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PepsiCo - Hidden Potato Chip Dominance

March 16, 2012 | About:
Micah Martin

Micah Martin

10 followers
When you hear the word “PepsiCo,” what do you think of?

I don’t have the resources of a major research firm, but I dare say that if you would ask a person on the street that question, the answers would run along the lines of:

"Pepsi"

“Diet Pepsi”

“The Joy of Pepsi”

"That one little girl with the ringlets in her hair from the Pepsi TV commercial"

"Mountain Dew"

"KFC? Taco Bell? Do they still own them?"

"Coke" (embarrassed look)

However, I believe that as investors, our first thought when we think about PepsiCo should not be about any of the above. I believe that, when hearing the word “PepsiCo,” investors should think about potato chips.

Business Summary

PepsiCo is an extremely well-known company that manufactures and sells beverages: carbonated and non-carbonated, dairy products and snacks worldwide. Some of their most well-known beverage brands include Pepsi, Gatorade, Mountain Dew, Diet Pepsi, Aquafina, Tropicana, PepsiMax, Sierra Mist and Mirinda. In addition to these brands, PepsiCo has been seeking to expand their juice/dairy productions primarily via acquisitions in the last couple of years. On the snack front, some of their most well-known brands include Lay’s, Ruffles, Doritos, Tostitos, Cheetos, Fritos Corn Chips, SunChips, Quaker Oats, Aunt Jemima, Cap’n Crunch, Life (the cereal), Rice-A-Roni, Sabritas and Walker’s.

Don’t just skim through that last paragraph.

I know I often go pretty quickly through descriptions of well-known companies, but remember, when you hear PepsiCo, think potato chips...

So, read, again, the brands that PepsiCo owns:

  • Lay's (the world's largest food brand, by the way)
  • Doritos
  • Cheetos
  • Tostitos
  • Ruffles
  • SunChips
  • Fritos Corn Chips


Now picture the potato chip aisle in your local supermarket. If you can’t picture it, next time you’re there, go check it out. You will witness one of Pepsico’s greatest strengths as a company- its dominance in potato chips. I currently live in China, and even here the market share (especially of the Lay’s brand) is quite high. I believe that you would be hard pressed to find a place where potato chips are sold and PepsiCo isn’t the major player.

That’s great, you might say, but what’s the financial performance like? How do potato chips affect PEP’s financial results? Let me show you.

In the “savory snack” market, which consists of potato chips, nuts, pretzels, popcorn, and other similar snacks, here is the 2010 worldwide revenue breakdown (from Euromonitor):

$29.9 billion- PepsiCo

$5.3 billion- Kraft

$1.5 billion- Kellogg's

$1.1 billion- Diamond

$0.5 billion- Nestlé

The market share that PepsiCo owns in the savory snack market is thus extremely large, and there are strong plans to continue to expand market share, both in premium and value categories of snacks.

As far as how this revenue affects and contributes to the company as a whole, I took the following data from the last 6 years of PepsiCo 10-k’s. (6 years ago was when the current business reporting units were formed):

Business Unit Divisions- Revenue/Operating Profit 2011 2010 2009 2008 2007 2006
(In Millions)
Total PepsiCo Revenue $ 66,504 $ 57,838 $ 43,232 $43,251 $ 39,474 $ 35,137
PepsiCo Americas Foods
Frito-Lay North America Revenue 13,322 12,573 12,421 12,507 11,586 10,844
FLNA Operating Profit 3,621 3,376 3,105 2,959 2,845 2,615
Quaker Foods North America 2,656 2,656 2,687 1,902 1,860 1,769
QFNA Operating Profit 797 741 781 582 568 554
Latin American Food/Snacks 7,156 6,315 5,703 5,895 4,872 3,972
LAF Operating Profit 1,078 1,004 904 897 714 655
PepsiCo Americas Foods (Total Revenue) 23,134 21,544 20,811 20,304 18,318 16,585
PepsiCo Americas Foods (Total Operating Profit) 5,496 5,121 4,790 4,438 4,127 3,824
PepsiCo Americas Beverages (PAB) Revenue 22,418 20,401 10,116 10,937 11,090 10,362
PAB Operating Profit 3,273 2,776 2,172 2,026 2,487 2,315
PepsiCo Europe Revenue 13,560 9,602 7,028 6,435 5,492 4,750
Europe Operating Profit 1,210 1,054 948 811 774 700
PepsiCo Asia, Middle East, and Africa (AMEA) Revenue 7,392 6,291 5,277 5,575 4,574 3,440
AMEA Operating Profit 887 708 700 667 535 401


A few observations from the above chart:

1. Despite the economic difficulties, increased commodity costs, and uncertainties of the past six years in North America, Frito-Lay North America has had a six-year annual operating profit growth rate of 6%. That is organic growth in North America alone and doesn’t count any of the high growth Frito-Lay is experiencing in developing economies.

