PepsiCo: Value with Safety

When investors talk about value, the company generally imagined is small, under the analyst radar, and/or (if known) unloved. In the case of my pick for the GuruFocus Monthly Value Idea Contest, it seems to clash head on with these general assumptions. For starters, it certainly isn’t small or unknown; with revenues for FY2009 of more than $43 billion and a current market cap of roughly $102 billion, PepsiCo (PEP) is the 30^th largest company (by market cap) in the United States. As for PEP being unloved, I’m less confident to categorize that answer. For value investors, PepsiCo has certainly been well liked over the past six months, with gurus Donald Yacktman, Jeff Auxier, John Hussman, and Mario Gabellli all adding shares (each of whom owns more than one million shares). On the other side, the business has taken some heat, mostly due to the declines of carbonated soft drinks sales in the United States (which fell 2.1% in 2009 and marked the fifth consecutive year of declines in the category) along with the headwinds of a global recession, which caused year over year revenues (2008 to 2009) to remain flat. As a result, while the S&P 500 has jumped forward 17% over the past six months and competitor Coca-Cola (KO) has hung on with a 10% appreciation in price, PepsiCo has sputtered, falling 3% over the same time period. On top of that, based on the company’s guidance given after Q3 2010, EPS for the year should rise between 11-12% to $4.21-4.24/share for fiscal year 2010, suggesting a P/E of roughly 15.2x at the current price of $64.15/share. This compares to Coca-Cola at 18.3x (based on just reported EPS of $3.45), Dr. Pepper Snapple (DPS) at 16.62x, and an industry average of 17.64x. While the problems presented from the decline in CSD’s and the global recession are well documented, I believe they are factually weak and fail to consider a couple of key trends; I believe their flawed rationale presents a value opportunity for long term investors with very limited downside risk (meaning permanent loss of capital).

The first thing to consider is that PepsiCo American Beverages (PAB), the business unit accountable for beverage sales (including RTD teas and coffees, sports drinks, juices, etc) in both North and South America accounted for $14.105B of the $39.683B in company revenues through the first nine months of 2010, equal to only 35.5% of total revenues (and 28.9% of operating profit). In reality, their chip/snack business (Frito Lay North America or FLNA) is more profitable than PAB, with operating profits of $3.26B vs. $2.17B in 2009. While PepsiCo may be known by their flagship brand, it is critical to realize that the relevance of CSD’s, while still important, is being mitigated over time with the expansion of other beverages and snack categories.

For the North American CSD business, the bottler acquisitions are another key point of recognition. Despite synergies (which are expected to exceed $400 million for the year 2012), I wouldn’t base an investment on potential savings. The point I wish to bring up is that PepsiCo has experience running the day to day operations from operating the Frito Lay snack business. As noted by CEO Indra Nooyi in March of last year, "The integration of the bottling companies into PepsiCo is going to be effortless because we know exactly how to operate a company where you've got to manage everything right [down] to the decimal point". In addition to the importance of managing costs in the mature CSD business, this will must sure costs are kept under check in growing categories as well. Based on the company’s success on the snack side, I expect the results from moving the bottlers in house to be beneficial to owners.

Any thorough analysis must include a look at the potential growth opportunities. Based on the 2010 EPS figure from above and fiscal year 2000 EPS of $1.51, PEP achieved EPS growth of 10.8% per annum over the past decade. That was during a period where the decline in CSD’s has already taken hold, along with the effects of a global recession at the end of the period. While that says a lot (and makes me optimistic), it doesn’t change the fact that the CSD business in the United States could easily continue to deteriorate. What will happen to future growth for PepsiCo in that scenario? Even though I think that outcome has been unrealistically extrapolated (by failing to adjust for industry innovation), I will play devil’s advocate and accept the continued decline of CSD volume in the United States. As I will discuss below, I believe that M&A, organic growth in international markets, Glocalization, and expansion into better for you products will be the key drivers of growth for PepsiCo over the next decade, and will lead to EPS expansion that outpaces the 10.8% growth since the turn of the century.

