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Stock Strategist

Still Some Pop Left in Pepsi

A leading portfolio of beverages and snacks will feed returns on invested capital.

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 PepsiCo’s (PEP) leading portfolio of beverage and snack brands has carved out a wide economic moat for the company, ensuring excess returns on invested capital over the long run. We believe Pepsi and Coca-Cola (KO) will continue dominating the domestic nonalcoholic beverage market, with their entrenched retail relationships and economies of scale creating powerful barriers to entry. Moreover, we expect rational pricing relationships between the companies to persist over the long run, leading to gains from price and product mix. Although Coca-Cola’s carbonated soft drinks enjoy greater share abroad, we believe Pepsi’s snack portfolio is well positioned for international gains. Pepsi also has established agreements to distribute brands such as Starbucks, Sabra, and Rockstar Energy, further strengthening its retailer relationships.

We anticipate growth will be fueled by Pepsi’s noncarbonated beverage and snack businesses, which should enable the company to offset the impact of secular declines in the consumption of carbonated soft drinks (which account for less than one fourth of overall sales) in developed markets. We appreciate the company’s focus on “guilt-free” products (roughly half of sales) that align with consumer trends, and we think sustained brand-related investments, with combined expenditures on advertising and research and development remaining above 7% of sales over our forecast, will allow Pepsi to develop and market innovative new products, bolstering the intangible asset source of its wide moat. In addition, efforts to drive efficiency gains, targeting $1 billion in savings annually, stand to enhance its margins and free up funds to support its product set.

Pepsi took control of its two largest bottlers in 2010, consolidating around 80% of its North American beverage system, and we expect these bottling operations to remain integrated with the company. This allows for increased control over packaging and distribution and deeper integration between the snack and beverage businesses.

Pepsi Enjoys a Wide Moat
Pepsi is a formidable player in the nonalcoholic beverage and snack categories; it has the top seven brands in salty snacks and nearly one fourth of the U.S. liquid refreshment beverage market, according to management. Its portfolio includes 22 brands that generate over $1 billion in revenue annually, leading to sticky relationships with distributors and retailers that depend on leading brands to generate store traffic. We expect this dynamic to continue, given the resources that Pepsi has to reinvest in its brands. Pepsi has consistently been a price leader, relying on product innovation to drive net pricing increases (by our estimates, maintaining a five-year historical mean price 1.7% above inflation) rather than competing on the basis of volume alone, which we consider further evidence of its wide moat.

Pepsi invests significant resources in maintaining and expanding its brands, including investments in research and development (averaging over $700 million over the past five years, or 1% of sales) and advertising and marketing (averaging $4 billion over the past five years, or 6% of sales). This has helped the company bolster its competitive advantages despite challenging dynamics in the carbonated soft drink category. Pepsi also benefits from strong brand loyalty and relatively price-inelastic customers. Taste is an essential consideration for Pepsi’s customers, as evidenced by the backlash against the 2015 change to Diet Pepsi’s formula (the original formula, with aspartame, was reintroduced in 2016), reducing the likelihood consumers will switch to a different beverage or snack brand on the basis of price alone.

Pepsi has historically been able to capture additional value per customer within this base by expanding the eating and drinking occasions for which its products can be purchased, whether through line extensions or reformulated packaging sizes. In addition to its mass-market brands, Pepsi offers products for more specific customer groups, including health-conscious buyers, athletes, and consumers looking for relatively premium or craft offerings, as well as regional products geared toward local consumer tastes. We believe that this diversified portfolio will allow Pepsi to defend its market share as consumer preferences evolve.

Pepsi is able to leverage its industry-leading position in the beverage and snack spaces to sustain long-term relationships with distributors and retailers. Retailers depend on Pepsi’s extensive portfolio of leading brands to drive foot traffic and inventory turnover, allowing for substantive pricing power. We expect these relationships to endure over the long run, as the number of channels consumers shop at continues to trend upward; by our estimates, over half of consumers shop in five or more channels.

Pepsi also benefits from significant cost advantages, in our opinion. Its widespread network of plants, warehouses, and distribution centers allows the company to minimize transportation costs and increase its supply chain efficiency. Pepsi’s scale also allows the company to enjoy significant purchasing power compared with smaller rivals, especially for inputs used in both its beverage and snack businesses, including corn, sweeteners, and plastic packaging materials. The combination of the food and snack businesses provides $800 million-$1 billion in synergies, according to management, and allows Pepsi to benefit from lower distribution and in-store marketing costs for its products, since they can be shipped or promoted together. Additionally, Pepsi codevelops or distributes smaller companies’ products through joint ventures or multiyear contracts, which allows it to earn economic rents.

We think these advantages will allow Pepsi to sustain its competitive position and reap economic profits for decades to come. We see adjusted returns on invested capital averaging 47% over our forecast (29% including goodwill), compared with a 7% weighted average cost of capital. Although niche snack and beverage companies may enter the market, it would be time-consuming and prohibitively expensive for them to rival the marketing budgets and distribution systems of the largest players in the space.

Shifting Consumer Preferences Are a Risk
We believe that Pepsi’s entrenched competitive position and expansive food and beverage portfolio mitigate its risks relative to nonalcoholic beverage players, but we expect the company to remain sensitive to shifts in the carbonated soft drink category, particularly if volume declines at a greater rate than the company can increase contributions from price/mix. Consumer preferences have evolved over the past decade, and an increasing percentage of the population now prefers healthier, lower-calorie beverages. According to Beverage Digest, carbonated soft drink consumption in the United States fell nearly 15% from 2005 to 2016, as consumers have increased consumption of noncarbonated beverages and bottled water. Offsetting these headwinds, Pepsi has been able to expand its portfolio of noncarbonated and “better-for-you” beverages to drive top-line growth.

Pepsi could also face intensifying competition in the snack category, which is relatively fragmented and exposed to private-label penetration, limiting its pricing ability. Additionally, Pepsi has historically relied on modest price increases and product innovation to combat softness in a particular category or geography. Regulatory measures to curb sugar or saturated fat intake, like soda taxes, could impede volume growth, as many of these policies impose a tax in proportion to package size. Rising commodity costs for key inputs, including corn, sugar, potatoes, and wheat, could also restrain profitability.

Pepsi should be able to comfortably manage its debt, in our opinion, given its strengthening profitability and robust free cash flows. Pepsi has returned a significant amount of cash to shareholders over the past several years, with share repurchases and dividends totaling over $6 billion in 2017, and we think it will continue to do so. Our forecast incorporates a dividend payout ratio averaging 65% over the next 10 years, implying nearly 7% dividend growth, and a buyback of around 1.25% of shares outstanding each year. Pepsi’s management team has shown prudent capital allocation, evident in excess returns on invested capital averaging more than 30% over the past five years, far above our 7% cost of capital estimate.

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Sonia Vora does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.