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:
“The Joy of Pepsi”
"That one little girl with the ringlets in her hair from the Pepsi TV commercial"
"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.
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)
- 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
$0.5 billion- Nestlé
The market share that PepsiCo owns in the savory snack market is thus extremely large, and there are strong plans to continue to expand market share, both in premium and value categories of snacks.
As far as how this revenue affects and contributes to the company as a whole, I took the following data from the last 6 years of PepsiCo 10-k’s. (6 years ago was when the current business reporting units were formed):
|Business Unit Divisions- Revenue/Operating Profit||2011||2010||2009||2008||2007||2006|
|Total PepsiCo Revenue||$ 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 (NYSE: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.
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.
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.
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.
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.
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.
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