How Can PepsiCo Derive Growth From North America Carbonated Drinks?

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For some time now, one of the world’s largest food and beverages companies, PepsiCo (NYSE:PEP), has been under investor pressure to spin-off the ailing beverages business. Revenue contribution of both the snack and beverage divisions is roughly equal for PepsiCo, but while the foods business is thriving on high demand in emerging markets and sustained growth in developed markets, the drinks business, and in particular the carbonated soft drinks (CSD) segment, has been on a decline. The company’s soft drink sales, which form around 17% of the net valuation, 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. Snacks are also more profitable than drinks; EBITDA margins for snacks and beverages stood at 24% and 16% respectively last year.

According to activist investor Nelson Peltz, CEO of Trian Partners hedge fund, which holds an approximately $1.8 billion stake in PepsiCo, the company’s stock could be worth $144 a share following a hypothetical spin-off, as the weak-performing soft drinks division is allegedly dragging down the more lucrative snack foods division. However, amid increased investor pressure, PepsiCo has remained committed to deriving cost benefits from synergies between the two businesses, which the company says range between $800 million and $1 billion annually. While the management believes that the combination of snacks and beverages yields higher cost-benefits, investors in favor of the spin-off argue how the cost-cutting at each company, following the split, would more than make up for their current synergies.

We estimate a $91 price for PepsiCo, which is roughly 8% below the current market price.

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See Our Complete Analysis For PepsiCo

PepsiCo has stuck to its guns so far, choosing to keep snacks and beverages together, and aiming to derive synergy benefits and productivity gains each year to keep investors content. The company has exceeded analyst estimates for its earnings per share for eleven consecutive quarters now, and increased its full-year outlook on currency neutral earnings per share growth to 9% year-over-year from the previously estimated 8% growth, following the third quarter results. However, despite this strong growth, some argue how the true potential of the stock is still to be unlocked. Although the management has spoken of synergy benefits and beverage potential, the fact remains that PepsiCo’s beverage division is still struggling.

Volatile macro conditions in some of the key emerging markets such as Russia, Mexico, and Brazil, have somewhat dragged down PepsiCo’s volume sales this year, but the continual slowdown in North America sales has been the Achilles heel of PepsiCo’s soft drinks segment. While the combined revenue for Frito-Lay and Quaker Foods, the snack divisions of PepsiCo, has grown in each of the last couple of years in North America (excluding Mexico), revenue for beverages in the region has sequentially declined. Some of the headwinds in beverages are industry related, as customers look to reduce unnecessary calorie consumption. But in addition to being hurt by stagnant customer demand, PepsiCo is also losing share to its biggest rivals The Coca-Cola Company (NYSE:KO) and Dr Pepper Snapple (NYSE:DPS) in North America. According to our estimates, while Coca-Cola and Dr. Pepper’s value shares in the U.S. CSD market rose each year between 2011-2013 to 42.4% and 17.5% respectively, PepsiCo’s market share fell each year to 28.7% in 2013. Split or no split, PepsiCo will be looking to achieve meaningful organic growth in its drinks business, especially carbonates.

Where Could CSD Growth In North America Come From?

PepsiCo’s North America soft drink volumes have declined 1% year-over-year in the first nine months, with volumes falling 1.5% in Q3. This is mainly as customers are switching from calorie and sugar-fueled carbonated drinks to healthier, more natural alternatives such as sports drinks, ready-to-drink teas, and even coconut water. However, there are growth avenues for PepsiCo, which if exploited successfully, could expand volume sales and even profitability for the company’s soft drinks business.

  • Engaging Customers- CSDs in the U.S. is a mature market, with Coca-Cola, PepsiCo, and Dr. Pepper together accounting for approximately 89% of the industry volumes, by our estimates. This category has declined for nine consecutive years in the country, with volumes falling 3.2% year-over-year to below 13 billion gallons in 2013, and a further drop in volumes is expected this year. However, CSD still remains the largest segment of the U.S. liquid refreshment beverages market, constituting 43% of the net volumes, as of last year.

