Background

PepsiCo is a special situation with near-term (6-12 months) upside of ≈25% and longer-term (2-3 years) upside of ≈40-60%.  The downside is limited to ≈10% due to high recurring underlying cash flows, a wide moat supported by strong brand equities and stable demand, and the ability to buy cheap put protection.  While not central to the thesis, it’s instructive to note that PEP ~5% out-of-the money puts are cheap, costing 4-5% annualized, which enables one to size this investment with great confidence and with an assymetric risk-reward profile of up 25%, down 10% (even better up 28%, down 7% including the dividend yield).  With VIX still at low levels, cheap put protection is a unique aspect of buying into large, high-quality consumer staples undergoing transformation or restructuring, as I believe PEP is today.

I believe it is increasingly likely that PEP will break itself up over the next 1-2 years.  The current corporate structure is not sustainable, activists are circling, management is embattled and the stock has underperformed.  This is usually a good recipe for transformational change, and I believe it will lead to that ultimate outcome here.  On February 19^th, Trian Partners published a white paper (available at http://trianwhitepapers.com/) outlining the case for a breakup.

In a full breakup scenario, I believe PEP will be worth $95 at year-end 2014, and could reach $125 by year-end 2016.  If a breakup does not ensue, I see upside in the stock as activist pressure will catalyze cost cutting.  In the short-term, earnings should surprise positively because mgmt. will do everything in its toolkit to prove (to investors and to the board) that they can deliver value without breaking up.  At ~$80, the valuation at 17.5x 2014 earnings represents a discount to both the peer group (18x) and to PEP’s average historical valuation range (18.2x).  This give me confidence that any progress (real or perceived) addressing PEP’s structural issues will be a positive surprise for the market and will be reward with P/E expansion even if earnings growth doesn’t accelerate materially.

Why Now, and What the Street is Missing

Timing is almost everything when it comes to investing in large cap consumer staples special sits, because these are typically slow-growth companies without a ton of upside absent structural or cultural change. I believe the timing is now for PEP for a few reasons.

First, sentiment is awful in consumer staples.  The S&P Staples Index is the 2^nd worst sector YTD.  Within staples, sentiment is worst in beverages.  Of the 40 stocks in the XLP (Staples ETF), PEP and KO are in the bottom quartile on YTD basis.  Fundamentals have deteriorated with both KO and PEP struggling to grow, soft drinks under increased scrutiny in key markets like Mexico and macro slowdown in important emerging markets.  Yet, PEP’s business mix is much more skewed toward snacks/food (65% of EBIT), and this business appears quite healthy (3-4% revenue growth, 10% EBIT growth in 4Q13).  That PEP is covered by beverage analysts does not help its shareholders during times like this. 

Second, PEP stock has been flat for six years.  It was at $80 in January 2008 and it is at $80 today.  During this time EPS grew by 22%, so the P/E contracted by 20% (22x to 17.5x).  While not “cheap” absolutely or relative to growth expectations, what this tells me is that there is definitely room for P/E expansion if fundamentals improve or if the breakup scenario plays out.  We are not getting a bargain, but we are paying a fair price and are not taking risk of P/E compression. This is important. 

Third, the Street is exceedingly skeptical of both management’s aptitude and Trian’s chances of affecting change.  I think partially this is because Trian’s involvement with Pepsi has been confusing.  He has publicly discussed PEP in the past, but only in the context of his activist position in MDLZ.  He has yet, until now, put any significant pressure on PEP specifically.  It’s worth noting that Trian has had success breaking up Cadbury/DPS, KFT/MDLZ, and IR/ALLE.

Investors make three fundamental mistakes about PEP today:

First, Investors over-penalize PEP for its beverage business.  While the Beverages business represent maybe ~35% of the total value of the company (see “Sum of the Parts Valuation” section below), it receives 90% of the Sellside’s focus.  On the 4Q13 earnings call, by my count, eight analysts asked 11 questions. Of the 11, six were about beverages, four were about general financial/guidance, and only one was about snacks/Frito-Lay.  This is astounding, considering where the value lies.

