Pepsi: A Value King in the Beverage Industry
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Although Pepsico (NYSE: PEP) is known mostly for its cola drink, the company’s products include several internationally recognized brands of beverages and food. The company generates global net revenue of $65 billion selling items under its namesake label as well as Fritos, Lays, Doritos, Tostitos, Cheetos, Quaker, Rice-A-Roni, Gatorade, Tropicana, Mountain Due, and 7UP.
The future of Pepsi is impacted by how the company responds to declining beverage sales volume in North America and profit margin compression caused by higher commodity costs. This article examines Pepsi’s product diversity, expansion developments, and superior positioning to continue delivering shareholder value.
Pepsi has demonstrated its commitment to business expansion by acquisitions of Wimm-Bill-Dann and Pepsi Bottling Group. The $3.8 billion purchase of a 66% stake in Wimm-Bill-Dann in February 2011 culminated with a September closing on the remaining interest. This positioned Pepsi as the largest food and beverage company in Russia. The purchase is expected to add $3 billion of annual sales for Pepsi. It is also aimed at supporting the company’s goal to develop a $30 billion operation throughout Central Asia and Eastern Europe by 2020.
Pepsi recently completed a transaction with Tingyi Holding, one of the leading food and beverage companies in China, to create a strategic beverage alliance in China. Projections indicate that China will comprise the world's largest beverage market by 2015. The alliance makes Tingyi's beverage subsidiary – Tingyi-Asahi Beverages Holding Co Ltd., which is one of China’s largest beverage manufacturers – the franchise bottler for Pepsi in China. Tingyi-Asahi Beverages will partner with current Pepsi bottlers to manufacture and distribute the Pepsi and Gatorade brands. In addition, the coalition will co-brand their juice drinks under the Tropicana name.
This agreement assigns all Pepsi indirect equity interests in Chinese company-owned and joint venture bottling operations to Tingyi-Asahi Beverages. The holdings of existing joint venture bottling partners in China are unchanged by the transaction. Pepsi has an option to increase its interest in the venture with Tingyi-Asahi Beverages to 20% by 2015. Pepsi announced in March the implementation of a new global structure and strengthened management team. This initiative retains the reporting segments but furthers the company’s goal of coordinating international expansion among the global groups. New management immediately assumed key leadership posts.
Brian Cornell, a former executive at Pepsi and most recently President and CEO of the Sam’s Club division of Wal-Mart is now CEO of PepsiCo Americas Foods. This moved the preceding CEO at PepsiCo Americas Foods, John Compton, to the new position of President of PepsiCo. Cornell will report directly to Pepsi Chairman and CEO Indra K. Nooyi. He now deploys his 30 years of consumer product marketing experience to lead Frito-Lay North America, Quaker Foods & Snacks North America, PepsiCo Mexico, and South America Foods plus PepsiCo customer teams and all Power of One activities within the Americas. Compton will continue to report to Nooyi and assume responsibility for all global beverage and food groups at Pepsi plus global operations, marketing, and strategy. The objective behind Compton’s new position is building of global branding, product innovation, and improved cost control throughout the company.
Although the Pepsi carbonated soft drink is the most popular selling beverage of the company, non-carbonated drinks are the fastest growing category. Pepsi intends to continue adding this type of product following success with Lipton, Aquafina, Tropicana, Gatorade, SoBe, and Propel. Naked Juice and Izze sparkling juices were added to the lineup in 2006. Pepsi is also focused on health and wellness by eliminating trans fats from several snack foods and increasing “good for you” foods under the Quaker Oats brand.
In March, cola drinkers were introduced to the newly launched Pepsi NEXT. This carbonated drink is aimed at consumers who prefer regular cola taste to diet cola, but resist the full-sugar content of regular cola. With 60% less sugar than regular Pepsi, the Pepsi NEXT product is intended to capture new cola drinkers. Also in March, the Quaker Oats division of Pepsi began introducing a new line of packaged Quaker Oatmeal Cookies. The product features the nutritious nature of whole grain oats, which has been a popular ingredient of home-baked oatmeal cookies for several generations. The new Quaker Oatmeal Cookies also contain dried fruit pieces and nuts to create seven different flavors. The Frito-Lay division of Pepsi debuted The Doritos Dinamita in March. These new tortilla chips are spicier than regular Doritos and rolled in the shape of a taquito. Packages of the highly flavored chips include names such as Chile Limon and Nacho Picoso.