Ever since the merger of PepsiCo and Frito Lay in 1965, M&A has been a key part of the company’s growth. While some forays into “Diworsification” have occurred (like the purchases of KFC, Taco Bell, and Pizza Hut in the 70’s and 80’s), others, like the Tropicana and Quaker/Gatorade acquisitions at the turn of the century, have helped to develop the product portfolio that is currently driving PepsiCo profits. M&A in the past couple of years has been focused on developing the future of the beverage portfolio, especially outside of CSD’s and in international markets. One example is Lebedyansky, the largest natural juice producer in Eastern Europe, which was acquired by PepsiCo in March 2008. Not only does this give PepsiCo 42% of volume in the Russian juice market (home of 141 million people), but when coupled with the recent Wimm-Bill-Dann Foods acquisition (currently being completed) makes PepsiCo the largest food and beverage company in Russia. For the first nine months of the year, the company has achieved double digit increases in beverage volume and single digit growth in snack volume in Russia.

Organic growth also plays a key role in international growth. As YUM! Brands (YUM) investors would happily tell you, the company added more than 262 restaurants in China during the fourth quarter, and more than 500 throughout 2010; in aggregate, the company has more than 3,700 KFC’s and Pizza Hut’s in China, along with another 6,350 in emerging markets across 67 countries. At those 10,000 plus restaurants, the emerging middle class is being introduced to the PepsiCo product line each and every day (lifetime contract with PepsiCo). It’s like McDonald's (MCD) for Coca-Cola in the U.S., except that China has more than four times the population. Without delving into demographic/economic shifts in emerging markets, I think it is safe to say that PepsiCo will clearly benefit from this trend in the future. This is being reinforced by PepsiCo’s own push into AMEA (Asia, Middle East, and Africa), an operating unit that has reported net revenue growth of 19% through the first nine months of 2010 (to more than $4.5B).

Another aspect of this organic growth is being driven by the success of marketing and Glocalization efforts. A great example of this is the extension of Lay’s potato chip, the largest global food brand in the world. Worldwide sales for this brand exceeded $8.5 billion in 2009, and have grown at a CAGR of 13% over the past 25 years. PepsiCo’s savory snack share is almost unbelievable: 64% in the United States, 76% in Mexico, 62% in Russia, 44% in the UK, 39% in India, and the leader in market share in 31 other countries in which they compete. How has PepsiCo been able to replicate their domestic success in international markets? They have gave consumers what THEY want, not what WE want. Examples include red caviar flavored chips in Russia, chili limón chips in Mexico, and soft shell crab flavored chips in Thailand. Following a similar strategy has made Ruffles the #1 savory snack in Brazil, where revenues and net operating profit before taxes have increased 3x and 10x, respectively, in less than six years; as a reference, per capita core savory consumption is still only 1/3 of Mexico and 1/10 of the United States in Brazil.

The continued success of PepsiCo in marketing and product development is well documented; in 2009, they had the highest amount of new product sales out of any company in the industry in North America ($536M). The company currently has 19 brands that have retail sales in excess of $1 billion, compared to only six in 1990 and one in 1980. Fast Company recently ranked Frito Lay the most innovative food company in the world, attributing 12 of the top 20 snack innovations of 2009 to the company. Many of these brands are currently sitting in the $250M-$1B sales range (roughly 15 brands), and will be the future $1 billion brands of PepsiCo. Continued innovation (like Trop50, which achieved over $100M in revenues in its first 12 months) and Glocalization (like the soft shell crab flavored chips) is the reason why of the $180 billion global macro snacks market, PepsiCo commands a 17% share; expect for this to continue to grow as they expand into adjacencies (things like nuts and dips/spreads, which they have already started doing in places like Brazil and at your local grocery store).

The expansion into healthier (called “better for you”) products is also a strategic shift for the company. Since the recent Wimm-Bill-Dann acquisition, this category accounts for roughly $13 of net revenues, and achieved top line annual growth of 10% over the past three years. As CEO Indra Nooyi has recently noted, the company’s goal is $30B in revenues from this category by 2020, implying 11.6% top line growth per annum in better for you products (from the base $10B). On top of these new categories, look for PepsiCo to focus on nutrition as an aspect of CSD/savory snack development. While this growth with mostly be non-organic, there are some opportunities from the current portfolio.

