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PepsiCo Remains Neutral

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We maintained our Neutral recommendation on PepsiCo, Inc. (PEP - Free Report) following appraisal of the second quarter 2012 results.

PepsiCo’s second quarter 2012 earnings declined 7% year over year to $1.12 per share hurt by a sluggish top line and currency and commodity cost headwinds. However, earnings edged past the Zacks Consensus Estimate of $1.09. Revenues declined 2% in the quarter to $16.46 billion mainly due to currency headwinds and re-franchising of the beverage business in China and Mexico. Excluding these headwinds, organic revenue was up 5% helped mainly by price increases. Read our full report at PepsiCo Beats EPS; Misses Sales.

We are encouraged by the company’s strong brand portfolio, its product and geographic diversity and solid cash flow generation. The company is the second best player in beverages globally and a leader in macro snacks. It owns two of the three top health and wellness brands. PepsiCo’s overall product portfolio comprises 22 brands including Pepsi, Mountain Dew, Gatorade, Tropicana, Lay's, Doritos, Cheetos, and Quaker that generate more than $1 billion each in annual retail sales. PepsiCo has the competitive advantage of selling both snacks and beverages which are complementary food categories.

Product innovation plays a huge role in the company’s success. The company regularly creates new flavors of existing products as well as maintains a robust pipeline of new products. The company also supports its existing brands and categories with stepped-up marketing and innovation. In fact, the company will increase its advertising and marketing spending from 5.2% to 5.7% of revenue in 2012. With the increase in marketing investments, the company is seeing improvement or stabilization in brand equity scores for major brands in most markets. The higher brand equity scores will translate to strong sales growth and also enable increased price realization in the long run.

The company’s operations in Russia, Mexico, Canada and the United Kingdom contribute significantly to revenue and profitability, while its businesses in the emerging markets of China and India hold significant growth opportunities. The company has tripled its revenues from the emerging and developing markets in the past five years. The economic outlook of these fast growing nations is at present much better than the developed markets due to an improving standard of living of the middle class.

PepsiCo’s restructuring program, announced in February 2012, is expected to result in productivity savings of more than $1 billion in 2012 and $3 billion over the next three years. These strategic initiatives are expected to help the company achieve its long-term target of mid-single-digit constant currency net revenue growth, core constant currency operating profit growth of 6–7%, and high-single-digit core constant currency earnings growth.

We believe PepsiCo’s marketing support investments, brand building innovation and cost saving efforts will boost growth. However, we prefer to remain on the sidelines until we see some meaningful impact of these investments on operating results.

Moreover, a challenging consumer spending environment, sluggish growth in the North American businesses and higher commodity costs raise concern. PepsiCo also faces strong competition from The Coca-Cola Company (KO - Free Report) . In the U.S. measured channels, The Coca-Cola Company commands a larger share of carbonated soft drink (CSD) consumption. The Coca-Cola Company also enjoys higher market share in many markets outside the United States than PepsiCo.

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