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PepsiCo Maintained at Neutral

Zacks Equity Research

We have maintained our Neutral rating on PepsiCo, Inc. (PEP) following appraisal of the first quarter 2012 results.

PepsiCo’s first quarter 2012 earnings declined 7% year over year to 69 cents per share as top-line growth was offset by commodity inflation. However, earnings edged past the Zacks Consensus Estimate of 67 cents. Revenues were up 4% in the quarter to $12.4 billion driven mainly by pricing benefits.

The Europe, Asia, Middle East and Africa (:AMEA), and PepsiCo Americas Foods divisions did well in the quarter. The company maintained its previously provided 2012 guidance of core constant currency earnings to decline by approximately 5%.

We are encouraged by the company’s strong brand portfolio, its product and geographic diversity and solid cash flow generation. The company is the number two 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 Oats 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 2012, the company aims to double the contribution of new products to total revenue in both snacks and beverages globally. In fact, the company will increase its advertising and marketing spending from 5.2% to 5.7% of revenue in 2012. The brand investments are expected to boost revenue 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 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.

However, a challenging consumer spending environment, sluggish growth in the North American businesses and higher commodity costs raise concern. Rising cost of raw materials is hurting the company’s margins. Input cost headwinds thus result in price increases for the finished products, which may not always be possible to pass on to the budget constrained consumer in this sluggish economy.

Changing consumer preferences toward healthier drinks, as a result of increasing health consciousness, are affecting the company’s carbonated soft drink (CSD) volumes. PepsiCo also faces strong competition from The Coca-Cola Company (KO). In the U.S. measured channels, The Coca-Cola Company commands a larger share of CSD consumption. The Coca-Cola Company also enjoys higher market share in many markets outside the United States than PepsiCo.

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