In 2010, the company converted their entire Lay’s Kettle business and Lay’s flavors business to 100% all natural, meaning no artificial colors, no preservatives, no artificial flavors, and made with all natural ingredients. As noted by PepsiCo America Foods CEO John Compton, “We have talked extensively to consumers about this idea, and they come back and tell us the number one motivation for purchase is products that claim to be all natural.” The Lay's potato chip business has grown roughly 8% since the all natural rollout, compared to a food and beverage category that has booked less than 1% growth. On top of that, Lay’s grabbed an additional 1.7 share points during that same time frame, which is impressive expansion in the highly competitive potato chip segment. Based on this early success, PepsiCo is set to make a big push into all natural in 2011. The platform will be expanded to include Tostitos, Sun Chips, and Rold Gold, as well as Fritos in the back half of the year. When all is said and done, more than 50% of the Frito-Lay portfolio will be launching all natural next year. This shift has helped to draw in a crowd that tends to avoid “junk food”. As noted by Mr. Compton, “...the purchase intent went up for heavy users, medium users, and importantly, light users who tend to come and go from the category.” The company also launched the first natural mainstream CSD with Sierra Mist Natural in the past six months; while it is still early to tally the results from this endeavor I think it is safe to say that PepsiCo will continue moving in a direction that looks to satisfy health conscious consumers.

Besides these business/strategy advantages, the company is also shareholder friendly. From 2002 to 2009, the company returned $37 billion to shareholders through buybacks and dividends. With a current dividend yield of roughly 3% (the dividend has doubled ever six years since 1978, on average) and an earnings yield of 6.58%, the total yield at the current valuation is roughly 9.58%; this compares to a current ten year bond yield of 3.65%. So you are essentially receiving 3x as much earnings for the same amount of investment on two securities that I would personally consider to be of comparable risk. With that being said, 10 year T-bills are probably the last place you want to be right now, so choosing PEP stock as an alternative is not the best measure of value.

PepsiCo is not a place to look for a quick 50% gain. But this is the kind of investment where you can park your capital for 5-10 years and expect to achieve 10-12% per annum with limited risk. Based on PepsiCo’s current position and the recent moves that they have made in securing long term share in emerging markets, I think that there is no reason to expect PEP to trade below the industry average considering an average ROE in the low 30’s and an average ROA in the mid/high-teens over the past ten years; in fact, the current P/E is lower than the low P/E reached from 2000-2007. As noted in the paragraphs above, the justification for this is weakening with each strategic change management makes, and with every long term investment that has the potential to become the company’s next $1 billion brand. The catalyst for the multiple expansion is continued success in driving international growth and successfully leveraging the advantages of moving the bottlers in-house.

If the stock was to reach the industry average multiple of 17.64x, the price would increase $10.27/share, or 16% from today’s quoted price. To me, that would be a very nice short term gain considering the rare chance of permanent loss of capital.

This analysis has focused on the business and the strategic direction rather than on specific forecasting. The basis for the value play (in the short term) is based on comparables with historical multiples and industry/competitor multiples, which are far from flawless. More importantly for true investors, the basis for value in the long term is the company, the management, the brands, and the people.

Competitors, as always, will be there trying to take share. The near duopoly with Coca-Cola in beverages and clear leadership position in key markets in savory/salty snacks are the competitive moats that management must continually defend at all costs. On top of that, management has it's eye on expanding share in adjacent categories, a move that could add to the moat in the coming years. Recent marketing projects, like the Pepsi Refresh and Crash the Super Bowl advertisements have done a fantastic job of creating a connection and feeling for the brand, especially among younger consumers. I personally think long term value investors will be handsomely rewarded for buying shares of PEP and holding them for the next 5-10 years (barring 30/40/50x multiples on large caps like in 2000; in that case, sell all your stocks and buy some far out index puts).

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