The Long and Short

Inflation does not flatten Pepsico

Meredith Contente | October 14, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Pepsico’s results for the last quarter underscore the company’s success at navigating a difficult operating environment and should serve as a catalyst for spreads to continue to tighten. The company’s debt still trades wide to its peer, The Coca-Cola Company. But given the added diversity, growth and higher margins associated with Pepsico’s Frito Lay business, the trading relationship between the two credits should reverse.

PEP’s third quarter 2022 results came in ahead of consensus estimates on all metrics, despite raw goods inflation hovering in the high-teens area. PEP almost fully offset the increased pace of inflation with price hikes, as the gross margin contracted slightly, while better operating cost controls resulted in EBIT margin growth. The strong quarter led PEP to raise full year guidance for both the top and bottom lines. Nevertheless, PEP trades wide of KO (Exhibit 1).

Exhibit 1. Pepsico trades wide of The Coca-Cola Company

Source: Bloomberg; APS

Revenue growth driven by price increases

PEP posted organic revenue growth of 16% in the third quarter, which came in ahead of consensus estimates calling for 10% growth. This marks PEP’s fourth consecutive quarter of double-digit revenue growth. The increase was fueled by a 17% increase in net pricing, slightly offset by a 1% decline in volume. While most business units witnessed double-digit growth, Latin America and Frito-Lay North America (FLNA) saw the biggest gains, 22% and 20%, respectively. Year-to-date, organic revenues were up nearly 15%, as pricing accounted for roughly 13.5% growth and volumes were up approximately 1.5%. Management noted that they were able to gain market share this quarter through strong price realization.

Stringent cost controls boost operating margin

Despite a 17% increase in net pricing, PEP saw its gross margin contract 20 bp year-over-year (to 53.1%). That means that PEP is witnessing commodity inflation slightly greater than 17%, which is consistent with inflation guidance in the high-teens area. Management noted they have been focused on the balance of the cost structure given that raw material inflation is largely out of their control. PEP effectively eliminated enough wasteful spend in the quarter to grow their operating margin by 30 bp year-over-year, to 15.3%. Year-to-date, the operating margin grew 10 bp year-over-year (to 16.1%). Management noted that it has rigid processes in place that help to eliminate unnecessary complexity in each business line, thereby helping to keep costs down. As such, PEP aims to deliver at least $1 billion in annual productivity savings through 2026.

Frito Lay – PEP’s crown jewel

While FLNA is PEP’s second largest business unit from a revenue perspective (behind PepsiCo Beverages North America), it is the largest generator of operating profit. The margins associated with FLNA are more than double that of the North American Beverage unit (Exhibit 2). That said, we view FLNA as the crown jewel of PEP. In addition to generating the majority of operating profit, the business unit adds an element of revenue diversity that its peer KO does not have. Additionally, FLNA has been accelerating its share gains as it achieved roughly a 2% share gain in both volume and value in the third quarter.

Exhibit 2. PEP Revenue and Operating Profit Breakdown (3Q22 & YTD)

Source: PEP Earnings Report; APS

PEP has also been focused on improving the nutritional breakdown across their snack portfolio since 2020. As part of PEP’s “snack a little smarter” campaign, 64% of its product portfolio now contains 1.3 mg or less of sodium per calorie, while 71% does not exceed 1.1g of saturated fat per 100 calories. Additionally, the FLNA portfolio now includes more products made from whole grains.

Revenue and EPS guidance raised

Given the better-than-expected results, PEP raised its full year guidance on both organic revenues and EPS. Organic revenues are now expected to grow 12%, versus previous guidance of 10% growth. Core EPS growth (excluding foreign exchange) is now being guided to the 10% area, up from 8% previously forecast. The new EPS guidance translates to core EPS of roughly $6.73 for the year. PEP continues to expect an effective tax rate of 20%. Shareholder rewards are being guided to the $7.7 billion area, comprised of dividends of $6.2 billion and share repurchases of $1.5 billion. Free cash flow for the year should fully cover shareholder remuneration.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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