2. Pepsico acquired their bottlers in 2010, which is the primary reason for the doubling in revenue and operating profit increase in the North American beverage business. Growth in beverages has been difficult to come by for PepsiCo in developed economies, but I believe that the bottler acquisition will help.

3. 2011 revenues from food and drinks are roughly the same, but a greater percentage of operating profit comes from food. I emailed PepsiCo’s investor relations to see if I could obtain a division of food/beverage revenue from Europe and AMEA, but they don’t disclose that information publicly. So, if I divide up food/drinks 50/50 from Europe/AMEA, then this would be the (rough and unofficial) break-up (in millions):

Beverage Revenues- 32,894

Beverage Operating Profit- 4,321.5 (40%)

Food Revenues- 33,610

Food Operating Profit- 6,554.5 (60%)

4. Finally, the observant reader will notice from the above chart that these percentages were even more in favor of snacks before the acquisitions of PepsiCo’s bottlers in 2010. In 2009, before the acquisition of the bottlers, food accounted for 62% of revenues and 65% of operating profit, and beverages accounted for 38% of revenues and 35% of operating profit.

In short, I believe that when you buy an ownership in PepsiCo via its common stock, while you do receive value from the beverage business, you are also purchasing an incredible potato chip franchise that has a powerful moat, as well as strong growth potential worldwide. I believe this potato chip franchise will continue to grow in the developed North American market, as well as continue to add strength to the fast-growing AMEA and Latin American markets. With an eye towards furthering this growth, PepsiCo spent an estimated $1.5 billion on research and development of new products and flavors, for both beverages and snacks, during the past three years.

There are vast amounts of information available on PepsiCo’s business, such as the strong growth of Gatorade, their losses of late in market share to Coca-Cola (KO) in their beverage unit, and the continued high cost of commodities, but I believe the strength of the potato-chip franchise of PepsiCo is the most significant business factor when viewing the company as a potential investment.

Management

Some people have complained about CEO Indra Nooyi’s leadership and the lagging stock price during her tenure, but in my opinion she has done a great job with the cards she has been dealt. She came into leadership in 2006, right before an extremely turbulent economic time worldwide. In addition, she has faced high commodity costs and more selective North American beverage customers than past PepsiCo CEO’s have confronted.

Despite these challenges, I believe that she has hit some home runs while CEO, including the bottler acquisition to give PepsiCo greater flexibility in the North American drink market, a move which Coca-Cola quickly followed. She also presided over the major 2010 acquisition of Wimm-Bill-Dann Foods, Russia’s leading branded food and beverage company. Importantly, these acquisitions have been done with an eye to protect shareholders’ interests and not dilute their shares.

She has also increased PepsiCo’s emphasis on nutrition and healthier products, which I believe will pay dividends in the long run. Wimm-Bill-Dann, for example, is extremely strong in dairy products and juice, and will be an asset for PepsiCo as the company strives to increase the nutritional value of its food.

Competitors

When discussing competitors for PepsiCo, the first one that comes to mind is Coca-Cola. While Coca-Cola is the most significant single competitor, there are vast differences between the two companies, such as:

1. As mentioned above, PepsiCo receives significant revenues/profits from food, whereas Coca-Cola only produces beverages.

2. PepsiCo has more of a stake in North America (and the U.S. in particular) with the dual combination of its food and beverage business. Coca-Cola has larger volume and revenues from overseas.

3. PepsiCo’s No. 1 stated goal is to grow its snack business. Coca-Cola’s No. 1 stated goal is to grow its global beverage leadership.

Other competitors to PepsiCo that compete against the macrosnack business include Kraft, Nestle and Kellogg's, but in terms of actual "savory snack" competition, most of the competition does not come from any large multinationals, but rather from smaller, more regionally based potato chip companies.

Financial Strength

PepsiCo has consistent free cash flow, and that cash flow has been growing at an average annual rate of 7% for the last 10 years. The total free cash flow for 2011 is roughly $5.6 billion. It has used this cash flow in the past decade primarily to finance acquisitions, pay dividends, and buy back shares. This year management plans to spend an additional $3 billion to buy back additional shares, as well as more than $3 billion paying dividends.

The primary financial concern I currently have regarding PepsiCo is in regard to their debt position. They have been aggressively adding debt to take advantage of current low interest rates, and since January 2008 have tripled their liabilities while only doubling their assets. At the end of 2011, their current ratio was less than 1 for the first time in at least 10 years.

I am not overly concerned about their debt, as they do have strong free cash flow, but it is an area I will be keeping an eye on throughout the next year.

