Is PepsiCo Headed For A Split?

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PepsiCo

PepsiCo (NYSE:PEP) has been under activist pressure since January to separate the beverages and snacks businesses. While the company’s beverage division is struggling, mainly due to declining carbonated soft drink (CSD) sales, the foods division, including Frito-Lay and Quaker Foods, is witnessing steady top line growth and is relatively more profitable. According to activist investor Nelson Peltz, CEO of Trian Partners hedge fund, which holds $1.2 billion stake in PepsiCo, the weak-performing soft drinks division is dragging down the more lucrative snack foods division. [1] Fueled by rumors of a possible spin-off of the beverages business, PepsiCo’s stock has jumped 8% in the last three months, rising to the 52-week high of $93.48 on August 26. According to Trian, the company’s stock could be worth $144 a share following the spin-off. However, amid increased investor pressure, PepsiCo has remained committed to deriving benefits from synergies between the two businesses. While the management believes that the combination of snacks and beverages yields higher cost-benefits, investors in favor of the spin-off argue how and the cost-cutting at each company, following the split, would more than make up for their current synergies.

We estimate a $89.92 price for PepsiCo, which is roughly 3% below the current market price.

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Snacks Division Is Growing At A Fast Rate And Is More Profitable

PepsiCo’s beverage division, which constituted 48% of the net revenues last year, is struggling mainly due to the headwinds in the core CSD category. The company’s soft drink sales fell by 8% between 2011-2013, as CSD sales in developed markets continued to decline on the back of growing health and wellness concerns. On the other hand, sales for the snacks division, which forms 62.5% of PepsiCo’s valuation by our estimates, grew by 8% between 2011-2013. Frito-Lay North America is the most valuable division for the company, with 27% operating margins last year. In contrast, the soft drinks division in the region reported operating margins of only 14%. PepsiCo expects two-thirds of its anticipated mid-single-digit-percentage top line growth to come from the fast-growing foods division this year.

Although obesity and diabetes concerns have dragged down sales of sugary beverages, savory snacks haven’t been significantly impacted by the ongoing push for a healthier lifestyle. This is mainly as snacks have benefited from innovations such as low-cholesterol and gluten-free snacks and smaller packages, which encourage lesser one-time calorie consumption. In addition to international markets, where low consumption rates and increasing disposable incomes provide growth potential, snacks could also continue to grow in the U.S. owing to the large snacking habit of the consumers. In addition, growing population of youngsters (ages less than 15) in the domestic market will also increase the market size for salty snacks, which target children and young adults. The younger than 15 population in the U.S. is estimated to grow by 17% between 2010-2050, while the younger than 15 population in the world is expected to rise by 10%. [2]

The same cannot be said for the soft drinks business in the domestic market. Soda sales fell by 3.2% year-over-year to less than 13 billion gallons in the U.S. last year, capping-off the ninth consecutive year of decline in sales. [3] Although companies have tried to reverse this trend of falling CSD volumes by introducing low-calorie/diet variants, the usage of artificial sweeteners has evoked safety concerns and natural low-calorie sweeteners have been criticized for their bitter aftertastes. Moreover, while PepsiCo dominates the domestic snacks market with a solid 36.6% share and boasts a 28% share globally, the company trails its chief competitor Coca-Cola in terms of soft drink volume sales in both the U.S. and most international markets. [4] PepsiCo could continue to report weak soft drink volumes, owing to stagnating CSD sales in the developed markets and stiff competition from Coca-Cola.

Spin-Off Could Provide Cost Benefits And Potentially Improve Profitability

Investors suggest that a spin-off could allow both the separate companies to streamline their operational, advertising and marketing expenses, and also reduce corporate overhead costs. According to PepsiCo, synergies as a combined business allow the company to save around $800 million to $1 billion annually. PepsiCo had earlier in the year announced its five-year productivity savings plan for 2015-2019, according to which it plans to save $1 billion each year by optimizing global manufacturing operations and simplifying organization systems to drive efficiency. The company is on course to draw an incremental $1 billion in savings this year, after saving $900 million in 2013, as part of its savings program for the period of 2012-2014. Although the productivity savings plan is expected to drive margin expansion, counterarguments suggest that a new strategy and segregation of the foods and soft drinks divisions could derive even further savings. Cost-cuts resulting from the split, for example, a possible consolidation of PepsiCo’s four U.S. headquarters into two, could result in lower corporate overhead for each company and more than offset the present synergies. In addition, a trimmer business, especially the ailing beverage division, could potentially further expand margins and compete better with Coca-Cola.

Synergies Allow For Cost Savings, According To PepsiCo

Although some investors believe that a spin-off would allow the snacks business to achieve its true potential, current synergies between the snacks and soft drinks divisions also present a reasonable argument for the contrary. Both snacks and soft drinks derive benefits from overlap in raw material purchasing, packaging and advertising. According to PepsiCo, snacks and beverages are bought together 55% of the time in the U.S., and therefore gain from common advertising and distribution channels. Some investors argue how PepsiCo has been shaving-off advertising spend allocated for the foods division in favor of the ailing soft drinks division. This means that snack sales, which although are growing, could still be subdued due to relatively lower advertising activity. However, the company has looked to encourage snack food consumption by diversifying snacking options and in fact, leveraging its soft-drink partnerships.

In 2012, PepsiCo launched Doritos Locos Tacos in partnership with Taco Bell, a subsidiary of Yum! Brands, which crossed 1 billion in retail sales by October last year. [5] Going forward, PepsiCo aims to replicate this success by partnering with restaurant chains such as Pizza Hut, also owned by Yum! Brands, and Buffalo Wild Wings. The company is looking for innovative ways to incorporate its snacks in menus of these restaurants to boost sales of the Frito-Lay division. PepsiCo expanded its presence in foodservice last year by replacing Coca-Cola as the official soft drinks partner for Buffalo Wild Wings. [6] Apart from selling beverages, PepsiCo’s snacks will soon be used in some new menu items at Buffalo Wind Wings, which spreads across more than thousand locations in North America.

It remains to be seen if PepsiCo goes ahead with the suggested spin-off of the beverage business. Although current synergies argue why PepsiCo should remain intact, cost-benefits from the split and potential margin expansion thereafter could be more beneficial for both the standalone businesses in the long run.

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Notes:
  1. PepsiCo bubbles to new high as Barron’s supports snacks spinoff, bidnessetc.com []
  2. Global population forecasts []
  3. The U.S. liquid refreshment beverage market remained flat in 2013“, March 2014, beveragemarketing.com []
  4. Time to split?, barrons.com []
  5. Doritos locos tacos sales pass $1 billion“, huffingtonpost.com []
  6. Pepsi partnership presents opportunities for Buffalo Wild Wings“, March 2014, startribune.com []