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Morningstar | Pepsi Turns Around North America Beverage Volumes in Third Quarter; Shares Remain Attractive

Pepsi posted strong top-line results in the third quarter, with organic sales up nearly 5% (with a 3% contribution from price/mix) and volume expansion in each of the firm's six segments. From our vantage point, this performance indicates the brand equity of Pepsi's food and beverage offerings (a key determinant of our wide moat rating) remains healthy, and that the firm's efforts to drive innovation within its portfolio and better promote new offerings have gained traction with consumers. Most importantly, we were pleased to see organic beverage volumes grow 2.5% (marking the third quarter of sequential improvement), including a return to volume growth in the North America Beverages segment (one third of sales). While we expect to adjust our near-term outlook to incorporate management's revised outlook for full-year organic growth (expected to be around 3%, which is about 60 basis points above our outlook) and earnings per share (now $5.65, versus $5.70 prior, due to a roughly 1% foreign exchange headwind), we aren't expecting a material change to our $123 fair value estimate. Shares are trading around a 10% discount to our valuation, which we view as an attractive entry point for investors.

The North America Beverages segment posted 2.5% organic growth during the quarter, with volumes up 1% (admittedly, on a 6% decline in the year prior) and price/mix strengthening (up 2%, versus a roughly 1% increase over the last several quarters). We attribute this improvement to strengthened innovation and execution in both the firm's core brand portfolio (including trademark Pepsi, Gatorade, and Mountain Dew) as well as the success of more recently launched offerings, like Bubly and LIFEWTR. We expect 1% to 2% annual improvements in price/mix longer term as consumers shift to noncarbonated (2% industrywide compound volume growth over the last five years, versus a 1% decline for carbonated soft drinks) and more premium beverages.

Looking ahead, we think the firm's ability to balance investments between these two categories will be crucial to top-line growth in this segment, as we surmised the decline in segment volumes over the last few quarters was a result of the firm over-allocating resources to its newer offerings relative to its largest brands. In this context, we appreciate the firm's strengthened advertising investments in brands like trademark Pepsi and Mountain Dew, both of which experienced sequential top-line acceleration during the quarter, according to management. We expect advertising expenditures to remain above 6% of sales over the next several years, or north of $4 billion annually (comparable to the dollar amount spent by Coca-Cola), which should ensure that its products maintain visibility relative to competition.

However, this step up in advertising expenses, coupled with continued input cost pressures (particularly for transportation and aluminum, which have weighed on players across the industry), weighed on operating margin, which contracted 75 basis points to 17.3%. While we expect full-year operating margin to remain comparable to 2017 (in the range of 16% to 17%), we still expect margins to expand toward a high-teens rate longer term as some of these cost headwinds subside, pricing continues to strengthen, and the company extracts additional cost efficiencies.

Performance abroad also remained robust during the quarter, with high-single-digit organic sales growth in the Europe Sub-Saharan Africa and Asia, Middle East, and North Africa (AMENA) segments and 10% organic growth in Latin America. In aggregate, organic sales in emerging markets grew 10%, in line with our view that these regions are poised for outsized growth as Pepsi continues to expand distribution of its core brands and develop offerings that resonate with local consumers. Accordingly, we expect mid-single-digit sales growth in the AMENA and Latin America regions longer term, versus around 3% sales growth for the consolidated company.