Q3 recap and investment thesis
PepsiCoNASDAQ:PEP) released Last month, its Q3 earnings report (“ER”) It performed well in a challenging environment for another quarter. Both lines were better than consensus estimates. Its non-GAAP EEPS The revenue came in at $1.97, beating consensus estimates of $0.12. Its total revenues reached $21.97B. That’s 8.8% YoY growth, beating consensus estimates of $1.15B. Net revenue fell by 3% due to foreign exchange rates. After adjusting for currency rates, total revenue growth was a solid double-digit 11.8%. The company also increased its full-year guidance for 2022. As CEO and Chairman commented, Ramon Laguarta During the ER
“We are very happy with our third quarter results as our global business momentum continues to be strong. Based on our year-to date performance, we expect our full year organic revenue to grow 12 percent (previously 10%) and core constant currency earnings to increase 10 percent (10 percent previous).
All in all consensus estimates Now, GAAP EPS for the fourth quarter will be $1.62 and $6.78 respectively. Its stock prices are at an all-time high thanks to these strong results. As of this writing, its stock price is at $178, which is only 3% lower than its record price of $184.
This article will explain why I believe that the stock’s strong profitability will continue. However, you’ll also see why I think it is slightly overvalued. As such, the total return potential in the next few decades will be limited.
Contextualizing Q3 results
The following charts provide a more detailed overview of PEP’s Q3 results. They show its profitability over five years. The top panel shows that PEP’s quarterly earnings have been remarkable consistent even in extreme market turmoil, since 2020’s COVID breakout. It earns an average of $2.1B per quarter in net profit. Its current quarterly earnings of $2.7B is well above the average by a large margin.
In the meantime its key profitability metrics, such as return of equity (ROE, middle panel), and return on capital (ROIC (bottom panel), have been both strong and stable. To be more precise, its ROE fluctuated within a narrow range of 61.5% and the current level at 55.4% is very close to the mean. Its ROIC is similar to its historical average of 15.94%. However, its current ROIC stands at 16.84%.
Moreover, we will soon see that PEP has also been turning the good levers for its profitability.
PEP’s stable margins and peak operation efficiency
As described in earlier article,
The DuPont framework gives management three knobs to control ROE or ROIC. These are profit margin (“PM”) and asset turnover ratio (“ATR”) as well as leverage. Simple math can show that ROE simply represents the sum of these three things.
ROE = PM + ATR + leverage
PM could be the most important of these three knobs. Investors prefer higher PM. However, excessively high PM can invite competition and unwanted attention and is often not sustainable. ATR is a good knob. It reflects the company’s knowledge and accumulation of experience. Leverage is a bad knob to turn, especially above a certain threshold.
The chart below shows how PEP management has been turning its first two knobs lately. The top panel shows the PM and the bottom panel its ATR. As you can see, PEP’s PM has been remarkably stable. The PM for PEP has fluctuated between 10% and 1.25% on average, with the exception of two quarters in 2019. The current PM for PEP is 11.61%, which is roughly the same as its long-term average. Another reference point is that the PM for the entire economy fluctuates between 8-10% and rarely exceeds 10% over extended periods.
The bottom panel displays the ATR (aka asset utilization rates). As can be seen, PEP has been able to steadily increase its ATR throughout the years. In 2018, PEP’s ATR was 0.82x. PEP has steadily improved to 0.897x. The COVID pandemic interrupted this trend temporarily. The overall trend is still upward, and the current ATR is 0.897x, which is significantly higher than the average of 0.841x. It also marks its peak level in 5 year.
PEP’s leverage, balance sheet strength and leverage
The chart below also shows its leverage knob. As you can see, the company’s total level of debt was stable over the years. It fluctuated in a small range between $32B and $45B. Its debt reached $45B in 2020, and then declined to $39.2B in 2019. This is roughly the same level as its historical average. The current level of its debt is at par with its historical average. However, its profitability has steadily improved over time. This has resulted in its leverage steadily decreasing as you can see below. Its leverage ratio was 7.2x in 2018 when it first began. It now stands at 4.97x. Its current level is not only much lower than the 5-year average, but also at the conservative level of 5 years ago.
This financial strength should enable further growth efforts, both organically or via acquisitions. The company is well-positioned organically in the beverage and snack markets. It maintains its market leader position by continually innovating its iconic brands. It has also been active in acquisitions. It recently signed a long-term distribution deal with Celsius Holdings, a beverage company that makes energy drinks with fat burning capabilities. PEP received 8.5% equity and one member of the board of directors as a result of the $550million investment. This move diversifies PEP’s income streams and should be beneficial to operations long-term.
Valuation, risk, and final thoughts
As I have already stated, I believe the stock is slightly overvalued in terms of its valuation. See the table below. The stock is currently valued at 17% above its historical averages in terms of its PE multiple. Its current FW PE is 26.3x, which is lower than its historical average of 22.5x. The current dividend yield of 2.58%, below the historical average of 2.8%, indicates an 8% valuation premium. Consensus projects that its EPS will grow from $6.78 this fiscal year to $8.25 over five years. This translates into an annual growth rate 4%. Based on this projection, the total return is projected to range from 4% (low-end projection), to around 35% (high end projection), translating to an annual return between 1.1% and 7.8%.
I don’t see any structural risk associated with the stock, other than the valuation risks. There are likely to be more headwinds in the future. Investor sentiment could be affected by high inflation, fears about a recession, disruptions to supply chains, and other factors such as the high rate of inflation. These headwinds are temporary or psychological in nature, but I see them as largely temporary.
These shares are best suited for conservative accounts, given current conditions. In the current scenario, I expect a 4.6% annual return. However, this is a very limited return potential. There is no reason to overlook the stock’s safe-haven nature, A+ financial strength and A+ earning consistent.