South of the Border Frito Fiesta
A look at PepsiCo’s (PEP) biggest source of growth in 2Q
PEP blew the lid off the Wall Street consensus targets in its recent second quarter, reporting non-GAAP EPS of $1.86 which topped consensus estimates by 12 cps. The company raised its guidance for full-year organic revenue growth to 10% from its previous estimate of 8%. However, it left its previous guidance for core EPS of $6.63 in place.
PEP reported impressive organic revenue growth of 13%, but this relied on a 12% boost from net pricing. We were stunned by the inelastic demand evident in the company’s results. Despite huge price increases across all segments, Europe was the only segment reporting negative volume growth. PEP’s developing market segments all showed healthy volume increases despite prices boosting growth by 9-15%.
Management’s comments on the conference call seemed to indicate it is less than confident that price inelasticity will hold as strongly in the second half. We share this concern given the pressure on consumers’ budgets and multiple big retailers signaling in recent weeks that they would be protecting their margins by both passing along higher costs to consumers and expecting lower prices from their suppliers- like PEP.
While we have other concerns regarding PEP, this report will focus on the amazing boost provided by the company’s Latin America segment which has provided the lion’s share of growth for the last several quarters.
A Closer Look at Growth
The following table shows the components of revenue growth for each of PEP’s segments for the last six quarters:
There are several items to notice in the growth breakdown:
As we pointed out above, despite aggressive pricing of 12%, PEP managed to hang on to positive volume growth of 1%. The company raised its forecast for full-year organic sales growth from 8% to 10%. However, management seemed less confident about price inelasticity enduring, stating in the conference call:
“We're still watching elasticities closely as Ramon just mentioned. Elasticities are good right now. We don't plan for them to be as strong in the back half, and we'll see what happens with that. It's certainly hard to gauge because inflation is having so much impact on the consumer in so many ways.”
Europe was the only segment reporting volume declines (-9%) as inflation and the Ukrainian crisis took their toll on results. This segment also saw the largest hit from foreign exchange losses.
Quaker Foods volume growth remained positive only because of an easy comparison against a 20% volume decline in the year-ago quarter. However, this is by far the smallest segment and not as integral to growth.
Latin America, AMESA, and Asia Pacific all saw solid volume gains despite price increases ranging from 9-15%. However, foreign exchange offset much of the growth in AMESA and Asia Pacific.
The point we want to draw attention to is the stellar sales growth in Latin America which we will examine more closely below.
12% of Sales Is Providing the Bulk of the Growth
PEP investors should be aware of the extent to which the company’s Latin America segment has been contributing to overall profit growth. The first table shows non-GAAP operating profits for each segment and the second shows the year-over-year dollar growth to make it easier to see each segment’s contribution to total non-GAAP profits.
Despite being just under 12% of company revenue, Latin America has been providing the bulk of the growth in non-GAAP profits for some time. In the 6/22 quarter, Latin America produced $149 million of the $198 million increase in total company non-GAAP operating profits. Here is the commentary from the 10-Q regarding Latin American profit improvement:
“Operating profit increased 18%, primarily reflecting the net revenue growth and productivity savings, partially offset by certain operating cost increases and a 40-percentage-point impact of higher commodity costs, primarily cooking oil and packaging material. Impairment and other charges associated with our decision to sell or discontinue certain non-strategic brands reduced operating profit growth by 23 percentage points. Certain indirect tax credits in Brazil and lower charges taken as a result of the COVID-19 pandemic contributed 7 percentage points and 4 percentage points, respectively, to operating profit growth.”
The impairment charges were adjusted out of the non-GAAP results so that was not a factor in the non-GAAP profit improvement. However, it does not appear that the lower COVID charges and the tax credits were adjusted out of non-GAAP results. We will ignore the 7 points of growth coming from lower COVID costs. While that tailwind will disappear for growth in upcoming quarters, it does not represent a surprising source of profits in the 6/22 quarter. However, we estimate the tax credits only added about a penny per share to EPS. Thus, the bulk of the profit growth is coming from the massive increases which have yet to meet with volume declines. Let’s revisit the components of Latin America’s organic growth in the last few quarters:
Latin America volume growth was 7% despite a 15% increase in prices which was the fifth straight quarter of mid-teens price increases. Clearly, consumers in Latin America have been willing to spend money on drinks and snack food despite higher prices. Management made the following observations regarding the demand in Latin America in the conference call:
“Your question on Latin America, we're seeing -- and I think it relates to the amount of transfers, money transfers that are coming from the U.S. into Latin America. We're seeing that number really high as a consequence of the high employment in the U.S. and the higher salaries. We're seeing that money being transferred to a lot of the economies in LatAm, and that's helping a lot of disposable income in those countries. And we're seeing, to our surprise really, from the beginning of the year, very low elasticity. It's actually positive elasticities even though, obviously, we're passing price to the consumer in those markets in intelligent ways and in ways that consumers will feel less pressure on.
But I think disposable income in LatAm is above what it was in the past, a consequence of developed economies doing very well and money going into LatAm and the consumer is feeling good in Latin America. Also, post-COVID we're seeing behaviors of social expansion, if you want. So consumers coming out of the houses, consumers having more fun externally in LatAm and in many parts of the world. That tends to drive higher consumption of categories because people get together and have fun and we are part of fun experiences normally. So that's how we're seeing the trends in our categories.”
We can’t say that the next quarter is the one where Latin American consumers will cut back on spending. However, investors should realize how much of PEP’s recent growth has come from unusually strong demand from this region and a return to more normal growth in this segment would negatively impact PEP’s overall growth rate.
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