While Inflation Runs Rampant, Pepsi’s Leading Snack and Beverage Mix Should Serve It Well

Business Strategy & Outlook

For many consumers, the Pepsi trademark elicits images of cola containers and ads extolling the brand’s taste superiority versus Coke. While PepsiCo is still a beverage behemoth, its business now extends beyond this industry, with Frito-Lay and Quaker products accounting for over half of sales and over an estimated 65% of profits. A diversified portfolio across snacks and beverages is considered the source of many of the company’s competitive advantages. Though management missteps have stymied performance in the past, the confluence of better execution and benefits inherent to its integrated business model has allowed Pepsi to reaccelerate profitable growth, and there is plenty of room to run.

After years of sluggish sales growth and underinvestment, Pepsi has committed to reinvigorating its top line. To that end, it has made significant investments in manufacturing capacity (for example, production lines to meet demand for reformulated packaging), system capacity (route optimization and sales technology), and productivity (harmonization and automation). These investments are considered prudent and believe they will allow the company to strengthen key trademarks such as Mountain Dew and Gatorade, deepen its presence in growth markets like sub-Saharan Africa, and yield enough cost savings to reinvest and widen profits. Recent strategic pivots in the energy category (such as the Rockstar acquisition and Mountain Dew line extensions) should also underpin growth and margins.

Pepsi’s growth trajectory is not without risk, as the company faces secular headwinds such as shifts in consumer behavior. Additionally, changing go-to-market dynamics, such as online commerce that encourages real-time price comparisons and obviates the extent of Pepsi’s retail distribution advantage, allow for more nimble and aggressive competition. Still, structural dynamics emanating from Pepsi’s scale, the cachet of its brands, and the breadth of its portfolio, which support its wide moat, should enable the company to maintain and augment its competitive positioning.

Financial Strengths

Pepsi’s financial health is considered excellent. While leverage has ticked up due to recent acquisitions, the company still has a strong balance sheet with manageable debt levels and robust free cash flow generation. Strong interest coverage ratios also lend credence to the firm’s health in this regard. Pepsi is not forecasted to have any issues meeting its contractual obligations for the foreseeable future, given the reliability of its business and its stalwart positioning across its categories.

Historically, the company has regularly produced around $7 billion in free cash flow (high-single to low-double digits as a percentage of sales). Management has prioritized strategic investments across the business of late, which is considered prudent to aid its competitive standing over the long term. While capacity (particularly in snacking growth areas) and digital capability investments will remain elevated in 2022 and beyond, free cash flow is expected to normalize at or above historical levels, particularly as the company’s revenue management and supply chain digitization initiatives continue to bear fruit.

Management’s guiding principle as it relates to debt levels is to maintain access to Tier 1 commercial paper. While the prerequisites for this status vary by rating agency, there are no impediments to Pepsi’s ability to continue relying on this short-duration paper, and current leverage levels (around 2.5 times net debt/EBITDA) are considered appropriate for the firm. Moreover, the firm’s commercial paper access is viewed as one of the biggest testaments to its financial strength; this cheap financing should facilitate and perpetuate Pepsi’s financial flexibility. As the pandemic ends, liquidity should be of no concern to Pepsi investors–in addition to roughly $6 billion in cash at the end of fiscal 2021, the firm has undrawn credit facilities in excess of $7 billion.

Bulls Say

In still beverages—a category facing fewer secular challenges, particularly in the U.S.–Pepsi is a much more formidable competitor to Coca-Cola.

Pepsi’s global dominance in salty snacks may be underappreciated; with volume share more than 10 times that of the next-largest competitor, the firm benefits from unparalleled unit economics and go-to market optionality.

The firm’s consolidated beverage and snack distribution operations, combined with its direct store delivery capabilities, allow for better execution in merchandising.

Company Description

PepsiCo is one of the largest food and beverage companies globally. It makes, markets, and sells a slew of brands across the beverage and snack categories, including Pepsi, Mountain Dew, Gatorade, Doritos, Lays, and Ruffles. The firm uses a largely integrated go-to-market model, though it does leverage third-party bottlers, contract manufacturers, and distributors in certain markets. In addition to company-owned trademarks, Pepsi manufactures and distributes other brands through partnerships and joint ventures with companies such as Starbucks. The firm segments its operations into five primary geographies, with North America (comprising Frito-Lay North America, Quaker Foods North America, and North America beverages) constituting around 60% of consolidated revenue.

(Source: Morningstar)

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