Proposing a Value-Enhancing Deal for PepsiCo

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

PepsiCo (NYSE: PEP) has outperformed most of its peers over the past 12 months. After trailing Coca-Cola for a long period of time, the company has caught up and now trades at a very small discount to Buffett's favorite company.
 
There are two explanations for such overperformance. First of all, last year PepsiCo presented a medium-term strategic plan, which was followed by good operating results. Secondly, the market is expecting a large-scale strategic change. Here I will focus on the much-awaited strategic change. Specifically, I will analyze the possibility of PepsiCo dividing itself into one food (snacks) company and another beverage company. I think that if this were to happen many other enterprises would be interested into merging with those separate entities.
 
Here, I will examine the pros and cons of a possible merger of PepsiCo's beverage business with Anheuser Busch InBev (NYSE: BUD), which already distributes PepsiCo beverage products in various parts of Latin America, such as Brazil and Argentina. But first, I will review the pros and cons of a potential merger between PepsiCo's food business with Modelez International (NASDAQ: MDLZ).
 
The absolute world-wide snacks powerhouse.

If PepsiCo's food business would merge with Modelez International, I see a number of significant pros.
 
Pros:

- Global top-line of $68 billion would make this food company the world’s second largest.
 
- The combined advertising budget would be as large as $3 billion, which would be one of the largest in the food industry .
 
- Modelez would get a better exposure to emerging markets while both companies could cut costs in developed markets.
 
- The two companies could leverage their unique market position through combining their  procurement and R&D platforms. The combined R&D budget could go as high as $700 million (the second largest in the food industry).

Cons: There is essentially one--high break-up costs. According to Mondelez's filings, the total break up costs at the Kraft-Mondelez de-merger were as high as $2.7 billion. Taking into account that deal, Credit Suisse's analysts calculate that de-merging PepsiCo would come with one-time costs that could go as high as $2.1 billion (the calculation is made by adding up on-going synergies that do exists between PepsiCo's food and beverage units).

A marriage that could be extended from Latin America to the world.
 
As I mentioned before, Anheuser Busch-InBev already is (though its subsidiary Sao Paulo based subsidiary AmBev) PepsiCo's biggest bottler. Hence, the combination of these two companies would be a natural one. Besides, Anheuser Busch-InBev is an expert in slashing costs and streamlining operations, which is exactly what PepsiCo needs in the U.S.

Pros:

- Scale in emerging markets particularly where both beverage companies have strong market share presence (Latin America, China,and Russia).
 
- Distribution synergies would be a big plus.
 
- Both companies have already a partnership where they jointly purchase goods and services (such as IT Hardware) in the United States. Besides, both have recently teamed up on joint promotions and retail marketing. A full merger could be a natural extension of the relationship that these two companies already have in place.
 
- Following what has been done in the beer industry, PepsiCo could move to a model where only distribution is outsourced. This means that, in the U.S., a lot of the manufacturing could be kept in-house and consolidated to much larger facilities.

Cons: Again, mainly break-up costs (estimated at $2.1 billion).
 
The bottom line
 
Assuming that PepsiCo "de-merges" and both the remaining separate entities (food and beverage) are acquired at average M&A multiples, PepsiCo's shareholders could benefit hugely. I estimate that if the food business is bought at 14 times EV/EBITDA and the beverage business is bought at 14.5 times EV/EBITDA, taking off $2.1 billion in break-up costs from the total, PepsiCo shares should be valued at $97 (a 17% upside from current market prices).
 
That said, if the current company breaks up without someone else picking up the pieces, a de-merger would be a disaster. The company would have to pay more than $2 billion in break-up costs and then would lose a lot of currently existing synergies between the two businesses (above all in the U.S.). If I was a shareholder, I would vote for a break-up only if buyers could be found right next to the exit door. 

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Federico Zaldua has no position in any stocks mentioned. The Motley Fool recommends 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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