INVESTORS HAVE TURNED THEIR BACKS this year on consumer-staples stocks, while chasing after companies that promise faster growth. In PepsiCo’s case, they’ve had added reason to look elsewhere, given declining revenue and profits in the company’s North American beverage division — home of Pepsi products, Gatorade sports drinks, Tropicana juices, Aquafina water and other familiar brands.
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Under CEO Indra Nooyi, PepsiCo has made small acquisitions around the globe. Buying key bottlers is Nooyi’s first swing at dramatically changing the business.
Pepsi has suffered as cash-strapped consumers have traded down to private-label products — or quenched their thirst at the kitchen sink.
Writing off Pepsi (ticker: PEP) would be a mistake, however, given its powerful snack-food franchise and the cost savings the company could realize from the planned $7.8 billion acquisition of two of its key bottlers. Besides, its shares, now around 63, look cheap. As the economy starts to recover, Purchase, N.Y.-based Pepsi could regain its fizz.
Pepsi earned $5.9 million, or $3.68 a share, last year, on revenue of $43.3 billion. This year, the company is expected to earn $3.76 a share, and next year, with the bottlers included, it could net $4.22.
That’s consistent with CEO Indra Nooyi’s recent statement that Pepsi is targeting 11% to 13% growth next year in earnings per share, excluding the impact of currency translation, and assuming the bottling deals close on schedule, early in 2010. Some fans of the stock expect Pepsi to enjoy robust growth for at least several years.
“We see a path for double-digit earnings growth over the next three years,” says Bill Pecoriello, CEO of ConsumerEdge Research, who has an Outperform rating and a 12-month price target of 72 on Pepsi’s shares.
Mario Gabelli, chairman and CEO of Gamco Investors, which manages mutual funds, is even more optimistic, noting that in the next few years, “the stock [could] trade 50% to 60% higher, which, with the dividend, gives you a pretty good return.”
Gabelli, whose funds own Pepsi shares, bases his analysis on what he thinks the company’s parts could be worth in private-market transactions. Pepsi pays a dividend of $1.80 a share, and yields 2.8%.
Pepsi trades for 15 times next year’s consensus estimate, near the bottom of its 10-year range of 13.1 to 31.6 times expected earnings. It also trades at a discount to arch-rival Coca-Cola (KO), which sports a price/earnings multiple of 17, and consumer-products giants such as Colgate-Palmolive (CL) and Procter & Gamble (PG), which trade, respectively, for 17.3 and 15.6 times 2010 forecasts.
If Pepsi’s profit grows by double digits this year and next, the company could earn as much as $5 a share in 2012, says Ian Jamieson, a portfolio manager at BlackRock, which owns the stock. As the market anticipates that profit growth, the shares could climb to 85, he says, assuming Pepsi’s P/E expands to reflect the strength of its business.
PEPSI DIVIDES ITS BUSINESS along geographic lines, into PepsiCo Americas Beverages, Frito-Lay North America, U.K./Europe, Latin America Foods, Middle East/Africa/Asia and Quaker Foods North America. On a product basis, beverages contribute roughly 37% of revenue and 40% of operating earnings, while snack foods account for 63% of sales and 60% of profits.
Table: Calling All Consumers
The company’s snack portfolio is a chip-lover’s dream, and includes brands such as Doritos, Ruffles, Lay’s, Fritos and Cheetos, as well as Rold Gold pretzels. Even in a challenging economy, snacks have done well, both in the U.S. and abroad. Pepsi officials have noted that more people are eating at home these days than in the past, which has hurt beverage sales but helped the snack-food business.
Revenue in the PepsiCo Americas Beverages division fell 10% in the first nine months of this year, to $7.4 billion, while operating profit declined 11%, to $1.7 billion. The company doesn’t break out the performance of individual brands, but industry data indicate that results for Pepsi, Gatorade and water disappointed.
In contrast, at both Frito-Lay North America and Pepsi’s international snack and beverage unit, operating profit has increased by 7% so far this year. And that’s despite headwinds from unfavorable currency translation, which could abate in the current quarter, as the dollar shows signs of firming.
“In every snack country we’re in, we are either No. 1 or No. 2,” says Chief Financial Officer Richard Goodman. “There is no real global competitor.”
That gives Pepsi the ability to price its products slightly above local brands, thereby boosting profit margins. The North American snack-foods business, for instance, boasts operating margins of 25%.
In its beverage business, Pepsi long has played No. 2 to Atlanta-based Coke. The gap between the two cola titans globally has narrowed slightly in recent years, but Coke has a far larger footprint overseas. It generates about 75% of sales and 80% of profits from outside North America, compared with Pepsi’s roughly 40% of sales and 34% of profits.
Pepsi manufactures and distributes its snack products globally. “We think of it as a huge competitive advantage because we control everything that happens,” says CFO Goodman.
