(Happy Thanksgiving Financial Uproarians. I didn’t get to have a turkey dinner, so y’all can go to hell)
Oh hey, it’s Pepsi. Do you guys know I used to sell chips for that particular company? Of course you don’t, since I have literally never mentioned it in my life.
(Does a search for “chips” on FinancialUproar.com, laptop explodes)
I never commented on my thoughts about Pepsi as an investment back when I worked for them, because I knew that my limited experience with the people I dealt with would cloud my overall judgement, and because of my rule of I don’t eat and crap in the same place. You shouldn’t look for a lady where you work, and you shouldn’t load up your portfolio with your employer’s stock either. Even if they give you a discount to buy it.
(Use the discount, buy it, and then lighten your exposure to it periodically. It’s that simple.)
But I’ve been quit for a whole year now, and I haven’t begged for my job back in tears for weeks now, so I suppose it’s safe for me to talk about the company a little. I’ll try to focus on the big picture aspect of the business and less on my exposure to it.
Unlike my unfulfilled hatred of all things Coca-Cola, I’m not terribly bearish on Pepsi. I doubt it’ll outperform the S&P 500 over the next decade or two, but I think you’ll be fine to invest in it over the next few years, mostly because of something that’s bound to happen.
For the sake of this blog post, let’s divide Pepsi up into 4 different divisions. There’s the North American soda division, the North America food division, (including the chips, plus Quaker, Aunt Jemima, Tropicana, and so on), everything in Europe, and everything everywhere else. Europe does a fairly decent chip business, but for the most part the rest of the world part is mostly soda.
An activist investor, Nelson (WHOO!) Peltz, has taken a position in Pepsi that’s worth approximately $1 billion. Like all other activists, he immediately made a big show about how Pepsi was running their business wrong, saying that the food division should be separated from the soda part, which is very slow growing. Let’s take a look at Pepsi’s 2013 annual report for the deets.
As you can see, it’s a pretty steady business, with one notable exception — Latin American foods. North American soda (which is PAB above) saw volumes decline by 3% and 4% annually over the past 2 years. The company is able to make up for it with price increases (or, depending on the product, making the packaging smaller). Even in Latin America volumes are slowing, revenue is increasing because of currency fluctuations and pushing through price increases. It’s pretty sad when the best part of your business managed a 3% increase in volume, but that’s the reality of investing in giant corporations like Pepsi. You run into the law of large numbers.
Peltz thinks the company should divide into two parts. The North American food part along with the Latin America food part would be one company, which we’ll just call Frito Lay for the rest of this blog post. All the soda would be the other company, along with the chip business outside of North America. We’ll call that Pepsi for the rest of this post.
Pepsi would have revenues of $41.3 billion, with an operating profit of $5.4 billion. Those are operating margins of 13.1%.
Frito Lay would have revenues of $25.1 billion, with an operating profit of $5.7 billion. Those are operating margins of 22.7%.
As a whole, the company has operating margins of 16.7%.
Remember how everyone says soda is the cash cow? Nope. Chips are the business to be in. It helps to not have to compete with the potato chip version of Coca-Cola.
Peltz’s thesis can be summed up in just a couple sentences. The food business has much higher margins than the soda business, which also suffers from the handicap of shrinking volumes. Because soda makes up more than 60% of the total business, the market is valuing the entire company as a no-growth soda company, instead of a no-growth soda company PLUS an exciting food company (which, frankly, only looks good compared to soda).
Peltz isn’t a rookie at this, doing the same thing to Kraft Foods just a couple years ago. Management gave in, and the company spun of Mondelez, which has to be the lamest name for a snack food company ever. (Mondelez’s brands include Chips Ahoy, Oreo, Ritz Crackers, etc., while Kraft kept the boring stuff like peanut butter and Stove Top stuffing.) Both companies trade at a higher valuation than since before the spinout, but that could easily be because of the market’s overall exuberance.
Is Pepsico really undervalued? The company combined trades at a price to operating income ratio of 14.6. We’ll use operating income because it tends to be a more true picture of what the company earns on a normalized basis. All data from here on out comes from Google Finance, so you know who to blame if it’s wrong. (NOT THIS GUY, he’s in charge of shoddy math)
Let’s take a look at Pepsi’s competitors, from a price to OI perspective:
||Market Cap (B$)
||2013 OI (B$)
||Price to OI
|Dr. Pepper Snapple
The jist of the fancy table I made there is pretty straightforward. If a company has better operating margins, it will trade at a higher multiple. Monster is really expensive because of its high margins and, unlike the others, it’s actually growing. Coca-Cola Europe (which is the continent’s largest bottler) is cheaper, but it should be, based on it’s crappy operating margins. Dr. Pepper Snapple seems to be in the sweet spot (heh), and is probably the spot where I’d put my money.