Risks

The biggest real risk to PepsiCo in the near term is continued historically high commodity costs, especially in combination with the current global macro-economic uncertainty. PepsiCo has stated in the past and again mentioned in their 2012 outlook that they will not be able to pass along all of the commodity costs they are experiencing along to price-conscious consumers in the form of higher prices.

Other risks, such as flat or declining soda consumption in the US, and an increased customer focus on health, could continue to slow PepsiCo’s growth, but I believe that management has taken and is taking active steps to counter these developments.

Finally, I freely admit that I am no expert on the European economy or Russia, but roughly 20% of PepsiCo’s revenue does come from Europe, and roughly 25-30% of that European revenue (5%-ish of PepsiCo’s total revenue) comes from Russia itself. With European debt problems and Putin getting re-elected — much to the dismay of some Russians — there is definitely a chance, however remote, that financial or political crises could impact revenue/growth in Europe.

Valuation

PepsiCo is currently trading at a historically low valuation by a number of different metrics (price/sales, price/cash flow, and price/earnings, among others.) If you slap a P/E ratio of 15 on 2011’s core EPS of $4.40, the resulting price is $66. I don’t think there is much margin of safety in that price, so I will consider purchasing additional shares were the price to get back in the $60-61 range.

In addition to its historically low valuation, at $64.50, PEP is yielding 3.3% for its next dividend payment in a few months. At a price of $61.50, where I would consider buying, the dividend yield would be 3.5%.

Combine the dividend yield with 40 years of annual dividend growth, share buybacks, and a shareholder friendly management, and I believe that a defensive investor willing to pay a fair price for a wide-moat, quality company will find PepsiCo a reasonable long-term choice.

Over a 10-year time horizon, I expect PepsiCo’s total return to be satisfactory and believe that by continuing its growth in both dividends and earnings, it could very well beat the long-term S&P 500 average during that time period.

Guru Purchases

As this is GuruFocus, it’s worth also noting that several gurus have been adding to their stakes in PepsiCo in the last quarter (ending 12-31-11), including George Soros, Mario Gabelli, and Donald Yacktman. Donald Yacktman, in particular, has demonstrated strong commitment to PEP, adding to his sizable stake in PepsiCo in recent quarters, buying approximately 2 million shares last quater between prices $60.29 and $66.57. It is currently the largest holding in his Yacktman Fund, comprising 10.59% of total assets.

Disclosure: Long PEP

Rating: 4.2/5 (24 votes)

Comments

mcwillia
Mcwillia - 2 years ago
Timely and insightful article. PEP is a value and yes, their salt franchise is more valuable than their sugar franchise. Nice job.
sjzhao2003
Sjzhao2003 - 2 years ago
Nice job. I agree with you and Don Yacktman that the snacks business is more valuable but less visible than the soda business.

But a couple of points are worth thinking about. One, Pepsi dominates the snacks aisle in the US, but the picture is far less clear in many faster growing emerging markets because taste preferences are different and there are always local champions to deal with. That's why PEP has to ramp up R&D expenses. But if the outcome of the R&D only serves specific local markets, return from R&D will be lower and the business will be less attractive. Also, people seems to want more excitement from snacks, hence more R&D to come up new flavors every year (the product cycle is much slower in the soda business). Two, Indra Nooyi's incompetence has to be dealt with, preferably soon. There are many reports on her strategic missteps, which i don't see the need to regurgitate here. Luckily, the damage has not been fatal, which is indicative of the quality of the underlying assets.

Overall, if i have to choose between KO and PEP, I'd prefer KO even with a little bit of premium, because the soda business is far more attractive than the snacks business. Part of the reason is the pace of the product cycle, and another reason is that soda aisle is dominated by two BRANDS, whereas the snacks aisle is dominated by one company through many brands, so the branding support (read, spending) is much higher. If you compare the margin for KO with that of PEP's beverage business, that tells you why KO is a better run business and deserves a premium.

Micah Martin
Micah Martin - 2 years ago
Thanks for your thoughts Sjzhao2003! My responses to your points are below:

1. It’s definitely true about emerging markets having different taste preferences… I live in China, where Lay’s market share is high, and while Lays’ “Hot and Sour Fish Soup” potato chip flavor doesn’t really do it for me, it’s fairly popular among many Chinese people. That said, some flavors do cross cultural taste preferences- Lay’s Classic American flavor is the #1 most popular potato chip in China.

2. You make an excellent point regarding the product cycle being much slower in the soda business than in snacks. I probably should have considered that more when studying PEP. However, I do believe that PEP’s R&D expenditures are in line with other food companies. Based on their 2011 10-k’s, KFT spend 1.3% of revenues on R&D and K spent 1.4%. If you just take PEP’s revenue from food ($30 billion) , they spent roughly 1.67% of food revenue on R&D in 2011. (That assumes ALL PEP’s R&D expenditures go towards food, but I’m sure at least some of it goes to the beverage business.) In short, $500 million a year for R&D is something I’m totally fine with to keep the profitable snack business growing in emerging markets and to give consumers more choices to be excited about.

