Description

Short Pepsi

Punchline

During the last few years, Pepsi hasn’t really grown volumes but has instead boosted its earnings by taking price. This year, due to inflationary headwinds, FX moves, and Russia/Ukraine, Pepsi has taken several years of pricing in one year. The market thinks Pepsi’s pricing reflects superior pricing power and has maintained Pepsi’s premium P/E multiple. In reality, Pepsi has likely taken years of pricing this year and left itself vulnerable to accelerating volume declines, either due to price gaps from private label competitors or a weakening consumer having difficulty paying 20% more for a bag of chips. Volume declines are deadly for CPG companies because it leads to significant manufacturing fixed cost de-leverage. Short sellers today aren’t paying much to expose themselves to Pepsi unsustainably holding up its earnings power.

Shorting Pepsi, along with a basket of other CPG companies taking massive price despite suffering volume declines, can provide investors a low risk 25% return.

Overview

At first, I wanted to pitch shorting a basket of low volatility stocks. SPLV. VIC didn’t need another mip bear raid on tech companies and there is reason to believe that it’s the broader market and ‘safe’ stocks that need to catch up and crack. However, its not fun pitching an ETF and SPLV, led by utilities, has already started to come under some pressure. Don’t get me wrong, SPLV is a high conviction short, but last week I saw something highly unusual and bearish. Pepsi delivered an ‘earnings beat’ based on 17% price and -1% volume. What is going on?

The CPG industry is not very complicated. Historically, CPG companies were great businesses because they had brand, manufacturing, and distribution scale and sold a necessary product. Today, CPG companies are pivoting from great businesses to good businesses. CPG houses still own long-duration brands but there are undoubtedly less brand and distribution advantages today due to changing consumer behavior, the internet, and e-commerce.

Despite lower barriers to entry, consumer staple stocks have been one of the best performing industries this year. XLP is down 10-11% including dividends, and I would argue half of that is just math from a stronger dollar. Within the industry, there is an assortment of companies with varying quality. A few names stick out as strong performers: PEP, G, KIS, CPB. The prevailing logic is that these stocks are where people are hiding while there is economic uncertainty. Frankly, that is reason enough to potentially short them. But are these companies growing?

Yes, it seems like they are. Pepsi is expected to make $85bn in sales this year vs. $79bn last year. However, Pepsi is growing sales by materially taking price hikes. In the last quarter, Pepsi grew sales 16% organically, a rate that should raise eyebrows since Pepsi is a behemoth slow-growth food & beverage company, based on 17% price increase. In addition, Pepsi is suggesting that this isn’t unusual. During the next quarter, Pepsi’s CFO hinted that organic growth will be ~7% with ‘high-single’ digit pricing and a 2-3% decline in volumes.

I think this level of price hikes is unsustainable, and Pepsi, along with GIS (-12% vol/+17% price), CPB (-4% vol/+14 price), and K (-2% vol/+14% price), are all going to get in hot water next year as they lap these comps. In other words, the market believes that food companies are safe, because they have pricing power; however, the unusual use of pricing this year leaves this basket of companies vulnerable over the next few years to significant price gaps vs. private label, a weaker consumer, and the negative fixed cost leverage of potentially accelerating volume declines.

The significant price hikes are also masking what should ‘eventually’ happen to these companies during a prolonged inflationary period. Pepsi this year will deliver about a 14.7% operating profit margin, 30bps higher than last year. In the context of the economic environment (inflation + FX), this is very impressive. Pepsi also has (had) a huge Russia business which represented 4-5% of sales in 2021. Inflation should eventually become a headwind for these companies, but it seems like they are delaying judgment day by taking unusually high price hikes this year. This makes sense because taking price hikes, unlike selling more tonnage of Frito-Lay, is 100% margin. Of course, part of this is paying for rising costs, but a 17% price hike is more than compensating for inflation.

Now, investors are able to short PEP, along with CPB/K/GIS, at near peak multiples off of an earnings power that is reset for the largest ever hike in prices. In other words, short sellers are getting a cheap put option that today’s price hikes cause tomorrow’s volume issues. That, in turn, will lead to reduced pricing power in the future. These are good businesses, but they are overplaying their hand.

Valuation

Ignoring the macro arguments that food companies, that are thought of as modestly growing dividend stocks, should be uniquely impacted by a rapidly rising 2-year bond, investors don’t need to overcomplicate the thesis.

Pepsi trades for 24x fwd P/E. Over the last decade, Pepsi has traded between 16-27x fwd P/E. If my thesis is correct, that Pepsi has pulled forward years of pricing power and otherwise is a 1% volume growing business, Pepsi should be trading at a historically low multiple, not 10% off its highs. I don’t think it’s at all a stretch to say fair value for Pepsi is close to 18x 2023 EPS (~$7) or $125/shr or down 25+%.

Sure, this isn’t the juiciest (no pun intended even though Pepsi sold Tropicana last year) return profile, it can be sized aggressively. The odds of materially losing money short Pepsi here are low. Also, Pepsi can act as a standalone short or a funding short. For the Microsoft guys out there, you can short Pepsi, go long Microsoft, have a positive P/E point carry and arguably much higher EPS growth.

If we are right, why does this opportunity exist? I think it’s because we are in a rolling bear market. The market has shot ARKK stocks, is shooting tech stocks, and will soon shoot safe stocks. The logic behind why that works is potentially because the most unprofitable, frisky stocks is where investors lose hope first. In turn, they realize that shorting the safe stocks doesn’t ‘work’ since people bid on safe stocks while de-rating risky stocks. Long-short breaks down. 9 months into this bear market, people think shorting safe stocks ‘just won’t work,’ especially when its needed. In our view, that is exactly why now is the time to short safe stocks such as Pepsi, especially in light of how they have preserved their earnings power.

Catalyst

Continued mediocre volume trends and a lack of further pricing power in 2023/2024.