As a reminder, the soda part of Pepsi has operating margins of 13.1%. This tells us a couple of things:
- It could probably cut costs, but it has the disadvantage of owning more bottlers than Coke.
- It isn’t such a great business to be in, even compared to its competitors.
Now the big question. What sort of valuation would a soda only Pepsi command?
I’m going to go with a market cap of 15x operating profits. Admittedly, this is a number that I kind of pulled out of my ass, but with the following caveats:
- It’s a recognizable name, but not considered quite as bulletproof as Coke. Therefore it would get a premium, but not a huge one.
- It would have the potential of growth in the developing world, which would help justify the premium.
- It’s an imperfect measure anyway because it doesn’t consider any debt the company may have, but I ain’t figuring that crap out.
So, based on an operating income of $5.4 billion and a multiple of 15x OI, I gander the soda part of Pepsi is worth $81 billion.
But first, words on synergies
One of the arguments folks bring up against splitting up Pepsi is the synergies the combined company gets. They point to things like a combined sales staff, putting chips and pop on the same truck, building store displays with both brands, and the ability to work together to make the whole operation more efficient.
Whenever somebody makes any of those arguments, I immediately know they haven’t a clue what they’re talking about.
Frito Lay is ran essentially as a separate company as Pepsi beverages. Chips and pop never come in the same truck because they don’t come from the same warehouse. There is not one warehouse in the company that shares space between the two divisions. There is shared office space, but it’s minimal.
Frito Lay sales reps and Pepsi sales reps work together, but not overly so. We would build “power of one” displays, when a store would have soda and chips on sale for the same time. Some of these events were planned out, but as a joint effort between Pepsi, Frito Lay, and store reps. For the most part, the benefits of these promotions was to get a store filled with product one week, and then not need it the next week. There’s value in selling product now compared to a week from now, although it’s pretty minor.
Here’s how a lot of displays work in the grocery business. Unless you’ve got a good spot and a great price, product is going to sit there. Even if you have a good price, folks are acclimated to going to the chip aisle and buying their chips there. I’ve walked into stores countless times to an empty sale item on the shelf and a full display somewhere else in the store. That’s just the way it works.
So I would take the old product from the display, move it over to the shelf, and refill the display. Because, heaven forbid, you don’t want to lose display space, no matter how poorly it’s doing. The only time this works is if the store has a great deal. Great deals come along about 4 times a year for each store (more if you’re Wal-Mart), so most of the time I would build displays for nothing.
Anyway, the point? The combined entity synergies stuff is hot garbage. Frito Lay is ran separately from Pepsi. There are two sets of sales staff. There are two separate warehouse systems, and even two separate support groups. The only time chips and pop are on the same truck is when the chip guy buys a Pepsi.
Now onto chips for reals
As a reminder, Frito Lay (and Quaker thrown in) had operating profits of $5.7 billion on sales of $25.1 billion in 2013. That’s a 22.5% operating margin, which is succulent. Let’s compare it to its competitors. Like with the soda division it’s a bit of an imperfect exercise, but we’ll do what we can.
||Market Cap (B$)
||2013 OI (B$)
||Price to OI
Again, all of these are imperfect competitors, but mostly because Frito Lay doesn’t have a big competitor. When it comes to chips in North America, they’re the undisputed champions.
Take a look at the competitors’ operating margins. They’re good (especially Kellogg’s, which trades at a significant discount to its peers. If you want a stock in the sector to look at I’d start there.), but they’re nowhere near Frito Lay and its 22.5% margins. I think we could almost be generous and give Frito Lay a 20x operating income valuation, but let’s be a little conservative and say 18x. Investors will be willing to pay a premium for Frito Lay because it’s growing, it has such good margins, and it’s the dominant player in its industry.
Based on 18x 2013’s operating profits of $5.7 billion, Frito Lay can be valued at $102.6 billion.
And based on 15x Pepsi’s operating profits of $5.4 billion, the soda division is valued at $81 billion.
Currently, the combined company has a market cap of $141.65B. Split apart, I say the companies are worth $183.6 billion.
Together, the company is undervalued by 29.6%. So if you think Peltz will be successful and split the two companies apart, you’re looking at some decent upside. I wouldn’t buy the stock based on that news, but if I was thinking of buying it anyway, it would probably push me over the edge towards buying it.