Pepsico Inc. is a company all of us know and most people love. But companies like Pepsico, Coke, Mondelex, etc. have seen challenges in their businesses as people are choosing so-called “healthier snacks” at the margin.
But we think the death of traditional snacks that tend to be high in sugar, salts, and fats is highly overrated. Whether we like it or not, people find foods high sugar, salt, and fats very appetizing. All one has to do is watch an episode of Tripple D (Drive-in, Diners & Dives) to see that people eat foods high in these elements every day.
PepsiCo, Inc. is a diversified consumer products company that sells a wide lineup of food and beverage products worldwide. The company is organized into a number of segments organized by type and brand. (1) The company’s Frito-Lay North America segment offers branded dips such as Cheetos cheese-flavored snacks, Doritos tortilla, Fritos corn chips, Lay’s potato, Ruffles potato, and Tostitos tortilla chips. (2) The Quaker Foods North America segment provides more “health” food products such as cereals, rice, pasta, mixes and syrups, granola bars, grits, oat squares, oatmeal, rice cakes, simply granola, and side dishes under the Aunt Jemima, Cap’n Crunch, Life, Quaker Chewy, Quaker, and Rice-A-Roni brands. (3) North America Beverages is the flagship segment that offers beverage concentrates, fountain syrups, and finished goods under the Aquafina, Diet Mountain Dew, Diet Pepsi, Gatorade, Mountain Dew, Pepsi, Propel, Sierra Mist, and Tropicana brands; and ready-to-drink tea, coffee, and juices. (4) International is organized around geography as opposed to the product. Its Latin America segment provides snack foods under the Cheetos, Doritos, Emperador, Lay’s, Marias Gamesa, Rosquinhas Mabel, Ruffles, Sabritas, Saladitas, and Tostitos brands, Quaker-branded cereals and snacks, and beverage concentrates, fountain syrups, and finished goods under the 7UP, Diet Pepsi, Gatorade, H2oh!, Manzanita Sol, Mirinda, Pepsi, Pepsi Black, and Toddy. (5) The company’s Europe Sub-Saharan Africa segment offers snack food under the Cheetos, Chipita, Doritos, Lay’s, Ruffles, and Walkers; Quaker-branded cereals and snacks, beverage concentrates, fountain syrups, and finished goods under the 7UP, Diet Pepsi, Mirinda, Pepsi, Pepsi Max, and Tropicana; ready-to-drink tea products; and dairy products under the Agusha, Chudo, and Domik v Derevne brands. (6) Its Asia, Middle East, and North Africa segment provides snack foods under the Cheetos, Chipsy, Doritos, Kurkure, and Lay’s brands; cereals and snacks under the Quaker brand, beverage concentrates, fountain syrups, and finished goods under the 7UP, Aquafina, Mirinda, Mountain Dew, Pepsi, Sting, and Tropicana brands; and ready-to-drink tea products. The company was founded in 1898 and is headquartered in Purchase, New York. In the last 12 months, the company earned about $5.65/share after significant adjusts for changes in income taxes on revenues on $65 billion.
From a valuation perspective, we think the company looks at least fairly valued. Consumer products companies are low volatility, defensive names (from an operating perspective) so they tend to trade at higher valuation multiples. Furthermore, they tend to be non-cyclical. In the case of Pepsi, people have to eat in good times and bad. Since most of the company’s products are reasonably priced, people consume them through thick and thin.
Normalized PE is about 22 based on trailing earnings and 21.4 based on analysts expectations of future earnings. We are a little more bullish on the company’s financial performance as we are looking for the company to earn somewhere between $6.00 and $6.50 a share in 2019. The average analysis is looking for something closer to$5.50 and $5.60. We see the risk in our estimate as driven by currency. We think the dollar will move higher in the upcoming year and this will tend to depress earnings reported for the international divisions.
The company has a very conservative capital structure. Enterprise value is $204 billion, while the market cap is $178 billion. So debt to total capitalization is just 13%. In addition, the company reduced its debt outstanding by $5.4 billion in 2018. The company has not been one to buy back stock oddly enough. They tend to pay their excess cash flow to shareholder through dividend payments. The company’s dividend yield, by the way, is just over 3% which nice in an environment where intermediate-term, investment-grade corporate bonds yield 2 to 2.5%.
It is somewhat unclear why the company has such a conservative capital structure when the operating risk of the business is so low. The company could easily buy $20 or $30 billion in stock, paid for with long-term debt, and still have a conservative capital structure. This would reduce the share count by 16% and the tax shield of doing so would be worth about $0.25 billion a year. We, nonetheless do not expect the company to do so, but it is always a benefit that a positive surprise of a significant share repurchase program is an option.
Long-term investors have been rewarded nicely for holding the company’s shares. As you can see from the chart below, the stock has been rising nicely within a long-term trend channel. There is no reason to believe that this trend will not continue as the trend appears stong.
Recently, the PEP shares broke out of a horizontal trading range that started back in Q1-2018. From a trend standpoint, the stock looks like it has a lot of upside in it, so we would like to be bullish. At the same time, the RSI suggests the stock is overbought and momentum is a bit high and sits at a level where the stock has historically sold off or traded sideways.
We have to respect this risk as we construct a bullish trade on PEP. In this case, we think a short put-spread risk-reversal is in order. To construct a short PSRR one buys a call and sells a put spread to help pay for it. The resulting payoff pattern looks like a call. Indeed, one can think of a CSRR as a “synthetic” call for this very reason. The benefits of a CRSS is that it keeps the premium cost down and reduces time decay. But one would suffer a somewhat larger loss if the stock sell-off relative to just buying a call outright. With PEP trading at $127.09, consider the following structure.
To initiate the trade, the investor will have to pay $74 up front. If the stock takes off, this structure will move into the black very quickly. If the stock sells off, losses will be limited to $574 per structure (the difference between the two strikes plus the premium paid). Like a typical out of the money call, the probability of profit is less than 50% (35% in this case). The breakeven level is $130.74, so the stock needs to trade above this level at expiration for the investor to make money. To give the stock some time to get there, we chose options that have about 3 months to expiration.
The objective of the trade, however, is to ride the underlying trend. If that trend continues and we would not be surprised to see the stock trade above $137 at expiration. At the same time, we have to respect the risk that the stock is overbought and may have a correction in the near term. This structure protects the investor in the scenario where the share price sells off harshly. We do not see this as an insignificant risk. The US equity market has rallied like a son of a gun since December 24. Market prices rarely move in straight lines, so a correction could come at any time.
Image Source | Martin Pechy, Pexels.Com