Second, at $80-ish, the market’s implied valuation for the Beverages business does not make sense.  Using my estimate of Frito-Lay’s standalone value of ~$60 per PEP share, and valuing Quaker Foods at ~$5/share, the remaining market price for Pepsi Beverages is $16-17/share.  This equates to 7.5x my 2014 EPS estimate for “Beverage Co”.  Mind you, this is not for just North American beverages, it’s for the entire global business. With soft drink peer DPS trading at 14x, and even US tobacco trading at 13-14x, I believe Pepsi Beverages is worth at least that if not substantially more (At 14x, Beverages is worth $30/share. Adding $60 of Frito and $5 of Quaker gets to my price target of $95).

Third, Wall Street suffers from inherent biases about “junk food”.  Investors looking in from the outside see negative volume growth and stagnant earnings, and it’s easy to attribute this to secular challenges or inherent problems.  Wealthy Wall Streeters in general are not Pepsi’s core customers, and so the mental shortcut is understandable, if deeply flawed.  I firmly believe that PEP’s issues are entirely self-inflicted, a result of poor management and ineffective allocation of resources, a holding company model that saps entrepreneurship and risk-taking.  The good news is that it’s entirely fixable.  An instructive precedent in my view is McDonalds during the dark days of the early 2000s.  As MCD’s fundamentals deteriorated, the Street began to question the secular direction of the fast food business.  The challenges were viewed through the scary lens of obesity concerns and consumer lawsuits.  As history played out, the issues proved to be not macro but micro, not secular but self-inflicted.  As management (pressured, as it happens, by an activist) refreshed the menu and improved customer service, MCD’s earnings trajectory recovered and the stock went to new highs.  Today PEP is in a similar situation.  Wall Street perceives the business as secularly challenged in both salty snacks (salt/fat) and carbonated soft drinks (sugar/calories).  I believe this is misplaced. In salty snacks, Frito-Lay has been putting up impressive numbers, both in the US and globally, for many years and shows no signs of slowing.  In beverages, half the business is non-carbs (Gatorade, Tropicana, tea/coffee) and is growing.  The half represented by carbonates is declining in the US, but US soda represents maybe 15% of PEP’s total revenues, and contributes much less than to the intrinsic value of the company.  Also, the success of Monster and Red Bull in the energy category shows sugary drinks still appeal to consumers if supported with strong messaging and innovation. 

Catalysts

PEP is catalyst rich.  The rhetoric in the press has heated up.  Trian owns roughly 16mm shares or 1% of the company, up from 12mm shares at yearend. This situation could attract other activists and mgmt. will ultimately be forced to address the chronic underperformance of both the business and the stock.  In the short-term, mgmt. has a couple of “easy outs” to appease investors yet stop short of breaking up the entire company, both of which would be positive for the stock: (a) spin-off just the North American bottling assets, or (b) spin-off Quaker Oats.  In the short-term, I also see minimal risk to earnings and potential upside from some much-needed belt tightening.  Longer-term, as discussed more below, I think Frito-Lay would make for an attractive takeover target.  3G paid $27bn or 13x EBITDA for Heinz last year; the comparison is interesting because like HNZ, Frito-Lay enjoys category dominance (more on this below).  At 13x EBITDA, PEP is worth $95 (20% upside), which corresponds to my estimate of sum-of-pieces value. 

What is Pepsico, and Historical Context

PepsiCo is an immense company ($65bn in revenue, $13bn in EBITDA, $120bn market cap, 280,000 employees, #43 on the Fortune 500) but not a well understood one.  PEP is basically a holding company with three distinct and separate operating companies: two snacks/food companies (Frito-Lay and Quaker Foods) and the eponymous beverage company.  The operating businesses are run centrally from corporate headquarters in NY.

