PEPSICO INC. $65 (New York symbol PEP; Conservative Growth Portfolio, Consumer sector; Shares outstanding: 1.6 billion; Market cap: $104.0 billion; WSSF Rating: Above average) is the world’s second-largest maker of soft drinks after Coca-Cola. Leading brands include Pepsi, Mountain Dew and Slice.

Through its Frito-Lay division, PepsiCo is also the world’s leading maker of salty snack foods, such as corn chips (Doritos, Fritos) and potato chips (Lay’s, Ruffles, Stax).

New products cut risk

In the past decade, the company has expanded its operations to other areas of the processed food market. In 1998, it acquired the Tropicana fruit juice business, and in 2001, it bought cereal and snack food maker Quaker Oats Co. for $13.9 billion in stock. In fact, soft drinks now account for less than 20% of PepsiCo’s revenue.

Thanks to these acquisitions, PepsiCo’s revenue grew from $25.1 billion in 2002 to $35.1 billion in 2006, or 8.7% compounded annually. Profits before unusual items rose at a compound annual rate of 11.2%, from $1.96 a share (total $3.5 billion) in 2002 to $3.00 a share ($5.1 billion) in 2006.

PepsiCo’s main reason for buying Quaker Oats was to gain control over Gatorade, which now accounts for roughly 80% of the sports-drink market in the United States.

In the past few years, consumers have switched to healthier beverages, and strong sales of Gatorade have helped offset weaker soft drink demand. Growing demand for Tropicana juices has also helped the company profit from this trend.

Healthier focus should pay off

PepsiCo focuses most of its new product development on healthier products that command premium prices. For example, it just launched a new, vitamin-enhanced version of its top-selling Aquafina bottled water.

It also plans to start selling a new line of fruit and vegetable-based snack foods under the “Flat Earth” brand, as well as a drink called “Tava” that contains chromium, a mineral that helps increase metabolism. These so-called “nutraceuticals” — nutritional products that seem to carry pharmaceutical-grade health benefits— are big, profitable sellers in drug and health food stores, but have yet to crack the broad consumer market.

Products like these should appeal to health-conscious baby boomers who tend to drink fewer soft drinks as they reach middle age. They also tend to generate higher profit margins than soft drinks.

Besides developing its own products, PepsiCo uses acquisitions to expand its brand portfolio, particularly in fast-growing niche markets. It recently paid $169 million for California-based Naked Juice Company, which makes 25 types of all-natural fruit juices. PepsiCo feels that its expertise in distribution and marketing will greatly expand sales and market access for Naked Juice.

Another area of growth for PepsiCo is overseas markets, which now provide a third of its revenue and a quarter of its profit.

Winning new customers worldwide

Spreading economic prosperity in developing countries has made PepsiCo’s products more affordable to more people. The company wisely tailors many of its products for local tastes, which helps it improve its market share.

The company’s balance sheet is strong. Long-term debt of $2.55 billion is just 17% of stockholders’ equity. It also has $2.8 billion (roughly $1.70 a share) in cash. Intangibles represent a high 22% of its total assets. But these include some of the best-known brands in the food industry. In fact, 17 of its brands generate sales of over $1 billion a year.

Strong brands make it easier for the company to pass along higher raw material and other costs to its customers without hurting its market share. They also help shield the company from any prolonged downturn.

The company plans to sell some of its shares in its main bottling affiliate, which should raise $300 million. That will help PepsiCo fund a planned $3.3 billion share buyback plan.

Cheap for a leader

The stock now trades at 19.7 times the $3.30 a share it will probably earn in 2007, which is cheap for a well-managed industry leader like PepsiCo. The company also has a long history of annual dividend increases. The current rate of $1.20 yields 1.8%.

PepsiCo is a buy.