Margins Fizzle for Wide-Moat PepsiCo in Q3

The strength of PepsiCo’s PEP brand intangible assets was on display in the third quarter, as organic sales popped 9%, on top of 5% growth in the year-ago period and up more than 13% from the prepandemic period in 2019. This performance is even more laudable, given the balanced contribution from higher prices and favorable mix (a 5% benefit) as well as increased volumes (up 4%). We attribute these gains to the firm’s astute focus on upping the ante as it relates to investments in consumer-valued innovation and marketing, which we view as key to winning in the intensely competitive food and beverage aisles in which it plays.

However, profits cooled in the period, as supply chain disruptions and inflationary headwinds, combined with recent acquisitions of lower-margin businesses like Pioneer Foods in Africa, took a toll. Adjusted gross margin slumped 120 basis points to 53.6%, and adjusted operating margin contracted 70 basis points to 16.1%. Profitability stands to be volatile in the near term, though actions to raise prices should serve as a modest offset. But longer term, we still see plenty of room for margin expansion as the firm extracts inefficiencies (with its current $1 billion productivity initiative aiming to digitize and streamline processes across various workflows in production, logistics, sales, and marketing).

Management edged up its full-year guidance, calling for organic sales growth of 8% (from 6% prior) and core constant-currency EPS growth of more than 11% (from 11% prior). However, there is not much disparity between its revised outlook and our previous expectations (7% and 12.9%). As such, we see little to warrant materially altering our $153 fair value estimate outside of a low-single-digit bump to reflect time value. With little movement in shares on the news, we view the wide-moat operator as fairly valued and would suggest investors await a more attractive risk/reward opportunity before building a stake.

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