PEP’s present-day structure may be characterized as a historical accident.  In 1961, during the conglomerate era, Pepsi-Cola merged with Frito-Lay.  This legacy structure has survived ever since, even as the winds of Wall Street shifted toward more focus and less diversification and as similar conglomerates have broken up into more focused, more effective pieces (RJR Nabisco, KFT, SLE, FO, Cadbury, to name a few in the consumer sector.  The list goes on outside of consumer – TYC, ITT, GD, MHP, etc., etc.).   The companies that have broken up have richly rewarded shareholders (Bloomberg Spinoff index 10-year return of +220%, more than triple the S&P 500’s +60%).  Those who have not have struggled, with management’s focus sapped by constant portfolio horse-trading and endless restructurings.  For the remaining “conglomerates” like P&G, Nestle, Unilever, and PEP, the costs have been dear: slowing organic growth, greater sensitivity to global cycles, persistent market share losses, writedowns of acquisitions and high cash restructuring costs.  The benefits have been elusive.  Branded consumer product businesses with strong brand equities and a high market share in one category gain no further advantages by entering a second category.  Hershey in chocolate is a case in point, as is Wrigley in gum. Coca-Cola tried diversification in the 1980s and quickly retracted. The old Anheuser-Busch once owned Eagle Snacks; the company’s pole position in beer did nothing to help Eagle, which they ultimately divested. 

That PEP happens to manufacture and sell both Lay’s potato chips as well as Mountain Dew soda means little to the retailers, means less to PEP’s independent distributors around the world, and means absolutely nothing at all to the most important constituent, the end consumer.  On the contrary; I firmly believe that PEP’s persistent efforts to “bundle” and “connect” Frito-Lay with Pepsi Beverages has materially hurt and impeded Frito’s ability to compete effectively.  As one example, because of PEP’s “power of one” manta, Frito-Lay is forced to bundle with Pepsi brands in all its in-store promotions.  Why would the dominant chip brand, with a ~70% market share, bundle with the #2 competitor, instead of Coca-Cola, the clear #1 brand?  This conflict is compounded outside the US, especially in Western Europe and Latin America, where Coca-Cola dominates and where Pepsi-Cola is an extremely weak brand.  This is foolishness.  I believe the “power of one” strategy has depressed the intrinsic value of Frito-Lay relative to what is possible and achievable.  (Importantly, it’s clear the “power of one” can still work without any equity ownership/relationship, as evidenced by the various successful tie-ins Frito-Lay has done at arm’s length with Taco Bell, a subsidiary of Yum Brands).

Against this backdrop, I view the activists’ calls for a separation of snacks and beverages as increasingly relevant and more likely to succeed.  Management’s defense of the status quo is becoming increasingly desperate.  The CEO’s prepared remarks on the 4Q13 earnings call provide some interesting insight.  Her argument for keeping the company together is centered on the purported benefits of “scale” (a word she uses five times).  I believe talking about scale is dishonest and empirically does not hold water.  Yes, scale matters in a specific category.  Frito-Lay’s moat is reinforced by its massive scale against smaller, regional competitors. Hershey’s scale in chocolate allows it to strengthen its brand equities and win more shelf space at retail.  Gillette’s 80% share of razor blades poses a considerable barrier to new entrants.  But scale does not travel across categories.  In fact, cross-category expansion is what we call “diworsification”, and it can cause more harm than good.  Culturally, two different businesses competing for finite resources/attention can be disastrous, totally offsetting any possible economies of scale.  I can only imagine the immense resources, time and mental energy PepsiCo managers expand navigating through complicated integrated advertising or sponsorship deals, juggling needs and budgets from two organizations, thinking up incentive structure that reward divisional performance while encouraging cooperation, making internal cost allocations and coordinating logistics across two headquarters – PEP’s cost of doing business must be out of control.

Amazingly, the CEO on the 4Q13 call asserted that the company realizes $800-$1.0bn in annual synergies by operating “as one".  This number is so big that it warrants further analysis.  Using the midpoint of $900mm and stripping out of reported adjusted operating income means that “ex-corporate synergies”, the operating companies generate an EBIT margin of 14%.  This is the same margin as CCE (a bottler) and materially below beverage peers KO and DPS and food/snack companies like HSY, KRFT and GIS.  Stripping out Frito-Lay and Quaker, the implied EBIT margin for PEP Beverages is around 9%.  This leaves me scratching my head, because PEP’s US bottlers were doing 10% margin, standalone, prior to their acquisition by PEP, and Pepsi Beverages itself reported a 17% pre-tax margin in 2009, the last full year prior to the bottler consolidation (and prior to the $300mm in bottler merger synergies promised by management).

