth in Q3. Yet, net revenue declined 0.6% due to the impacts of foreign exchange.

Gross and operating margins held flat as costs increased alongside sales.

In fact, the free cash flow margin dropped as Capex increased, while changes in accounts payable reduced operating cash flow.

Nonetheless, with $6.1 to $7.3 billion in annual free cash flow and $8.1 billion in cash on the balance sheet, management has plenty of room to pay its $7.1 billion annual dividend and repurchase $1.1 billion in stock, yielding around 3.4% overall.

Valuation

Source: Seeking Alpha

PepsiCo’s valuation presents a conundrum.

At 20.0x operating cash, it’s cheaper than Celcius Holdings (CELH) and Monster Energy (MNST).

Yet, its 22.5x forward P/E ratio is higher than all its peers except Monster.

While these metrics aren’t out of line for the company compared to its 5-year history, it’s difficult for most investors to accept cash flows that yield little better than a Treasury bond.

Growth

Source: Seeking Alpha

PepsiCo also doesn’t come with much growth.

Even with the price hikes, its 5-year average annual revenue growth is 6.8%, compared to the double-digit gains from Celcius and Monster. 

Only General Mills (GIS) and Hain Celestial Group (HAIN) exhibit worse revenue gains.

Profitability

Source: Seeking Alpha

While PepsiCo’s gross margin is solid, its EBITDA and EBIT are below all its peers except Hain Celestial.

Even though it’s not listed here, Coca-Cola (KO) runs a free-cash-flow margin closer to 20%, just below its profit margin.

While Coca-Cola doesn’t make snacks, the profitability gap is wider than we’d expected.

Our Opinion 5/10

PepsiCo is a good company. Not a great one.

It’s seen free-cash-flow margins slowly erode over the years.

We believe more strategic initiatives are needed to address the profitability gaps between PepsiCo and its competitors.

As such, we’re more interested in peers like Coca-Cola.

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