PepsiCo's (NYSE: PEP ) fourth-quarter earnings report, set to be released Thursday, will be an important barometer of the carbonated soft-drink market. Hedge fund manager Nelson Peltz is pressuring the company to spin off its ailing beverage business, but PepsiCo CEO Indra Nooyi refuses to separate the businesses. If Coca-Cola Enterprises' (NYSE: CCE ) quarterly results are any indication, PepsiCo's beverage business could surprise to the upside. However, there is also reason to believe that this could be a terrible quarter for PepsiCo.
Strong earnings from Coca-Cola Enterprises
Coca-Cola Enterprises is Coca-Cola's leading bottler and distributor in Western Europe. Earlier this month, the company reported strong fourth-quarter results, achieving 20% volume growth for Coke Zero and 2.5% volume growth overall. It also reported higher-than-expected earnings on the back of higher volume and better pricing.
Coca-Cola and PepsiCo beverage volumes tend to mirror each other, so strong sales of Coca-Cola's beverages in Western Europe suggest that PepsiCo also did well in the region. Although the company does not break out beverages and food in the segment, Europe represented nearly 23% of PepsiCo's revenue through the first three quarters of 2013. Strong performance in this region could lead to a strong overall performance in the fourth quarter.
Other indications suggest beverage unit is in trouble
Coca-Cola Enterprises' strong quarter is the lone positive indication amid a torrent of negative indicators for PepsiCo's beverage business. A convenience-store operator polled by Wells Fargo analyst Bonnie Herzog warned that Q4 could be ugly for U.S. soft drinks, saying, "Scary, units [are] down in [soft drinks] ... expect a big shake-up if Q1 2014 looks anything like Q4 2013." If U.S. retailers believe that soft drinks had a miserable quarter, then there is strong reason to believe that PepsiCo's beverage unit will post disappointing results.
Disappointing soft drink volume could put further pressure on Nooyi to consider Peltz's proposal to spin off the business. It could also send PepsiCo's share price plunging as investors wonder whether the beverage unit will ever recover.
What to watch
Investors should focus their attention on organic sales growth. Through the first three quarters of 2013, snacks revenue grew 3% and beverage revenue grew 1%. However, PepsiCo America's beverages -- which represent nearly one-third of total revenue -- shrank 1% in the first three quarters, including losing 3.5% in organic volume.
PepsiCo's U.S. soft-drink volume will continue to decline as consumers grow increasingly wary of the beverages' healthiness. However, in addition to adding healthier beverages to its portfolio, PepsiCo can offset the decline with higher prices. Since organic revenue grew 1% despite a 3.5% decline in organic volume, investors can rest easy knowing that the company maintains a degree of pricing power.
Moreover, the snacks division remains a reliable growth driver for the company. Even as American consumers become more health-conscious, Frito-Lay North America -- which represents about one-third of segment profit -- grew organic revenue 7% on 3% organic volume growth through the first three quarters of 2013. So, not only is the salty snacks business growing even in a health-conscious U.S. market, it also demonstrates significant pricing power.
Nooyi has intimated that the snacks and beverage businesses can be co-marketed, thereby enhancing the value of both. It remains to be seen whether the two businesses can drive each other, but I suspect that PepsiCo will make the connection more explicit in the quarters ahead as it continues to fend off Peltz's advances.
PepsiCo's European operations may show strong fourth-quarter performance, but investors should focus on PepsiCo America's beverages organic revenue growth. If organic revenue shrinks, it suggests that PepsiCo was unable to offset volume declines with price increases -- or unable to increase volume through price cuts -- which could be a troubling sign of things ahead. However, if the beverage business shows revenue growth in a quarter that retailers call "scary," then the company may have better prospects than the market is pricing into its stock. So, keep an eye on organic revenue growth in the beverage business to get a sense of how good or bad the quarter was for PepsiCo.
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