Revenue in the fourth quarter of 2011 for Pepsi increased $20.2 billion. Excluding the impact of contributions from the Wimm-Bill-Dann acquisition, revenue was 8% higher than the same quarter of 2010. The gain was driven by both rising volume and higher prices. Sales volume of snack brands increased 8% for both the fourth quarter and the year. Beverage volume increased 3% for the quarter and 5% for the year.
Bottom line results were also better, with earnings per share 5% higher in the fourth quarter than a year earlier. However, Pepsi did face shrinking margins due to a 16% rise for raw material costs. Gross margin in the quarter decreased 252 basis points from the same period of the prior year to 51.6%. Operating margin fell 110 basis points to 11.1%. Nevertheless, the company demonstrated financial strength to withstand margin pressure by increasing volume. The acquisitions of Wimm-Bill-Dann and Pepsi Bottling Group should further benefit the company’s margins. Pepsi reported that it intends to reduce its workforce in 2012 by 3% from about 290,00 to approximately 281,000. Management expects this initiative to provide $1 billion per year of cost reduction in 2013 and 2014. That amount of savings offsets a continued rise of input costs similar to 2011.
Company management also plans to allocate 5% of revenue to capital spending. Pepsi cash flow also supports the goals of paying $3 billion toward additional dividends and another $3 billion for share repurchases. This follows $5 billion of share repurchasing in 2010 and $2.5 billion in 2011. Share repurchases were temporarily suspended when cash flow was allocated to bottler acquisitions. In addition, the company announced a planned increase in annual advertising spending by an amount between $500 million and $600 million. The advertising budget will focus on North American marketing of the Gatorade, Tropicana, Mountain Dew, and Pepsi brands. This is clearly a response to the company’s falling market share in North American last year to Coca-Cola (NYSE: KO) and other smaller rivals.
Rising input costs are obviously a challenge for Pepsi. Because the company produces both beverage and food products, it is more exposed to higher commodity prices than Coca-Cola, which lacks a food operation. However, a long-term downward sales trend is apparent for the overall market of traditional carbonated beverages. Flavored carbonated beverages are the exception due to their appeal with young and fast-growing ethnic groups. Pepsi has an advantage on this front with its new product launches and increased promotional spending. More importantly, Pepsi management is focused on the volume trend of rising per capital beverage consumption caused by ready-to-drink teas, juices, sports drinks, and bottled water.
The strong position of Pepsi in global markets presents obstacles to smaller competitors, such as Green Mountain Coffee Roasters (NASDAQ: GMCR). Despite the growth rate of revenue at this company, it lacks the diversified brands and cash flow strength of Pepsi. This inhibits smaller operations from gaining significant traction to displace Pepsi’s market dominance. Pepsi has little long-term risk given its favorable product mix, introduction of new products, pricing power, and high cash flow that supports promotional initiatives.
Pepsi’s slower sales volume in North America is offset by substantial presence in foreign markets. Also, I expect the introduction of new products and enhanced advertising expenditures to improve North American market share. Plus, Pepsi is the trendsetter in responding to consumer preference for healthier products. Even with sluggish beverage sales, Pepsi should experience mid-single digit sales growth with its diversified product line. Narrow profit margins are still likely in the near term as commodity prices continue rising. However, the company’s cost cutting initiatives substantially offset the impact of margin pressure.
On the other hand, higher spending on advertising, adverse foreign currency translation, and Pepsi’s costs for building new product brands will surely lower earnings per share in 2012 compared to last year. Despite these factors, shares of Pepsi stock are valued at only around 14 to 15 times forecasted earnings over the next two years. This compares to a five-year average price to earnings ratio of 13.8 to 20.8. In addition, Pepsi’s price to sales ratio is only about 1.5 versus an average of 2.3 over the past three years. The ratio of price to free cash flow is only about 19, which is well below the 22.3 three-year average. Pepsi shares represent a superior value to chief rival Coca-Cola. Although the five-year growth rate at both companies is identical, Coca-Cola shares trade at a 20% higher price to earnings ratio.
Pepsi stock also embodies a better value proposition than small high-growth competitors such as Green Mountain Coffee. Shareholders of the latter hold a stock with a much higher price to earnings ratio and yet the growth rate of earnings per share is maturing into a slower pace than the five-year average. Moreover, because Green Mountain Coffee is highly impacted by the cost of a single commodity, its net profit margin last year was even lower than Pepsi’s.
The market for convenient foods and beverages still remains highly competitive. Companies such as Nestle, Kraft, Unilever, and Cadbury Schweppes are constantly attempting to strengthen their market shares. However, the industry is very mature and the weaker competitors are faced with the challenge of attracting consumers away from Pepsi brands. Meanwhile, Pepsi keeps rewarding consumers with superior products and shareholders with superior results.
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