A Great Company Hiding Inside of an Average One

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Investors seem to love PepsiCo (NYSE: PEP), and the company’s improved performance is obvious in certain areas. Since the company is doing well and recently increased its dividend yet again, it’s understandable that the shares have performed well. That being said, there are several things that PepsiCo investors need to realize, not the least of which is that their company should be doing so much better.

Years and years of competition, and still losing
PepsiCo investors I’m sure would say they don’t really care if the company wins the beverage wars with Coca-Cola (NYSE: KO). However, the beverage wars are more complicated than just Coke versus Pepsi. In fact, in the beverage industry, there are two different segments of the industry, and the sad part is, PepsiCo is losing both battles.

The first battle is in the carbonated beverage industry, and PepsiCo seems to have given up the fight. The main players are Coke and Pepsi, but Dr. Pepper Snapple (NYSE: DPS) is heavily focused on carbonated beverages as well. In fact, Dr. Pepper Snapple’s CEO said that “changing consumer behavior takes time, and we remain committed to giving consumers a reason to come back to the CSD category.”

With competitors this focused on carbonated beverages, PepsiCo seems less than focused with, carbonated beverage volumes down mid-single digits in the current quarter. When you compare this performance to Dr. Pepper’s decline in carbonated beverages of 2%, and Coca-Cola’s flat sparkling beverage volume, you can see that PepsiCo is losing market share to their competition left and right.

With PepsiCo America consistently underperforming its peers, the choice seems clear: PepsiCo needs to split its underperforming beverages business with its better performing Frito-Lay snacks business.

What are you waiting for?
If there is one question I would like to ask PepsiCo management, it’s "what do you see in the Quaker Foods business?" This division has been underperforming for multiple quarters, and yet again performed poorly in the current quarter. Quaker Foods reported anemic volume growth of 1%, but with operating profit down 14%, clearly the company had to cut margins to gain even a small amount of volume growth.

What’s worse is, Quaker Foods is a small part of the overall PepsiCo empire, and this quarter’s performance was actually better than in the past. The benefit to PepsiCo when they acquired Quaker Foods was the Gatorade brand. Since Gatorade is a more logical fit with the PepsiCo beverages business, there is simply no reason to maintain the Quaker Foods business. This business should be either sold or spun-off immediately.

2 red flags
Some investors might say it doesn’t matter if PepsiCo takes these steps to improve their business because the company is doing fine already. That might be true, but there are two issues facing the company that investors need to realize could become a bigger problem over time.

The first red flag is that PepsiCo’s strong performance should allow the company to retire a significant number of their shares through stock repurchases. However, on a year-over-year basis, PepsiCo actually underperformed each of their peers by this measure. Dr. Pepper Snapple actually outperformed its two larger competitors by retiring 3.66% of their outstanding shares in the last year. Coca-Cola rewarded its shareholders by repurchasing 1.42% of its share count. By comparison, PepsiCo retired just 0.89% of their share count. With the company using about half of its free cash flow to fund the dividend, you would expect stronger performance.

This leads us to the second red flag for PepsiCo: the company has a problem with stock options that seems to be multiplying exponentially. In the first six months of the year, the company issued $496 million in stock options and repurchased $1.2 billion in shares. In the first six months of this year, PepsiCo issued $823 million in options, and repurchased $1.03 billion in shares. This helps explain the company’s underperformance in retiring shares relative to peers. When you consider that PepsiCo issued 65.93% more shares in options and spent 14.17% less on share repurchases, clearly this is a problem investors need to be aware of.

If you consider PepsiCo’s higher usage of stock options, lower share repurchases, and questionable decision making in regards to Pepsi Americas' business and Quaker Foods, it seems clear that this is a great company hiding inside of an average one.

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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola and PepsiCo. The Motley Fool owns shares of PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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