Description

PepsiCo is a ~$80B business across global snacks and beverages. PepsiCo Beverages North America makes up about a third of sales but only ~22% of EBIT while Frito Lay North America is 25% of sales but 50% of EBIT. While on the surface, people may think that PEP is a COVID beneficiary, it actually wasn’t. While it was producing unprecedented levels of beverages and snacks, they were almost all purchased in large format stores (Grocery, Mass, Club, etc.) which negatively impacts the mix (larger packs). Additionally, they lost almost all of their food service business (smaller portion of sales relative to retail) but still impactful to the PnL since it commands a higher margin. As the country and economy opened up in 2021, it was able to gain back the food service aspect as well as retain much of the sales volume it was doing in retail, but with the added benefit of the convenience and gas business (higher $/oz and better margins).

To level-set, PEP has been executing and performing at a very high level over the past few years. However, in May of this year, GLP-1 drugs came into focus and investors had a shoot first, ask later mentality and shorted every major restaurant, packaged food, and beverage company. During this time, the PEP stock declined nearly 20% while the absolute multiple declined 21%. PEP’s portfolio consists of 58% convenient foods and 42% beverages. And while it appears that PEP’s business would be highly impacted by the adoption of GLP-1, it actually has a much more nutritious and “better-for-you” portfolio than the average person may think (Zero sugar products, protein snacks, baked chips, etc.). This past week, the MDLZ CEO went into detail on how he thinks the GLP-1 move was overblown. The company has a dedicated team on the impact and he noted that even with optimistic adoption levels, the impact is only 50-100bps on volume in ten years. He didn’t even mention any numbers in the near-term as it seemed like there will be no impact, like other companies have mentioned. While this is an overhang on the stock, I do think it should fade for PEP as there is likely little to no impact in the near-term (1-3 years at least).

As I have mentioned in previous emails, PEP has heavily invested over the past several years since Ramon took over as CEO – Capex levels have been 6% of sales vs historical at 5.2% or even as low as 4% during most of the 2010s. This included R&D, supply chain, GTM capabilities, automation, technology, brands, and more – most notably in PBNA and FLNA. Both operating segments (PBNA and FLNA) became much more sustainable BUs, where FLNA went from LSD organic sales growth to MSD-HSD%+ growth while PBNA inflected from LSD declines to LSD%+ growth. While the company did over-earn over the course of the pandemic due to strong double-digit pricing, I don’t believe they need to go through a period of under-earning. Over the next three years, I do have organic sales moderating from +10.5% this year, to +5.8% in 2025. I am relatively in-line with the Street this year on topline but modestly above consensus each of the next two years. PEP’s long-term algo is +4-6% organic sales growth and I think PEP can achieve the high-end of that range in 2025 with price/mix decelerating and volume inflecting positively (starting next year).

I am modestly above the Street on gross margins for the out years. The company should continue to benefit from the reversal of commodity increases but should also get a tailwind from mix. The smaller packs, which many companies say consumers are trading down to, are margin accretive. I embed 30bps YoY expansion in each of the next few years. While commodities are coming down, it will gradually lose pricing and it will return to more normalized pricing levels, which does pose a headwind in the near-future. Overall, I still think PEP can expand margin in this near-term environment.

I model a bit more EBIT margin expansion over the next two years because I have FLNA margin expanding 50bps and PBNA margins 130bps over the next two years. FLNA is PEP’s highest margin business unit. This leads me to be LSD-MSD above the Street on the EBIT (margin) line.

While I model some slight volatility in earnings growth over the next few years, I am at the high-end of PEP’s EPS algo or slightly above. My FCF number is slightly below the Street this year because there was a big swing (decrease) in accounts payable this year, which impacts CFO. My FCF numbers are above the Street from 2024 and 2025.My risk reward is $147 x $195, wiht risk to the upside as the company continues to transform its PBNA margin structure.

I did take down my P/E multiple a few turns to reflect the current environment, the possible GLP-1 overhang and volume lag. My current multiple 22.0x next year’s earnings, which even with the potential overhangs, gets you good upside

Catalyst

• PBNA getting back to mid-teens EBIT margin structure
• MSD-HSD PBNA organic growth led by volume
• Continued growth in FLNA division