Despite the assumed stagnation, Coca-Cola managed to squeeze-out 1% growth for its flagship drink Coca-Cola in Q2 in North America, on the back of its Share-a-Coke campaign. The company labeled Coca-Cola, Coke Zero, and Diet Coke bottles with common names of individuals, hoping for customers to buy these personalized bottles and cans and then promote this activity later on through social media. Soft drink companies depend on experiential marketing, and by forming an emotional connect with customers and leveraging present day trend of self expression on social platforms, Coca-Cola managed to grow in Q2, while PepsiCo reported a 2% decline in CSDs in North America during the same period. PepsiCo has tried to engage customers by sponsoring events such as the Super Bowl, but the company is still lagging Coca-Cola in terms of a big strategic hit. One of the reasons for this could be a smaller advertising spend behind its beverages, which PepsiCo could increase going forward to compete better. The drinks-only companies Coca-Cola and Dr. Pepper spent 7% and 8% of their net revenues respectively on advertising in 2013, whereas PepsiCo, which also markets snacks, spent only 3.6% of its net sales on advertising.

  • New Launches- Apart from the slowdown in sales for CSDs, what has hurt soft drink makers is a larger decline in sales of diet drinks. Customers remain skeptical about the safety issues associated with artificial sweeteners used in these drinks, such as aspartame, and have also criticized natural sweeteners for their bitter aftertastes. Beverage manufacturers have looked to solve this high-sugar problem by launching new low-calorie and naturally sweetened products, in a bid to spur CSD sales. Coca-Cola introduced its Coke Life in the U.S., U.K., and Mexico this year, after the naturally sweetened Stevia drink helped increase Argentina and Chile sales for the company last year.

PepsiCo also recently launched Pepsi True, a naturally sweetened drink containing 60 calories in a 7.5 ounce can (as opposed to 150 calories in a 12 ounce can), in the U.S., selling the drink on Amazon. However, PepsiCo’s efforts to lift its mid-calorie soda sales, which fell by high mid-single percentages in 2013 and in the first nine months of this year, haven’t met a positive initial customer response, it seems. Pepsi True has received over 3,600 negative reviews on Amazon following its launch last month, reflecting how PepsiCo’s attempt to launch a Stevia-sweetened low-calorie drink might have gone awry. Although the initial response to Pepsi True is disappointing, the company will look to launch new products and provide more options in order to gather customer attention. As an extension to PepsiCo’s snack-beverage partnership, the company is also in the middle of testing a Doritos-flavored-Mountain Dew variant.

  • Profitable Packaging- While new launches and higher investment in marketing could boost volume sales, a favorable product mix could help expand PepsiCo’s operating margins. Smaller-sized packs, even the whole-calorie options, have seen rising volume sales. This is because even though the 12-ounce bottles and mini cans contain the same calories per unit volume as the regular 20-ounce and 24-ounce bottles, the smaller packs have lesser cumulative sugar amounts. Health-conscious consumers who are wary of switching to diet versions, which allegedly alter the taste, are being swayed by beverage companies to switch to smaller-sized packs, which allow for lower one-time calorie consumption.

After rising by 34% last year, PepsiCo’s mini can business increased by 24% through June in the U.S. In addition, despite a fall in overall volume sales, higher proportionate sales of the mini bottles and cans resulted in a 2% year-over-year rise in the company’s operating profits for the North America beverage division in Q3. According to Euromonitor, while sales in the overall U.S. CSD market remained flat last year, mini can sales rose 3%, and as this category forms approximately 3% of the industry-wide volumes, there is room for further growth. PepsiCo’s Pepsi True was also launched only in 7.5 ounce cans, and going forward, the company might focus on smaller packages to drive margin expansion.

Future growth in the U.S. carbonated drinks market might depend on innovation in the low/mid-calorie segments, but even without volume growth, PepsiCo has the opportunity to improve its operating margins by leveraging profitable packaging and/or undertaking cost-saving initiatives. Margins for PepsiCo’s Americas beverages division stood at 14.2% in the first nine months of this year, compared to over 20% at rival Coca-Cola.

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