A couple weeks ago I laid out the theme of falling commodity prices within my Sagflation thesis, ultimately buying shares in Tyson Foods (Ticker TSN). In this post I continue with the deflationary theme but add in a restructuring story. One of my favorite signals when looking at a stock is a re-structuring or re-focusing of a strong brand. I call this the "Bain Capital" method since Bain Capital has a proven track record of buying distressed brand names and turning them around for a profit.
Pepsico, Inc. (Ticker PEP) has been popping up on my radar because of a re-emphasis on developing the popularity and identity of their brands, as opposed to just pushing volume. For about three years management has been focusing on improving productivity and re-investing savings back into R&D, brand-building and market-specific initiatives. During this time period of restructuring the returns of the business can appear worse than expected due to investment spending and uncertainty about the pay-off. However, as the investments begin to produce returns in the form of higher sales and improved margins, the stock can produce above average returns. For this reason, today I established a 2% position in PEP.
I have been considering Pepsico for its potential margin improvement due to my belief that commodity prices may continue to fall due to deflationary pressures. In the third quarter the gross margin declined 300 basis points annually, largely due to rising commodity prices. Sugar is a significant cost, as well as aluminum, corn, wheat, and gas. Due to a reduced supply of sugar from both Brazil and Australia, sugar prices have remained fairly high despite a pullback in other commodities. Since sugar prices have not declined significantly I have held back from Pepsico. That said, I expect more supply to come on the market as we roll through 2012 as growers are attracted by the higher prices in 2011. Management actively hedges commodity prices and the recent volatility may provide them with an opportunity to lock-in lower prices in 2012 relative to 2011, in my view. With all that considered, I decided Pepsico could benefit from falling commodities given its more stable sales characteristics and significant exposure to snack foods, which use corn and wheat. Wheat and corn prices have declined recently.
A risk to sales is that large retailers like Wal*Mart and Costco are able negotiate lower prices should the cost structure of Pepsico, and their competitors, decline due to falling commodity prices. Obviously these two retailers have significant leverage due to their size and from talking to a friend who has called on Costco, I know they can drive hard for price concessions. If Pepsico can increase volume of their products through their marketing campaigns, the company should have greater negotiating power when working with retailers. In addition, by improving productivity the company should be able to produce higher returns as the business lowers fixed costs and increases turnover. Improving returns should translate into an outperforming stock. That said, Coca-Cola has also worked on productivity improvements to lower its cost structure and has expanded vertically through its acquisition of the North American operations of bottler Coca Cola Enterprises last year.
Returning to the re-structuring plans, management began investing in its brands about 3 1/2 years ago when
it focused on Gatorade. Management then moved to Tropicana, Pepsi Max,
Sierra Mist, and Mountain Dew, each showing improvement. Now management
is focused on Pepsi, a potential bigger bang for the buck after the cola
fell to third place in the US in 2010 behind Coke and Diet Coke. Higher spending on marketing, funded by cost improvements, should enable Pepsi sales to improve going forward. In addition to the turnaround of established markets, the emerging markets remain a significant growth opportunity for the company to expand consumption with snack revenue growth of 31% in China and 26% in India this past quarter.
Last week they reported strong results after implementing price increases to offset rising commodity prices. An encouraging signal was that volume changes were within management expectations despite the price increase. Also encouraging was a reiteration of high single digit earning growth for 2011, despite less anticipated benefit from currency, implying the actual business is improving slightly better than expectations. Compare these results with a consensus EPS growth estimate of 6% in 2012 and I believe there is upside to forward year estimates should commodity prices fall or Pepsi sales improve.
The consensus analyst opinion is overweight for the stock. PEP trades at 13x the consensus 2012 EPS estimates. The dividend yield is an attractive 3.3%, higher than Coco-Cola's (Ticker KO) of 2.7%. PEP is trading close to its 52-week low.
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