Macro Headwinds Begin to Bite PepsiCo

 PepsiCo (PEP) delivered quite solid results in the second quarter, increasing internal revenue 8% and earnings per share 10%. However, near-term trading is likely to be driven by the firm's lower outlook for the remainder of 2011. While we believe Pepsi's momentum will continue into the second half of the year, we think its original guidance was too optimistic, and we are sticking with our fair value estimate and our 2011 EPS estimate, which implies mid- to high-single-digit earnings growth. We regard Pepsi, trading at just over 14 times 2012 earnings, as a relatively undervalued stock in an industry that could provide a safe haven if investors turn defensive as a result of sluggish macroeconomic data.

On a constant-currency basis and excluding the acquisition of Wimm-Bill-Dann, second-quarter revenue grew 8% year over year, a sequential improvement on the 5% growth achieved in the first quarter, as emerging markets again drove growth. Volume grew 6% and favorable pricing and mix impacts contributed a further 2% to internal growth. Our investment thesis maintains that Pepsi is an emerging-markets play, and its investments in Asia, Latin America, and Europe again paid off in the second quarter, with revenue growth of 17%, 18%, and 18%, respectively. Pepsi appears to have underperformed  Coca-Cola (KO) beverages in Latin America, although we expect growth in Gatorade to halt that trend over the next few quarters. After a fairly stable first quarter, results in North America were mixed in the second. Pepsi increased internal snack volume 2%, but beverage volume declined 1%. The beverage business has been weak for several quarters, and we think Pepsi's sluggish recovery from the downturn in beverages, particularly in comparison with Coke, is a key reason for its low relative valuation. The multiple gap with Coke closed in the first half of 2011, but Pepsi still trades at a slight discount to its great rival, and until management can secure a sustained turnaround in North America, we believe that will continue to be the case. We are optimistic that as the company focuses its attention on the flagship Pepsi brand and rolls out new packaging for Tropicana, beverage volume can return to modest growth. However, our 2011 EPS forecast implies a fairly difficult second half, as unemployment remains quite high and low-end consumers are still spending cautiously.

Management effectively lowered its 2011 forecast, stating that it now expects high-single-digit EPS growth, including a 1%-2% benefit from currency. Previous guidance had indicated similar growth would occur on an internal basis. We always thought that this guidance was optimistic, particularly as U.S. employment data began to worsen again and austerity measures in Europe kicked in. We have been forecasting mid- to high-single-digit EPS growth on a reported basis, and we are sticking with our assumptions. Pepsi's announcement may be a sign of things to come. Given the optimism in the food and beverage sector earlier in the year, we would not be surprised to see other consumer staples companies lower their guidance this earnings season. Dr Pepper Snapple DPS, for example, set optimistic high-single-digit growth rate targets early in 2011, goals that may now appear too lofty to achieve.

On a brighter note, if commodity costs remain at current levels, Pepsi's margins may benefit in 2012. We estimate that the firm is about 80% hedged on costs for the remainder of the year and the most costly hedges should roll off early in 2012. With the stock trading at just above 14 times our estimate of 2012 EPS, we think the market is still too fixated on the inevitable road bumps that Pepsi will face in the near term and missing the competitive advantages that the firm holds through brand power, scale, and distribution in its snack portfolio. Despite the challenges it faces in the near term, Pepsi could provide a safe haven in a flight to quality in the event of more bearish sentiment creeping into the market.

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