PepsiCo Ready To Make A Big Splash In China

PepsiCo’s (NYSE:PEP) push into the Chinese market has gathered speed with the opening of a new bottling plant in Zhengzhou and an R&D center in Shanghai. The R&D center, the company’s largest outside the United States, will focus primarily on importing local flavors and preferences into the range of snacks Pepsi sells under its Frito-Lay banner. ^[1] The new bottling plant has been built in partnership with Tingyi (HKG:0322), one of China’s leading packaged beverage manufacturers and suppliers.  The plant covers 24,000 square meters in area and has additional capacity for future expansion. This is the first new plant the two companies have set up since entering into a strategic alliance in late 2011. ((Tingyi and PepsiCo Open New Beverage Plant in China, Oct 25, 2012, PepsiCo Press Release))

These developments mark an important milestone in Pepsico’s plans to invest nearly USD 2.5 billion in the country over a three-year period, starting 2010. However, it will continue to face stiff competition from Coca-Cola (NYSE:KO) in the beverage segment and Kellogg (NYSE:K) and Kraft Foods (NASDAQ:KRFT) in the snacks segment as well as a number of local players. And to make its Chinese dream a success, it will need to focus of product innovation and scaling up its manufacturing and distribution to improve margins and position itself well for future growth.

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China – The Prize is Right

There is a good reason why Pepsi is seemingly pulling out all of the stops in trying to tame the Chinese dragon. Winning over China will win the war for Pepsi. And we’re not talking about just the cola wars here.

With nearly 1.4 billion citizens and a GDP growth rate in the high single digits, China has become the promise land for pretty much every industry out there. Rising disposable incomes have seen private consumption increase by leaps over the last decade. A growing preference for more ‘western’ products – ranging from clothes to consumer goods to foods, snacks and beverages – can spell only good news for an image-and-marketing driven company such as Pepsi.

In the savory snacks segment, which we estimate contributes a share of 60% to Pepsi’s stock price, the country has grown at a CAGR of around 44% over the period 2008-12. Meanwhile, soda sales in the country have nearly doubled from 2007-2008. The country is expected to become the world’s largest beverage market by 2015.

However, per capita consumption levels for both snacks and soft drinks remain very low – a fraction of what they are in the US. Estimates for China’s snacks market stand at around USD 12 billion. Compare this with the USD 36 billion market for the US, that too with a population less than 1/4th that of China.

This is precisely where growth lies and where Pepsi has entered with all guns blazing.

Pepsi’s Friends and Foes

However, conquering China will be anything but easy for Pepsi. Here’s an overview of what it feels like to be Pepsi in China right now.

1. The Beverage Segment

Coca-Cola, Pepsi’s arch nemesis in the beverage segment, is one of the most identifiable brands in the world, and has established itself quite well in the Chinese market. By maintaining its focus on presenting itself as an ‘All-American Cola Company’, the company has outpaced competition when it comes to the key differentiation in the soda industry, i.e. good marketing. Some of this goodwill took a severe beating in 2012, however, as reports of high chlorine content in the company’s flagship soft drink let loose some very negative publicity. The episode culminated in a public apology from the company this June. The company’s Q3 growth in the region slumped drastically to 2% compared to 11% in the same quarter previous year – although the company itself blamed it on macroeconomic pressures. Nonetheless, Coca-Cola continues to command a 15% market share in beverages in China, compared to Pepsi’s 4.4%.

Apart from Coke there are also small, local beverage manufacturers Pepsi needs to be wary of.

Meanwhile, Pepsi’s 2011 strategic alliance with Tingyi has made the company part-owner of China’s most extensive bottling and distributing network. The alliance basically turned Tingyi into Pepsi’s franchisee bottler in China, using the former’s established infrastructure to manufacture and distribute soft drinks and Gatorade. The deal also involved Tingyi re-branding its line of juices under the ‘Tropicana’ banner. Given Tingyi’s established presence in the Chinese market (nearly 14% market share in beverages), the deal essentially places Pepsi on the fast-lane for market growth.

2. The Snacks Segment

Pepsi’s performance in the snacks segment has been hampered so far by an inability to adapt to local tastes and preferences – a fact well-leveraged by local food companies in keeping the US-based giant at bay. Increasing competition also comes in the form of other multinationals such as Kellogg (NYSE:K) and Kraft Foods (NASDAQ:KRFT) who are also stepping up their own investments in the region.

On its part, Pepsi is taking measures such as setting up the new R&D center. The company also opened a new snacks manufacturing facility this year, its sixth in the country.

Raising Hell on the Chinese Battlefield

Pepsi seems to be going all out on its Chinese campaign, raising the stakes in practically every segment in which it operates. The latest developments demonstrate its renewed focus of product innovation – the key to the Chinese market in several aspects. The company continues to scale up manufacturing and distribution, thereby improving margins and positioning itself well for future demand.

All in all, we expect to see Pepsi’s dominance grow significantly in the region over a period of 4-5 years. While most of this growth will come at the expense of smaller, local players – as has happened in other countries – it remains to be seen how the rivalry with larger companies such as Coca-Cola and Kraft will play itself out in China.

We have a price estimate of $79 for PepsiCo, which is about 15% higher than the current market price.

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1. PepsiCo Opens China R&D Center as Competition Heats Up With Coke, November 13, 2012, Bloomberg.com [↩]