Barrons: PepsiCo (PEP) All Set To Regain Its Fizz

Thanks to the recession, investors stayed clear of consumer-staples stock, with PepsiCo (NYSE: PEP) being one among them. The rationale was declining revenues and profits in the company's North American Beverage division that constitutes Pepsi products, Gatorade sports drinks, Tropicana juices, Aquafina water and other familiar brands. The recession-hit consumers switched to private label products or stayed away from colas.

However PepsiCo cannot be written off easily, given its strong franchise in snack-food and the planned $7.8 billion acquisition of two of its key bottlers that will help it to cut costs substantially. PepsiCo reported profits of $5.9 billion, or $3.68 a share, last year on a top line of revenue of $43.3 billion. Though this year, the company is expected to earn $3.76 a share, next year, with the bottlers included, it could net $4.22. PepsiCo trades for 15 times next year's consensus estimate. This would be near the bottom of its 10-year range forward P/E multiple of 13.1 to 31.6. It trades cheap compared to its arch-rival Coca-Cola (NYSE: KO), which quotes a price/earnings multiple of 17, and other consumer-products stocks like Procter & Gamble (NYSE: PG) and Colgate-Palmolive (NYSE: CL) which trade, respectively, for 17.3 and 15.6 times 2010 forecasts.

Bill Pecoriello, CEO of ConsumerEdge Research, who set a 12-month price target of 72 and has an Outperform rating on PepsiCo's shares, says “We see a path for double-digit earnings growth over the next three years,".

"The stock [could] trade 50% to 60% higher, which, with the dividend, gives you a pretty good return." says Mario Gabelli, chairman and CEO of Gamco Investors. His funds own PepsiCo shares and he backs his analysis on what he thinks the company's parts could be worth in private-market transactions.

PepsiCo's Snack food business is the primary source of revenue, accounting for 63% of sales and 60% of profits. The rest is earned from beverages. The company's snack portfolio includes brands such as Lay's, Fritos, Doritos, Ruffles and Cheetos, as well as Rold Gold pretzels. Snacks did better even in a challenging economy, both in the U.S. and abroad. PepsiCo officials report that more people are eating at home these days than in the past, which has helped snack food business, but has hurt beverage sales.

Frito-Lay North America and PepsiCo's international snack and beverage unit reported a 7% growth in operating profit in the first nine months of this year, despite unfavorable currency translation, which could reverse in the current quarter, as the dollar is strengthening. PepsiCo's CFO Richard Goodman says "In every snack country we're in, we are either No. 1 or No. 2. There is no real global competitor." This has given leverage for PepsiCo to price its products slightly premium to local brands, thereby boosting profit margins. For instance, the North American snack-foods business enjoys operating margins of 25%.

Americas Beverage business was an underperformer reporting a 10% revenue drop this year, to $7.4 billion, while operating profit declined 11%, to $1.7 billion. Though the company doesn't release performance of individual brands, industry data indicates that results for PepsiCo, Gatorade and water was disappointing. For a long time, PepsiCo had been No. 2 to Coke. Though the gap between the two cola majors globally has narrowed slightly in recent years, still Coke has a far larger footprint overseas. It generates about 75% of sales and 80% of profits from outside North America, compared with PepsiCo's roughly 40% of sales and 34% of profits.

PepsiCo's snack business is integrated globally as it manufactures and distributes its snack products globally. "We think of it as a huge competitive advantage because we control everything that happens," says CFO Goodman. PepsiCo CEO Indira Nooyi has been mulling to extend this strategy to its beverage business. Earlier this year she announced a plan to acquire and consolidate PepsiCo's two largest bottlers, PepsiCo Bottling Group (NYSE: PBG), based in nearby Somers, N.Y., and PepsiCo Americas (NYSE: PAS), headquartered in Minneapolis. Post acquisition, PepsiCo will control manufacturing, distribution and marketing of its beverages in 80% of North America.

The PepsiCo Bottling Group was hived off by PepsiCo in 1999, when Beverages business accounted for 60% of its revenue and bottling was considered a low-growth business requiring substantial capital investment. Hiving off, the bottling business enabled it to diversify its product portfolio. Analysts expect it to acquire all remaining independent U.S. bottlers over time.

PepsiCo has been on a bull phase since March and is currently trading at 63 and as the economy recovers investors expect it to hit 70s next year, while one investor pegs its private-market value closer to 100 a share.

However, the bull case for PepsiCo could reverse if the beverage business continues to underperform, or if a call for taxing soda and other sugary drinks gains traction. Proponents of cola tax view it as a way to curb obesity in the U.S., while others see it as a way to fund for health-care reform. Pecoriello says "It's a risk, but not enough of a probability to make it into our base case."

PepsiCo has many levers it can use to boost revenue and meet its earnings growth, as Pecoriello and other PepsiCo fans opine. Even if very few of them work, PepsiCo's shares could regain their Fizz.