Simply, management’s numbers do not add up.  Synergy promises are made but never accounted for later.  New productivity targets are set but never make it to the bottom line.  I believe this is testament to how poorly run this company is, and the extent to which this management team has gone to try to preserve the status quo.  I believe Trian Partners is dead right in their assertion that almost the entirety of PEP’s $1.1bn in unallocated corporate expenses is unnecessary and can be eliminated through a “blank sheet of paper” process.

On the point of margins and cost structure, history has instructively shown us that the same set of assets can generate very different levels of profitability under different owners/cultures.  Two recent examples come to mind:  (1) Anheuser-Busch’s EBITDA margins went from 25% to 40+% under new ownership and (2) Estee Lauder’s margins expanded from 13% to 18% after a new CEO came in.  Notwithstanding management’s synergy claims, PEP strikes out on efficiency metrics and sports the lowest sales/employee, EBIT/employee, SG&A % of sales, of the peer group), which deeply undermines the management case.  The regression below shows that with 53% gross margin, PEP should in theory have 20% EBIT margins, 500bps greater than the actual 15% reported last year.  Note that BUD, famous for efficiency, is well above the trend-line, while PEP is the farthest company below the trend-line in the data set.  Note also that MNST is the smallest company in the dataset yet has the second-highest EBIT margins and its position above the trendline speaks to a highly efficient and lean cost structure.

With regards to tangible scale benefits across categories, the empirical evidence clearly shows there are none.  I have regressed scale (revenues) versus a number of metrics, including organic growth, valuation multiple, and others.  The data plainly shows that size has no correlation with organic growth or stock market valuation (in fact, there is slight negative correlation!).  Curiously, firm size does correlate highly with CEO compensation.  (PEP’s CEO was paid ≈$15mm annually over the last three years vs. typical $8-9mm for smaller peers like DPS and HSY). 

This analysis shines a light on the weakness of management’s claims about scale benefits.  The empirical evidence is strongly against it.  Experience demonstrates that it is the brand equity and quality of the management, rather than the size of the parent holding company, that is most relevant to retailers (Trian in its white paper has a section on how and why spinoffs have been so successful that is relevant to this issue; see pg. 20, “Precedent corporate spin-offs have unlocked significant value”).

Ultimately, the present management and board are presiding over an unsustainable and competitively disadvantage operating model.  The forces of capitalism will ultimately dictate the outcome—my sense is that if nothing changes, it is possible that in 2-3 years, 3G (via Heinz or Anheuser-Busch InBev) swoops in, acquires the entire company and takes all the excess returns from extracting efficiencies (of note, Buffett in his letter to shareholders mentioned a “partnership template” with 3G that may be used in “acquisitions of size”).  Short of that, I believe activist pressure makes PEP a very timely investment opportunity with at least a 50/50 probability of transformational change.  

The Business

Pepsico operates through four segments: Pepsi Americas Foods (PAF), Pepsi Americas Beverages (PAB), Europe and Asia, Middle East and Africa (AMEA). PAF represents houses the company’s snacks business in North America and Latin America as well as Quaker Oats in North America.  PAB houses the eponymous carbonated soft drink business and sells other brands (Mountain Dew, Gatorade, and Tropicana).  In rough terms, snacks represent 50% of total sales and 65% of total profits while beverages are 50% and 35%.

Despite its blemishes, PEP is a wonderful business: high unlevered returns on capital, stable margins with pricing power, good FCF conversion and consistent earnings- and FCF-per share growth.  The following charts depict a favorable story. The point isn’t that PEP isn’t great – it’s that it could be so much better.

