PepsiCo (PEP, Financial) is best known as the competitor to Coca-Cola (KO, Financial). The two giants effectively have the market for black gold (the other black gold) split between them. In addition Pepsi manufactures and sells salty and sweet snacks. Brands include: Pepsi, Mountain Dew, Gatorade, Tropicana, Lay's, Doritos, and Quaker. The food unit makes up 50% of revenue and the company derives approximately 50% from the U.S. Pepsi’s salty snacks have a large market share which is providing the company with a strong competitive advantage through scale. Back in the 60’s in the so-called conglomerate era, you may remember Teledyne, Pepsi merged with Frito-Lay. The combination has survived changing preferences among investors so far. Today, conglomerates are not popular. Buffett refers to the practice as empire building and diworsification, while academic theory also takes a dim view of the practice. Activists work 24/7 to break up stalwarts left and right and sometimes the initiative even comes from within.
Financial strength
PepsiCo is geared conservatively. With $9 billion in cash, only $30 billion in long term debt and TTM Ebitda of $12 billion its looking like a buyout-waiting-to-happen. In all seriousness, PepsiCo has a strong balance sheet. It can get into trouble if everyone stops eating chips and drinking soda but it is a pretty safe bet people are not going to, to that extent. Not too mention Pepsi is trying to diversify into more healthy offerings.
Management
Chairman and CEO Indra Nooyi has been running the show since 1994 after being promoted from the CFO position. She owns 2.8 million shares, so it is fair to say that she is invested into Pepsico’s future. Still, she and her team are on the receiving end of a fair bit of criticism from investors. Most notable in that regard are the presentation from the Trian Fund lead by Nelson Peltz and the letters to the board. I will quote a key paragraph below (emphasis mine):
We would like to see a separation of global snacks and beverages to empower focused management while eliminating the holding company structure and the excessive bureaucratic costs that go with it. We would close the Purchase and Chicago facilities (Quaker Oats to be run out of Frito-Lay and Tropicana to be run out of North American Beverage), thereby eliminating significant unnecessary corporate costs by having two headquarters (Plano for snacks and Somers for beverages) instead of four. Separating the businesses and closing Purchase and Chicago will be the catalyst to further and significantly reduce what we believe are billions of dollars ($1.1 billion of publicly disclosed “unallocated” corporate costs plus what Trian believes is a multiple of that amount which is undisclosed and “allocated” to the divisions) presently being spent on a centralized corporate bureaucracy
Both corporate bureaucracy and the strategy of keeping the beverage and snacks business together are criticized in strong words. The management team stands firmly behind the “Power of One” strategy which is to keep the businesses together, but I lean towards agreeing with activist investors that it is probably not a sound strategy. Although “The Power of One” effectively serves as a motive to keep the companies together there are compelling reasons to split them up. The strategic rationale of keeping the companies together to create economies of scale do not hold up well. How much scale do you get if you have a beverage business and you also make snacks that have their own brand… Not a whole lot but more about that later.
Valuation
Coca-Cola, which is Pepsi’s major competitor in the beverages market, trades at roughly 17x EV/Ebitda. You could conceivably argue Pepsi’s business is inferior to that of Coca-Cola which has a larger market share; but on the other hand, Pepsi’s salty snack business is a clear leader and it is still capturing more market share (see graph below). Not too mention it has tremendous growth potential globally.
Find more statistics at Statista
The reality is, the market is assigning PepsiCo only a 13x EV/Ebitda multiple and it may deserve so with its current strategy. These multiples are not super low by any means but you should not forget that these are defensive industries with predictable cash flows. The market tends to trade up these issues until only a moderate return is to be expected albeit with a high likelihood to actually materialize.
Pepsi offers something extra compared to other defensive stalwarts with that wild card upside because of the involvement of Nelson Peltz and the Trian Fund. I could very well see Bill Ackman (Trades, Portfolio), a famous activist who is looking for a big target, swooping in and support his efforts. The 3G guys, Brazilian investors who do LBO’s, backed by Warren Buffett (Trades, Portfolio) could tackle PepsiCo as well. It is right within their circle of competence and they are famous for cutting out excess costs. Excess costs are available in abundance according to Peltz so these specialists would have a field day. It is all speculation, but even a 3G executed split of PepsiCo in a beverage and snack business to subsequently merge Kraft and the current PepsiCo snack business would be an option. If that could pass muster with regulators, I'm not so sure though. Warren Buffett (Trades, Portfolio) would never undertake anything like this on his own. But he has shown to respect and be willing to team up with 3G in the Heinz and Kraft deals. He is also on the record saying he would have liked to own PepsiCo but perhaps due to his passive investment strategy he has not rectified that "mistake".
If you want to go on a stretch and assume costs are going to be taken out of the current PepsiCo structure, perhaps through brute activist force or through current management’s independent actions, that could lead to an increase of pro-forma EBITDA by $2 billion. At such a level of pro-forma EBITDA the company is trading at just 11.5x. That is not a lot given its profile as a defensive stalwart. As far as valuation goes, PepsiCo is not cheap but it is attractive given the predictability of the future cash flows actually materializing.
Risk
The U.S. and Europe are slowly trending away from a preference of sweet carbonated drinks to healthier alternatives like juice, water and others. Energy drinks are a strong category though. If this trend suddenly accelerated, that would definitely put pressure on the share price. Healthier snacking may pose a threat in the same way. Although PepsiCo has a few horses in the health game, it is still very much dependent on trafficking sugar and fat.
Outlook
In a vacuum Pepsico is by no means a bad company to own. It is a defensive type of stock that is likely to hold some value through most recessions. People continue to require beverages and snacks and Pepsico provides calories at a reasonable price backed up by a stable of strong brands. If things continue along as is, the stock may very well turn out to do just fine.
It gets much more interesting when we take into account certain value unlocking events. With the Trian’s fund involvement this is not just a hypothetical situation. The fund got a director assigned on the board and is actively working to unlock shareholder value. Since it got a board seat mostly behind the scenes.
In my opinion the “Power of One” is not a credible strategy to maximize shareholder value. Instead, it smells like a way to legitimize empire building or in this case, empire defending. After reviewing the New York analyst presentation that was put on earlier this year it confirmed this impression. It looks like it was designed to fend off some of the heat over the company’s “Power of One” strategy which was now referred to as “Better Together” and supported with half the slides.
Source: PepsiCo analyst presentation
The strategic rationale is that PepsiCo can leverage its scale and portfolio of brands to get premier positioning inside of stores.
The much more credible counter argument is that Pepsi’s effort to “bundle” Frito-Lay with Pepsi Beverages actually puts the brakes on Frito’s ability to compete. So what the company gains in additional beverage sales it loses in snacks.
This is a shame because Pepsi has a incredibly strong market position in salty snacks with dominant brands and has to give up competing for space where retailers insist on serving Coca-Cola.
What it all boils down to, is that PepsiCo in its current form is not a terrible investment by any means. Compared to Coca-Cola it looks pretty cheap and there is a terrific snack division hidden by the beverage segment. Investors can expect defensive stalwart type of returns but with a kicker. If lucky, a series of restructuring or corporate events take place and the different segments could re-rate and trade much closer to Coca-Cola type multiples. This implies significant upside in the 50% ballpark.
