Pepsi: Effervescent Results but Shares Fairly Priced

Pepsi's PEP top-line momentum persisted in the second quarter, with organic sales positive in each of the firm’s six segments and up 4.5% overall (versus our roughly 4% full-year estimate). While we intend to reassess our assumptions (3% to 4% sales growth and average operating margin around 17% over the next five years), we aren't anticipating a material change to our $125 fair value estimate. We continue to view strengthened pricing (up 4% in the quarter) as the highlight of results, as we think it reflects the substantial brand strength that underpins our wide-moat rating for the firm. In this context, while core operating margin contracted nearly 130 basis points to 17.7%, we attribute this to increased investments in its brands (management cited a 56-basis-point lift in advertising and marketing spending as a percent of sales in the first half), which we view as a prudent means to support its long-term pricing power and sales trajectory.

We believe management's heightened focus on innovation and brand investments has already started to improve performance in segments like Quaker Foods North America (3% of sales), which posted its strongest quarter of organic sales growth in three years (up 3%), and PepsiCo Beverages North America (32% of sales). Within the North American beverage business, we were especially pleased to see a 4% increase in pricing (in line with the first quarter and accelerating from the 2% rate seen in fiscal 2018), supported by a shift to higher-margin packaging sizes and more premium, value-added products (like functional beverages). We appreciate that investments within the domestic beverage business seem to be well balanced between Pepsi's leading brands and more nascent offerings in higher-growth segments. As evidence, management noted sequential volume improvement for the Pepsi and Mountain Dew trademarks, high-single-digit volume growth for ready-to-drink coffee, and mid-single-digit volume growth in its water portfolio.