The snacks business (Snacks = PAF excluding Quaker Oats, i.e. Frito-Lay plus Latin America Foods) enjoys a privileged competitive position and generates outstanding economics.  It enjoys dominant market share around the world (a staggering 70% share in the US and 60-80% in most of Latin America).  There are few businesses quite like it, who enjoy such share dominance (5-10x relative market share, see table below).  Frito-Lay is headquartered in Texas, away from PEP’s corporate office, and is famous for its special corporate culture and for having one of the best logistics/distribution capabilities around.  Frito-Lay does around $23bn in sales at a 20+% operating margin and 30-40% unlevered return on assets.  It has enjoyed solid organic topline growth, averaging 7% over the last three years. I believe a standalone Frito-Lay would be a “must-own” growth stock for consumer staples investors and would re-rate to 20-25x earnings, inline with similar growthy staples like HSY, EL and MJN. 

Pepsi’s beverage business (50% of sales but only 35% of profits) is more challenged and receives an unfair share of press and sellside attention.  Beverages is split pretty evenly between carbonated beverages and non-carbonated (Gatorade, Tropicana).  Organic growth has been negative reflecting both secular and market share challenges.  While this business is not pretty, I believe some of the issues are self-inflicted and fixable.  First, the portfolio has some strong brands like Gatorade (20% of the segment), which has 75% market share in sports drinks. Second, the business is weighed down by bottling assets that were acquired for $17bn and that should be divested.  Mgmt. is insistent on keeping bottling and distribution in house (in contrast, KO has already begun discussing refranchising their bottlers).  I believe there are definitely buyers out who would have an interest in the asset (Suntory is one possibility.  Suntory is PEP’s largest non-owned bottler in the US and recently IPO’d with a $14bn valuation and M&A ambitions).  On a standalone business, PEP Beverages would trade at 14-16x earnings (at least in-line with DPS, which has a disadvantaged portfolio that is more heavily skewed to CSDs).

Quaker Foods is small and should be divested, potentially in a Reverse-Morris-Trust merger with a partner like Post Holdings or B&G Foods.  QFNA is subscale and I believe the only reason it hasn’t been spun already is because it constitutes a part of PEP’s “Global Nutrition” group, which is a current strategic priority but for practical purposes has no place in this portfolio.  

Sum of the Parts Valuation

On a sum of pieces, I estimate PEP is worth $97 by year-end.  The SnackCo, represented by Frito-Lay and Latin America Foods, is worth $59 today, based on 2015E EPS of $2.67 capitalized at 22x P/E.  I derive 22x by applying a consumer staples average PEG of 2.0 to my estimated SnackCo LT EPS growth of 13%, which gets to a 26x P/E. I then haircut this to 22x.  Each 1x P/E on Frito = $3/share of value in the sum of pieces.

For Pepsi Americas Beverages, I assume 2-3% EBIT growth and value the stub as a dividend yield play, with a 5-5.5% dividend yield, inline with domestic tobacco stocks. This yields a value of $14-$15.

Europe and AMEA are trickier, because it is impossible to accurately separate snacks from beverages (terrible disclosure btw).  That said, I place a low P/E on Europe and a higher, growth-y P/E on AMEA, commensurate with the fact that AMEA has averaged double-digit organic EBIT growth over the last three years. In total, Europe and AMEA are worth $18/share at a blended P/E of 15x, slightly below the market P/E.

I assume Quaker Foods is spun off tax-free at 12x trailing EBITDA, providing $5/share of value.

Sum of Pieces Scenarios

It’s possible my assumptions are too conservative, especially with respect to the multiples.  Below is a range of Base, Bull and Bear scenarios. The price targets are for yearend 2014.

Frito-Lay Discussion

The biggest source of upside is the “extraction” of Frito-Lay (inclusive of Latin America Foods) from the PEP corporate umbrella.

Frito is a very good business.  PEP management rarely discusses market share with investors, because when you have a 70%+ share, it’s wise to just not talk about it too much.  Fact is, Frito has a 74% market share of mainstream salty snacks (Lay’s, Ruffles, Doritos, Cheetos, Tostitos, Fritos).  There are very, very few companies with such share leadership-- you can count them on one hand –Wrigley in gum, Gillette in razors, Anheuser-Busch in beer and Heinz in ketchup.  These companies traded above 20x earnings and were ultimately acquired for materially above 20x.

Frito-Lay (that is, by my definition, meaning Frito-Lay North America plus Latin America Foods) has compounded sales and EBIT at 6% and 7.5% over the last five years.