The same desire for greater control lies behind CEO Nooyi’s plan, announced earlier this year, to buy and consolidate Pepsi’s two largest bottlers, Pepsi Bottling Group (PBG), based in nearby Somers, N.Y., and PepsiAmericas (PAS), headquartered in Minneapolis. After snapping up the 68% of Pepsi Bottling and the 57% of PepsiAmericas it doesn’t already own, PepsiCo will control marketing, manufacturing and distribution of its beverages in 80% of North America. Many industry watchers expect it to buy the remaining independent U.S. bottlers over time.
WALL STREET GENERALLY considers food-and-beverage sales relatively recession-resistant, but that hasn’t been the case in the past two years. Volume sales of liquid-refreshment beverages fell 2.2% in the U.S. in 2008, and are down roughly 2% so far this year, according to John Sicher, editor and publisher of Beverage Digest. That follows increases of 1.9% to 4.7% in the three prior years.
Sales of carbonated soft drinks fell by 3.2% industrywide last year, following three years of slightly smaller declines. Sales of sports drinks and bottled water fell last year for the first time ever, after logging double-digit gains earlier in the decade.
The problems at PepsiCo Americas Beverages can’t be ignored, since the division accounts for 26% of Pepsi’s operating profit, a contribution that could jump to 35% after the bottling-company purchases close, estimates ConsumerEdge’s Pecoriello.
Volume sales in the domestic beverage business could grow by 1% to 2% a year as the economy recovers, and the company could enjoy price increases on top of that, says Pepsi’s Goodman. That should produce modest revenue growth.
To turn that growth into profit gains, “you have to take out all overlapping functions,” Goodman says. “You want to be absolutely as lean as you can.”
In PepsiCo’s case, that likely will mean cutting $300 million of costs as the company realizes synergies from the bottler mergers, which could translate into an additional 15 cents a share of earnings. The consolidated company could see a one-percentage-point pickup in its earnings growth rate.
Some analysts expect the savings will be even greater. Pepsi Bottling Group initially rejected PepsiCo’s offer to buy its outstanding shares at $29.50 apiece, stating in its rejection letter that it believed the merger savings would be “multiples” of the $200 million that PepsiCo originally said it could achieve. PepsiCo was able to complete the deal at a sweetened $36.50 a share.
The savings will come primarily from eliminating redundancies associated with running three publicly traded companies. The deal also could enable Pepsi to make faster decisions, enhance the development of new products and increase its leverage in negotiating with big retailers.
“Calling on a national account with one face and one voice is very important,” says a person familiar with the deal.
Nooyi, 54, became Pepsi’s CEO three years ago, after a lengthy career at the company, including stints as president and CFO. While Pepsi has made “tuck-in” acquisitions of small brands around the world during her tenure as CEO, the bottling deal is her first swing at dramatically changing the business. Her recent decision to hire Eric Foss, CEO of Pepsi Bottling Group, to head PepsiCo’s new North American Bottling Group, was widely praised, as he is likely to facilitate a smooth integration of the bottlers.
THE PEPSI BOTTLING GROUP was originally owned by PepsiCo, and was spun off as an independent entity in 1999. At the time, carbonated soft drinks accounted for 60% of Pepsi’s beverage sales, and the bottlers were viewed as lower-growth businesses that required significant capital investments. Liberating them freed Pepsi to invest in other businesses and diversify its product portfolio. Today, carbonated soft drinks represent only 45% of the Pepsi’s beverage sales.
When Pepsi bought Quaker Oats in 2001, it acquired the Gatorade sports-drink brand. For several years, volume sales grew by double digits, but in recent years Gatorade has suffered declining volume. This year, Pepsi has undertaken a major makeover of the brand, which accounts for roughly 8% of total revenue.
Gatorade is expected to introduce several new products next year, says Sicher, of Beverage Digest. The company is planning to launch a pre-exercise drink called Prime, and a post-workout beverage, Recover, to complement its current Perform line-up of sports beverages.
“We’re planning to introduce a significant innovation that will evolve Gatorade, and in some ways the [sports-drink] category,” said a Pepsi spokesman, who declined to elaborate.
The Bottom Line
PepsiCo has rallied about 34% since early March, to 63. Some fans think it could rise into the 70s next year, while one investor pegs its private-market value closer to 100 a share.
To be sure, the bull case for Pepsi could go flat if the beverage business continues to deteriorate, or if a push to tax soda and other sugary drinks gains traction. Some proponents of such a tax view it as a way to curb obesity in the U.S., while others see it as a way to help pay for health-care reform.
“It’s a risk, but not enough of a probability to make it into our base case” for the stock, says Pecoriello.
As Pecoriello and other Pepsi fans see it, the company has many levers it can use to boost revenue and meet its earnings goals. Even if just a few of them work, PepsiCo’s shares soon could be bubbling higher.