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December 2009

Pepsico

Research Report by Peter Hughes, Check Capital Management

Price: $62

Pepsico (PEP) is the world's largest snack-food company, as well as the second-largest producer of soft drinks. The company has 18 brands whose sales each exceed $1B annually, including Gatorade, Tropicana, Mountain Dew, Doritos and Quaker Oats. Over 40% of sales come from outside the U.S. The firm was founded in 1898 and has enjoyed consistent growth over most of its history. The graph at right shows results over the last sixteen years. The Business

Pepsi's EPS & Dividends

$4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00

$0.50

$-

EPS

Dividend

Pepsico has assembled a group of very strong brands in the beverage and food industries. Using the cash from its core soft drink business, management moved into related high-margin businesses, each guarded by significant barriers to entry. Frito-Lay was acquired in 1965 and provides over 40% of firm profits. PEP also bought Tropicana in 1998, Quaker Oats in 2001 and Naked Juice in 2007. These product lines have strong synergies with the soft drink segment because they share much of the same distribution system. After moving into a new product area like snack food, Pepsico expands the brands' product offerings and distribution, increasing its profitability. The Frito-Lay division now sells over 40 different products worldwide. Pepsico enjoys oligopoly status in both of its main product categories. Frito-Lay holds 60% share of the salty snack food market in North America and 35% worldwide. Pepsico has 31% share of the U.S. soft drink market versus 43% for Coca-Cola. Globally, Pepsi has 2008 Revenue by Segment 21% soft drink share to Coke's 50%. ($ Billions) Because of its products' high marketshare, 20 Pepsico commands significant economies18 16 of-scale in advertising, research, 14 production and distribution. 12 Three factors make it very difficult for new 10 farms to make serious inroads into PEP's 8 6 markets: brand strength, shelf space and 4 distribution. Creating a new brand and 2 raising awareness for it would cost billions 0 of dollars, money which smaller firms Frito-Lay N. A. Quaker Pepsi Beverages Pepsi Int'l N. A. don't have. Furthermore, retailers are unlikely to give up meaningful shelf space

1 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777

of a profitable product to experiment with a new one. Furthermore, the cost and expertise needed to develop a world-class distribution system are unavailable to newcomers. All of these factors insulate Pepsico's products from cutthroat competition, and suggest that it will continue to be successful for years to come. Pepsico continues to grow. The company's easiest growth comes from abroad, where it can sell its products to the expanding middle classes of developing countries. Because of the company's history and expertise, it is relatively easy for PEP to move into a new country, make minor product adjustments for local tastes, and find success. The company sells its products in over 150 countries, and has solid potential for future growth.

2008 Segment Operating Income ($ Billions)

3.5 3.0

2.5 2.0

1.5 1.0 0.5 0.0

Frito-Lay N. A.

Quaker

The company's North American businesses are more mature. The Frito-Lay division continues to post rising revenue in the U.S., but because of its high marketshare its gains are constrained by the growth rate of the overall snack foods market. The domestic soft drink business registers even slower growth. While soft drink sales in the U.S. grew about 3% per year during the 1990s, they have declined slightly each year since 2005. These declines amount to only about 1% per year, but do suggest a shift in the market. Increasingly health-conscious and active Americans are turning to lower-calorie alternatives. To meet this challenge Pepsico has taken several important steps. It has moved beyond soft drinks to noncarbonated drinks. Gatorade, Tropicana, Lipton, SoBe and Aquafina are all PEP products that appeal to consumers more focused on nutrition. The company is also moving into healthier snacks with brands such as TrueNorth, Stacy's and Sabra. Furthermore, Frito-Lay is reformulating many of its products to reduce fat content and calories. The Bottler Acquisition Pepsico is currently in the process of acquiring two of its largest bottling companies. PEP will pay $7.8 billion for the 65% of Pepsi Bottling Group and 59% of PepsiAmericas it does not already own. Like Coke, Pepsi went through a process of selling many of its bottlers in the 1990s in an effort to increase returns and focus management's attention on marketing and product development. However, current Pepsico Chairman and CEO Indra Nooyi believes that due to the evolution of the business it makes sense to bring the bottling and distribution parts of the business back in-house. By consolidating the bottling operations, PEP hopes to save $300 million per year. Also, it should help the company cross-market its food and beverage portfolios since many of these products are delivered to the same retailers. The increasing importance of the Pepsico's noncarbonated beverage portfolio also plays a role in this decision.

2 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777

Pepsi Beverages N. A.

Pepsi Int'l

Financial Metrics Pepsico's valuable brands and leading market positions help the firm achieve very strong financial metrics. The firm's net profit margin is 14% and its return-on-capital is 25%. Important, both of these ratios have remained at consistently high levels for over a decade, while the company has maintained a reasonable debt load. This stability makes the company easier to value and also demonstrates the enduring quality of firm's businesses. Pepsico produces a great deal of excess cash, and management returns much of this money to shareholders. The dividend is currently 2.8%. Furthermore, PEP has retired 11% of its stock since 2001, although repurchases have been temporarily curtailed in light of the coming acquisitions.

Pepsi's Financial Metrics

40%

35% 30% 25% 20% 15% 10% 5% 0%

Despite its market position and the 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 stability of these products, the firm Return on Capital Net Profit Margin isn't immune from the retracting economy and will likely post weaker-than-usual earnings growth in 2009. Q3 net revenue fell 1.5% to $11.1B. However, on a constant currency basis net revenue rose 5%. Q3 net income rose 10% to $1.7B and earnings-per-share rose 10% to $1.09. Management expects to post pershare earnings growth of 11%-13% in 2010, on a constant currency basis. Valuation Because of its market position and strong financial metrics, the stock of Pepsico historically trades at a high valuation. As the graph at right shows, over the last 20 years Coke stock has usually traded at more than 20 times its earnings, and often at much loftier levels. However, in the past year the stock has fallen to valuation levels not seen since the early 1990s. Although it has recovered somewhat from its low, the stock now trades at a valuation of 17 times earnings. The current stock price appears to offer investors a reasonable opportunity for solid long-term investment returns.

$80 Price $60 16 times Earnings Per Share

$40

$20

$0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

40 35 30 25 20 15 10 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

P/E Ratio

3

Check Capital Management Inc.

Costa Mesa, CA.

(714) 641-3579

(800) 710-5777

CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness.

4

Check Capital Management Inc.

Costa Mesa, CA.

(714) 641-3579

(800) 710-5777

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Pepsico

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