Assuming a normalized standalone capital structure and capital allocation, Frito’s implied EPS would have compounded at 14%.  This compares to PEP’s reported EPS CAGR over the same period of 3.5%.  Clearly, both the beverage business and PEP’s capital allocation decisions (among them, spending $25bn+ to acquire US bottlers and dairy assets in Russia) have been a significant drag on earnings per share growth.   

Freeing Frito-Lay from PEP will highlight the value of this franchise and will empower mgmt. to align incentives and focus.  It will give Frito managers the ability to allocate capital internally rather than have to send up cash to PEP parent.  Frito-Lay is a high-return business (35% unlevered ROA) and the ability to deploy its internally generated capital on high-return projects or tack-on M&A could significantly accelerate growth momentum.

A freed up Frito-Lay would also be free to pursue a transaction with MDLZ and develop closer relationships with Pepsi Beverages competitors such as KO, which could be immensely accretive outside the US in markets like Western Europe where Frito is relatively weak and KO quite dominant on the beverage side.

None of this is really quantifiable with any degree of accuracy, but I believe these are just two sources of upside for an independent Frito. A third source of upside is Trian’s so-called “blank sheet of paper approach” which could result in less bureaucracy, fewer employees, and a lower cost structure.

I do not contemplate much upside from any of these in my Frito-Lay projections; I assume 7-8% organic EBIT growth, which yields a 13% EPS growth (I assume excess capital is used to buyback shares).  I think Frito could do better than that (in 2011-2013, EBIT growth was 8%, 3% and 9%) but that is not required to generate attractive returns.  On my somewhat conservative numbers, Frito-Lay will be worth $75/share by year-end 2016, virtually equal to the current stock price.

From a stock-market standpoint, the market likes clean stories.  And a breakup would enable PEP to engineer a clean “GrowthCo”/“DividendCo” split, each piece suitable for different investor bases. This model has worked in a number of cases, most recently MDLZ/KRFT.  KFT’s separation into MDLZ “GrowthCo” and KRFT “DividendCo” has delivered ~30% total return since the spin (vs. staples index +20%), despite that fact that MDLZ has performed below expectations.

Further Discussion on valuation multiples

Focused consumer staples companies are rewarded by the market with higher P/E multiples.  There are two primary reasons for this: (a) focus usually results in better fundamentals, and (b) focused companies make for attractive takeover targets.  The chart below demonstrates clearly that “focused companies” like BEI in skincare, HSY in chocolate, MJN in infant formula and others trade at 20-25x while “conglomerates”, well above the group average.  It is quite telling that lower quality focused companies like HSH (a lunchmeat company with weak-ish brands), and MKC (a spices company with relatively more private label competition) both trade at 15-20% P/E premium vs. PEP.  I believe both Frito-Lay and Pepsi Beverages should benefit from multiple rerating as standalone entities.

The chart above excludes companies that were taken over. Wrigley, Quaker Oats and Gillette were all focused companies that were acquired for 25-30x earnings (and 15-20x EBITDA) as shown below.

Risks

Fundamentally, the downside on the stock is 14x 2015E Street EPS or ~$70 (12% down), at which point the stock would also carry a 3.7% dividend yield.  Technically, the biggest risk to this idea is its dependency on Trian (or other large activists or outside forces) to effectuate transformational change.  There is no way to gauge Trian’s level of commitment, or whether other activists will join the fray.  If Trian goes away, the stock will trade down (but not by much, at this price).  There are only a handful of activists/investors with the capital base and credibility to effectuate the necessary changes at PEP and the success of this investment rests, to some degree, on their actions.

Summary

PEP is a high-reward, low-risk proposition at this price level.  With activists circling and management losing credibility, it’s only a matter of time before structural change unlocks the intrinsic value of the pieces, of which Frito-Lay is the most valuable.  The availability of cheap put protection, financed by a 3% dividend yield, makes this special situation even more interesting. 

DISCLOSURE:

This foregoing analysis is based solely on our own subjective interpretation of publicly-available information.  We make no representations about the accuracy of the analysis or the veracity of the underlying publicly-available information on which it is based.