Earnings Analysis: Pepsico (PEP)

Notes:
Stock Ratings: 1 = buy at current stock prices, 2 = buy on a 5-10% dip in stock price, 3 = sell on a 5-10% increase in stock price, 4 = sell at current stock prices to raise cash.  Ratings are based upon 12-18 month outlook on stock direction and not necessarily related to moves I make due to financial positioning.

On Thursday, Pepsico announced their second quarter earnings results for 2016.  Earnings beat rather handily, coming in at $1.38 compared to expectations of $1.29.  Sales were also a fair beat at $15.4B compared to estimates of $15.36.  Those revenues are down 3.3% from a  year ago due to a 4% currency translation impact and 2.5% from discontinuation of operations in Venezuela, which occurred in the third quarter last year.  This results in an organic growth rate of 3.3%, which isn't bad, but it is below the 4% target management has set for the year.  Finally, management raised guidance for earnings by five cents to $4.71.

On the year, organic growth has been 3.4% and management has stated that they are still on target for 4% organic growth on the year.  Given that, there should be an expectation that we'll see a pretty strong increase in organic growth and revenues over the next two quarters.  Additionally, they've made some great strides in their gross margins, improving by well over 1% this quarter, compared to a year ago.  I do believe a fair chunk of this margin improvement is related to reduced commodity costs, however, they did note that there would be some slight commodity inflation this year.  This may rule out my theory depending upon how "commodity costs" include/exclude costs for transportation fuel and plastic (derived from oil) as well as the corns, grains, and oils they use to make their products.  Other things to note is that reduced pension costs are also a reason for the increase in earnings (though not described as to how much of an impact it has on the five cent increase).  This tends to be a temporary event and the cost always comes back somewhere.  If not this year, maybe next and earnings growth would then be stunted some amount.  

The other thing to note is the increase in spending - particularly for advertising.  This is a double-edged sword.  The spend can be an investment, resulting in an increase in sales.  It also could be money spent that has no impact at all - or pull consumers away from a product at the absolute worst.  So far, we're seeing the spending resulting positively, especially with the US consumer as everything North America seems to be performing well.

That said, I feel a little concerned that so much of what CEO Indra Nooyi spoke about during the conference call was all the different initiatives taking place to "engage the customer."  Don't get me wrong, I think these are strong tactics to help build a customer base and brand loyalty - things that help products transcend economic strife.  On the other hand, when that's everything the business is talking about in detail, something feels a little amiss.  Maybe I'm just too green and inexperienced in understanding what all of this will translate to, but it's important that I note my concerns here.  Add into this a stock that's now valued at almost 23 times its 2016 earnings and over 21 times 2017 earnings if I factor 8% EPS growth on this year's guidance, and as much as I like the company, I find it really hard not to consider it over valued.  

The saving grace(s)?  Well, I see them at two-fold.  First, if Pepsico does reach 4% organic growth, we could be looking at accelerating growth as we go forward.  That is a FABULOUS thing to have and investors flock to it.  Maybe the company will expand with innovations and economic recoveries in the next few years and we'll be seeing 7% organic growth by the time things peak.  That accelerated growth could translate into EPS growth of low to mid teens - meaning we're fairly priced.  This is a possible scenario worth keeping eyes on for now.  The second is the fact that with Brexit and overall economic performance, the Fed isn't terribly likely to raise rates yet.  Yesterday's job numbers gives me a little pause, thinking we could still see another hike in 2016 and if economic factors improve, the fear will become the market's reaction.

In the end, I maintain the stock at a ranking of 2, anticipating some accelerated growth to help justify current price levels, but I don't anticipate the price growing much beyond its current 52-week high or it will become too hot without more proof.  I'm sticking with management's $4.71 earnings estimates and a multiple of 22, which leaves me to believe the fair price is more around $104 as my price target.  Now that we're starting to enter the second half of the year, I'm starting some projections for 2017.  Currently, I'm estimating 10% EPS growth, leaving me with a 2017 EPS target of $5.18 and price target of $114.  Since stocks are about paying for future earnings, the $114 target is my reason why I feel we're not too over priced at this time.  Stretching the limits will put me in a position to downgrade and potentially sell some of the stock as I see down side risk being a factor of multiple compression down to 17, valuing the stock at $80.

Nothing on this site should be taken as advice, research, or an invitation to buy or sell any securities.  All views expressed are solely of my own and I am not a professional money manager.  Please consult with your financial adviser before taking any action in your own portfolio.