On Wednesday morning, PepsiCo (NYSE:PEP) reported third-quarter earnings, which beat estimates and closed up nearly 3% as a result. Last month the company spoke at the Barclay’s Back to School Consumer Conference, where they discussed the current headwinds they are seeing in the business and the economy. My key take away from the conference was this quote from CFO Hugh Johnston:
“The environment we currently operate in will not remain challenged forever. Commodity markets will rebalance and the developed market consumer will recover. The decisions that we make today will determine how we'll participate in that future recovery.
We have a fantastic portfolio and we worked hard over the past ten years to get our portfolio to this point… Our portfolio is positioned in attractive, global growth segments.
We believe the mix of our businesses across segments and geographies will produce consistent solid revenue growth, attractive and expanding margins… and strong cash generation and returns to shareholders.”
Heading into the conference, the chatter around PepsiCo was about a potential split up between the snacks and beverage business; here’s a quote from Bernstein Research analyst Ali Dibadj (from a phone interview): “There’s a large chunk of the company that’s just suffering, which is the North American beverage business, and that’s dragging down the rest of the company, which is doing okay; the point of the split is that you’re not getting the benefit of being together.”
Our first argument: no benefit from being together. Let’s look at what Mr. Johnston had to say during an interview on CNBC this morning:
You know, in all candor, I really don't see a lot of value in the idea. Let me start by saying, we turn over every stone to try to unlock value for shareholders; that is the purpose we have as management is to unlock that value for shareholders. As we look at things like emerging markets where we have the businesses combined across both the value chain as well as in the front and in trucks and with customers, and even in North America where we've got combined back office, combined R&D, combined procurement, even combined selling… I do know that splitting up the two businesses would create a lot of additional costs; the benefits to me are completely unclear so looked at it and just frankly don't see a lot of merit in the idea.
The go-to market benefits and the position of power that PepsiCo holds as a dominant partner for retailers is severely weakened by separating the two businesses and bringing in unnecessary redundancy costs. A great example of the benefits from the combination of the two businesses is in Russia, as noted during the Q&A on the third-quarter call:
I have to say we're delighted with the performance of our business; competitively, very strong. We've continue to manage our pricing carefully to protect gross margins, and to continue to drive revenue growth. And that's across all of the diverse categories in which we operate. Now, clearly, there will be a few more challenging months still ahead in Russia, and this is where scale [and strength] of your operating businesses really, really counts. At more than 2x the scale of our nearest competitor, with this very diverse operating model across a diverse set of categories, and really just a tremendous Power of One model both in terms of the supply chain that we operate across that geography, the strength of our go-to-market systems, both in traditional trade and organized trade… We've continue to make investments in Russia, but we have emphasized in our investments in go-to-market systems and our selling capability. We've expanded significantly the number of routes in 2011. We put more than 250 new routes to support that very broad-based business. We've continued to invest very strongly in coolers and racks, because driving our single-serve business, driving our traditional-trade business and having a platform to leverage all of those categories across is critical to our long-term future.
Another example from the call is in the convenience store channel, where PepsiCo is the company behind 11 out of the 15 top products sold. John Compton, the CEO of the PAF division, had this to say: “It's nice to have 11 out of the 15 top new items in the C&G channel, but that led PepsiCo to be the largest dollar growth contributor to the channel. So we are very important to the C&G store business, and they're pleased with our growth year-to-date.” The point is clear: accounting for a significant portion of a retailer’s sales is a competitive advantage, one that PepsiCo has and will continue to use to their benefit.
The second problem I have is that splitting up the business does not create value for long-term shareholders; on the other hand, it would certainly generate fat fees for bankers. In the many articles I have read on the topic, here is what are listed as the two rationalizations for the split: First, the stock has lagged Coca-Cola (NYSE:KO) and Dr. Pepper Snapple (NYSE:DPS); second, that the sum-of-the-parts valuation comes in anywhere between $70-90 a share (depending on who you ask), which means that it should be done.
On the first point, I don’t know what to tell you; if you won’t buy a cheap stock because it underperformed a competitor or an index over some time period, you are likely not a value investor, and have no interest in names like PEP, WMT, MSFT and BRK.B. This difference in philosophy may keep you from buying a great company like PepsiCo until the price confirms your beliefs (where I’m from, that’s called “dumb money”).
On the second point, I only have to go back three short months. In July, PEP was trading above $70 a share, in line with the lower end of valuation estimates (Mr. Dibadj is at $72); since then, the stock has fallen 10%, a bit more than the mid-single digits on the DJIA and S&P 500. This is a frequent occurrence in equity markets, with prices jumping between levels of over and under optimism, often based on short-term issues (like commodity inflation, a weak economy, etc); splitting up businesses with clear advantages from being together as one for the sake of short-term profits is irrational.
When Bill Ackman brought the axe to Fortune Brands, it made sense; there were no clear advantages from selling golf balls, tequila and shower faucets under one roof. The same is not true at PepsiCo, where the benefits are seen in all aspects of the business. For investors in PEP common, be thankful that management has shot down analysts' call to destroy long-term shareholder value by splitting up the snack and beverage businesses for the sake of a short-term payout.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.