3. A lot of people have opinions on Indra Nooyi, and I don’t believe I am qualified enough to declare her incompetent- I still have a lot to learn. However, while she has made mistakes, in 10 years when people look back on her time as CEO, I think there are 4 accomplishments they will remember her for- 1) Acquisition of the bottlers, which Coke quickly followed, 2) Acquisition of Wimm-Bill-Dann, 3) Emphasis on nutrition, and 4) Keeping the snack business and the beverage business intact. In all four of these situations, I think she did a good job thinking long-term.

4. I agree with you. KO’s beverage business is better than PEP’s beverage business. If I were looking to buy solely a beverage business, I would look to purchase KO. I also think you’re right in that the soda business is an extremely attractive business to invest in. (I think that’s why Warren Buffett owns KO.) The current margins are indeed higher at KO as well. All that said, I still believe that PEP is a strong long-term value for the price, primarily because of the hidden strength of their snack business.

sjzhao2003
Sjzhao2003 - 2 years ago
Ms Nooyi may have a plausible or even worthy vision for the company, but such vision has yet to be translated into consistent profitable strategies under her rein so far. One can't help wondering about her leadership capabilities. In addition, the many blunders in e.g. marketing would not have occurred without senior management's support, even though they are more tactical, rather than strategic, issues. Given that Nooyi has been there for a long time, I have to believe that the board hasn't done a stellar job of protecting shareholder interest, and I'm not sure they'll pick a more capable successor. As Buffett observes that the return on the equity-bond largely depends on management caliber, and that is where I'm having a lot of issues with PEP, despite the fundamental properties of its underlying businesses.
Micah Martin
Micah Martin - 2 years ago
Yes, she has made tactical mistakes while CEO. She has also admitted mistakes a number of times during her tenure. Sometimes her ideas (or others' ideas that she supported) weren't the best. I have no problem admitting that because it is true. Last month, for example, she herself admitted to the investing public that she acted too slowly both in funding PepsiCo's primary brands and making personnel moves last year.

This is where we differ: I don't believe her mistakes are significant enough to detract from the long-term investment value of PepsiCo. You do. Rather, I believe that her past mistakes allow me to purchase shares of PEP at historically low prices, and that the people and brands of PepsiCo will be profitable for years to come.
Cogitator99
Cogitator99 - 2 years ago
Thanks Micah for the interesting post. Curious as to what you think fair value for PEP is at the moment, and where it can be 3-5 years from now.
Micah Martin
Micah Martin - 2 years ago
Hello, Cogitator99. I hesitate in giving predictions five years out (which is why I didn't add the below numbers into my above article). The future is sure to be fickle. However, these are my personal estimates I am using in my investment decisions:

Fair Value Range- $72-77.

Estimate of Price Range 5 Years From Now: $78-87.

I believe these figures to be conservative, especially the lower end of each range. I think, personally, that there is a lot of upside in PEP while it is priced in the low $60's, but am not willing to pay too high of a premium for possible growth.
Cogitator99
Cogitator99 - 2 years ago
Fair enough. In my mind its worth about $75, so I was wondering what your range was.

Pretty much agree with what you wrote here. I already own PEP (6% position) but I was hoping to pick up more at a lower price. In my opinion everyone should have a high quality large cap component in their portfolio and this company is certainly a good candidate.

Thanks for your post, and looking forward to more of your work!

cyclop9
Cyclop9 - 2 years ago
Great article and insightful comments from readers...

But you mentioned this without going in detail: "_ but in terms of actual "savory snack" competition, most of the competition does not come from any large multinationals, but rather from smaller, more regionally based potato chip companies."

Could you name a few of those competitors especially i the Eastern and Western Coasts.
Micah Martin
Micah Martin - 2 years ago
Cyclop9,

Yes, I didn’t go into detail regarding PEP’s regional competitors because: a) it would make the article too long, and b) I don’t believe naming dozens of PEP’s regional competitors is necessary for an analysis of the company.

There are hundreds of local companies that compete in the “savory snack” industry in the US, but for a handy little list of some popular regional potato chips (including East and West Coast companies), check out:

http://www.countryliving.com/cooking/regional-foods-and-events/chip-brands-0709#slide-1

(I grew up in Iowa, and can definitely vouch for #11- Sterzing’s. They’re extremely delicious and highly recommended! Next time you’re in Iowa, be sure to buy a bag of Sterzing's…)

Please leave your comment:


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