We've all heard that statement countless times and it makes sense. What a bonus, a salty sweet kicker to go with a carbonated icon. Seems like an ideal situation doesn't it? PEP management, led by CEO Indra Nooyi believes so but Nelson Peltz, for one, thinks otherwise and want’s two divisions split up. Both Peltz and PEP management claim they are aligned with large shareholders, yet few seem to to go on the record voicing similar opinions. There’s no disputing that breakups add value for shareholders, especially short term, but should PEP be next? Let’s break it down simply and see if it does.
It’s no secret that the carbonated beverage market is shrinking, especially domestically. It turns out people don't like being fat and out of shape. The only growth in soda is emerging markets and “EurAsia” as PEP calls it in their regional breakdown. One can't help but wonder what happens when folks in those countries grow weary of giving their children sugar water like many parents in the U.S. have already. My belief is that if PEP or KO switched to pure can sugar in the U.S., like they have in other regions of the globe, it may help to slow volume decline. I think they’re losing out on an entire generation of customers as many parents refuse to submit children of any age to high fructose corn syrup or artificial sweeteners. But i digress.
Speaking of KO, it’s currently trading at 20x earnings. That’s not cheap by any metric to be sure but it's no doubt lifted by a 3.2% yield, currently 60 basis points higher than a 10-year treasury. Sounds interesting until you consider that income DECLINED 5% for FY 2013 shrinking EPS at the same time. Volume, a key metric in the beverage business was down in Q4 as well but up for the year as KO reported worldwide growth of 1%...wow. Suddenly, less interesting.
Not surprisingly KO signed a deal with GMCR recently in a deal that both companies probably needed. Who knows if it will pay off, but you can’t fault them for looking for another growth engine, it’s not like they have a food or snack businees to fall back on in lean times.
PEP reported a quarter which was received slightly better by investors though the beverage business wasn’t any better than KO. To be clear, they actually lost share to the “real thing” during the quarter. However, the food and snack business keeps chugging along with Quaker North America as the only black eye of a business growing revenues at about 5% across all regions YOY.
I know what you're thinking, surely PEP must trade at a premium to KO, you’re getting this nice snack biz with a similar beverage operation. Actually it doesn’t. At $80.07, where it closed Friday, it’s finally approaching 19x earnings thanks to some serious saber rattling this week, but it's still short of 20. Hmmm, interesting. PEP sports a yield just north of 2.5%, not quite what KO gives back to shareholders but the company spent $6.4 billion in share buybacks and dividends last year, better than a sharp stick in the eye. (I heard that somewhere)
The company plans to keep deploying cash to shareholders in these forms, though it seems doubtful that either will increase substantially as total free-cash flow for 2013 was $8.2 billion and growth is not expected to exceed this past year meaningfully in the coming fiscal year.
You must be thinking that the food business is a drain on the global beverage business. Why else would it trade at a lower multiple than a similar company with ONLY a declining beverage business and no snack business?
It’s not. The food side of the operation does only represent 40% of the revenue, BUT it makes up 60% of the profit for PEP. This is probably why similar business in the food and snack biz trade at a higher multiple than even KO. I looked at MDLZ, which Mr. Peltz knows well and HSY, one my stomach knows well. MDLZ actually trades at 26x earnings, likewise for HSY, give or take a few tenths. Both sport modest yields around 1.75%.
Interesting that PEP’s dividend yield is about in the middle of KO and these two food businesses, almost like it’s a hybrid of both companies. Neither HSY or MDLZ are hyper growth stocks either, one could even argue they are a bit rich at these levels. Actually, you could argue that for every company I’ve mentioned so far. Bu that’s another blog I guess. If nothing else the price of cocoa should start to crimp HSY margins at some point, even with hedges. MDLZ has a chocolate business in Cadbury too but cocoa is just one example as an input cost that is rising rapidly for all these players. Therefore, I don’t expect these PE’s to stay in the mid-20’s very long.
During the past year PEP earned $4.37, just using a rudimentary calculation I believe that the food and snack business contributed $1.75, leaving $2.62 for the flagship beverage business. So if you simply slap a similar PE to peers on these two businesses:
FLQ (Frito Lay/Quaker Foods) $1.75 x 25 = $43.75
PEP (Pepsi Beverage Company) $2.62 x 20 = $52.40
That gives us a combined value of..... $96.15 or 20% ABOVE Friday’s close.
If the pair was separated, clearly PEP would inherit the fizzy yield, while the snack business, which would be growing, would not have as salty a dividend, much like those of its peers. It’s easy to conclude that PEP is worth more TODAY as two separate companies, very little question, but what about five years from now?
I’m not smart enough to figure that out. I'm not sure anyone is to be honest. My main concern is that “activism” could signify a market top. Why wouldn’t you take a huge stake in PEP and hope to get a spinoff that could garner 20% when your downside is relatively limited as opposed to buying shares in something like AMZN or TSLA? Seems like a good strategy if you think the market is fairly valued. Simply, buy something that can be squeezed for value, take your winnings and move on to something else. Just one man’s opinion.
The currency issues for all these companies make calculations extremely complicated too. I also don’t think anyone can value the relationship with customers PEP garners by having both businesses under one roof allowing it to negotiate deals with the other in mind. I have no idea how you place a value on that long term. I could also make a case that PEP has to have the food business moving forward to have a profitable growing business at all. Perhaps that’s why KO took a shot on a GMCR stake, they can see their business is slowly eroding and know they need to find growth somewhere before their ample cash flow starts to run dry.
I’d leave the two companies together. I don’t think the 20% today would be validated five years from now when Peltz would be loooong gone. Maybe MDLZ would buy the spun off business at a premium, it’s happened many times before so 20% may be the low end of the spin value if you're willing to wait it out 12-24 months. Certainly M&A is increasing so anything is possible. But that still leaves you with a company with a business in decline on the other end in PEP. Since the people making this decision would be the ones left with the no growth beverage business, i don’t see it happening and don’t see it benefiting PEP long term.
It’s clear that Peltz won’t give up easy, maybe he shouldn’t, one can easilty see the companies parts are undervalued compared to peers as a whole. This will likely be a long drawn out battle, but Indra Nooyi can always hope that mother Mary comes to Nelson, speaking words of wisdom....Let it Be.
I have no position in any of the stocks mentioned.