This Portfolio Holding Is Poised for a Stronger Second Half
Our shares in one key portfolio holding have turned around from mixed June quarter results and more growth could be ahead.
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*PepsiCo has multiple levers to drive a stronger second half of the year, including its rebounding Quaker business
*Expected EPS growth in 2H 2024 remains well ahead of that for the overall market
*Explaining why the next key item for PEP shares is what its competitors say about promotional activity in 2H 2024
Our shares of PepsiCo PEP have turned around from their initial reaction to the company’s mixed June quarter results in which the company reiterated its guidance for at least $8.15 in EPS this year. For the June quarter, the company reported net revenue growth of 0.8%, bringing the first half to 1.5%. Not lighting the world on fire, but also not the negative comps like the ones we saw posted by ConAgra CAG on Thursday morning for its May quarter and guidance for more in the coming quarters.
The real story for the company has been and will continue to be profitability and continued margin improvement that will drive its bottom-line performance. In the June quarter, while PepsiCo’s organic revenue growth rose 1.9% year over year, its operating profit rose more than 10% as its overall operating margin expanded 150 basis points compared to the year-ago quarter. As we march into what will once again be a seasonally stronger second half, the outlook for that to continue is intact. Our preference is to favor management teams that focus on profits over market share. In our experience, sacrificing profits to gain market share is a losing battle over time.
For the first half of the year, PepsiCo generated $3.71 per share for its bottom line, which implies at least EPS of $4.44 in the back half of the year to hit the company’s “at least” $8.15 target. That’s more than 19% EPS growth compared to the first half of the year and is well ahead of the 11% to 12% expected for the S&P 500. That pattern of accelerated EPS has been one of the hallmarks of PepsiCo’s business mix that has, as we’ve discussed, been seasonally skewed to the second half of the year. It has also brought a richer margin profile.
Parsing management’s comments, that pattern should repeat even as management makes certain value adjustments in the near term. That is in response to some price sensitivity that’s developed in the marketplace. What’s allowing PepsiCo to still deliver revenue and margin gains are further productivity improvements and share further growth in the higher margin international business but also the accelerating rebound in the company’s Quaker business.
For newer members, the Quaker business has been a drag on overall revenue and profits following a salmonella-led recall that happened late last year. The company has been reconstructing the supply chain for that business and is in the process of refilling its pipeline. As such, that drag that was felt in the March quarter should become an even bigger profit generator in 2H 2024 compared to the $36 million generated in 1H 2024. In 2021 to 2022, the profit generated by the Quaker business alone in each of those years was $185 to $195 million. We would argue that many focused solely on the beverage and salty snack business may have forgotten about this drag and the impact the turning around of that business on PepsiCo’s bottom line.
So, while we may see less than typical margin expansion at Frito Lay in 2H 2024 as some of the portfolio is value repositioned, PepsiCo has levers to pull that should allow it to compete for consumer wallet share, but continue to drive margin and EPS growth. Of course, PepsiCo does not act in a vacuum, and this means we will be paying attention to comments from competitors like Coca-Cola KO, Keurig Dr. Pepper KDP, Utz UTZ and others on the pricing environment and expected use of incentives and market promotions to drive revenue.
We were early in dialing back our price target for PepsiCo to $185 and we will stick with that for now. We are seeing others, like BofA, Jefferies and TD Cowen lower their PEP targets to $190 to $200. Should we see more price target trimming in the coming days, it could pressure PEP shares. While it may be tempting to add to PEP shares, we will wait until we hear from the competitors mentioned above and others. If that chorus of companies signals that, like PepsiCo, they are more focused on margins and profitability than market share, that may give us the all clear to bring some additional PEP shares into the portfolio.
At the time of publication, TheStreet Pro Portfolio was long PEP.
