Time to Split?
Activist Nelson Peltz builds a compelling case for breaking up PepsiCo. Management disagrees.
Spinoffs are all the rage in Corporate America. Media companies such as Gannett and Time Warner are shedding their slow-growth newspapers and magazines to focus on their more attractive broadcast and cable properties. Abbott Laboratories split into two, separating the namesake medical-products unit and the faster-growing pharmaceuticals business, AbbVie. And Kraft Foods was broken in half, forming two separate publicly traded companies, Kraft Foods Group, the slow-but-steady grocery business, and Mondelez International, the better-performing snack and candy business.
One company that has stubbornly resisted the urge to split itself apart is PepsiCo (PEP), the 116-year-old soft-drinks business that now gets 60% of its profit from Frito-Lay, maker of Fritos, Doritos, and Lay's potato chips.
For years, some investors have grumbled that the soft-drink business was a drag on the more lucrative and faster-growing salty-snacks business. The grumbling has grown louder since activist investor Nelson Peltz entered the fray last year. In a white paper released last summer, Peltz's Trian Partners posited that Pepsi, whose stock recently fetched $92, could be worth as much as $144 a share.
"Shareholders are not happy with the status quo," Peltz tells Barron's. "While we think the best path forward to unlock value is a spinoff of the beverage business, we are open-minded."
Trian Partners, which holds $1.2 billion of Pepsi shares, has a history of getting results. The investment firm, also founded by Peter May and Ed Garden, helped drive the 2012 spinoff at Kraft and a turnaround at Heinz after winning seats on their boards. In the past, Peltz has said "there will be action" with regard to his dealings with Pepsi. Possible options include a proxy fight and an effort to obtain a board seat.
PEPSI APPEARS TO BE responding to his prodding. In February, management extended by five years a billion-dollar annual cost-cutting program by trimming fat from the company's corporate structure, retooling manufacturing, expanding automation, and improving its distribution network. And this year, the company expects to return $8.7 billion to shareholders in the form of dividends and share buybacks -- 35% more than in 2013.
At the same time, however, Pepsi has steadfastly held to its "Power of One" strategy that keeps both soft drinks and snacks under one corporate roof. "We have been performing while transforming," says Pepsi's Chief Financial Officer Hugh Johnston.
Asked about the call to break up the company, he would say only that Pepsi has been "pretty consistent about keeping the businesses together," noting benefits from an overlap in procurement and the supply chain. In the U.S., Johnston notes, snacks and beverages are purchased together 55% of the time.
Pepsi Chairman and CEO Indra Nooyi declined to speak with Barron's, but on the company's first-quarter conference call, she said that "the heavy lifting we've done to transform our portfolio is yielding results."
If management is unhappy with Peltz's persistence, Wall Street is encouraged. "The Peltz factor has been a material part of the improvement in Pepsi's recent performance," says Stephen Powers, a UBS analyst who recently upgraded the stock to Buy and carries a $100 price target.
Deutsche Bank analyst Eric Katzman wrote in a recent report entitled "Please Don't Go" that "activist pressure is forcing management to take a harder look at its portfolio, operations, and cost structure…making PepsiCo a better and more agile company as a result."
Pepsi points out that it has met or exceeded earnings expectations for the past 10 quarters, though some analysts say guidance was reduced between quarters, effectively lowering the bar.
Pepsi's shares are up 11% since Peltz first announced Trian's stake in the company in April 2013. Shares are near an all-time high, and many believe that his pressure on the company puts a floor under the stock, something that one might call a "Peltz put."
Peltz says that he and Nooyi were close friends until January 2013, when he began buying shares and privately agitating for change. Through a spokesman, Nooyi said that she still considers Peltz a friend.
The perennial No. 2 in soft drinks, Pepsi sold $17 billion of carbonated beverages last year, including Pepsi-Cola, Diet Pepsi, and Mountain Dew. Combined with Gatorade, Lipton Teas, Tropicana juices, and Naked Juice, beverages accounted for $31.8 billion, or 48% of Pepsi's $66.4 billion of sales last year. Pepsi has 14 brands that generate $1 billion of sales or more per year.
Coca-Cola (KO), in contrast, sells only beverages. Carbonated beverages, including Coke, Fanta, and Sprite, accounted for 70% of the company's 2013 sales of $46.9 billion. Coke has 17 brands that generate sales of more than $1 billion a year.
Coke's total beverage sales are growing by 3% to 4% a year, while Pepsi's are increasing by 2% to 3%.
Coke and Pepsi became fundamentally different companies, however, when Pepsi acquired Frito-Lay in 1965. Today Pepsi's snack business accounts for more than half of sales and 28% of the global snack market. Frito-Lay has eight multibillion-dollar brands.
Pepsi's snack brands grew 4% last year, but boasted 27% operating profit margins; beverage sales fell 1.5% and had 14% operating margins. The company earned $6.8 billion in 2013, or $4.37 a share.
Peltz argues that a split would allow both beverages and snacks to operate more entrepreneurially. "The goal is to keep corporate overhead down and enable the businesses to live up to their potential, by empowering operating management and eliminating corporate bureaucracy," Peltz says.
Trian thinks Frito-Lay can shine brighter by putting more advertising and marketing dollars behind the brand. While Nooyi said on the second-quarter call that Pepsi would spend 5.9% of revenue on advertising this year, it used to be 8%, according to Trian. Peltz's firm asserts that Pepsi has been siphoning off advertising dollars to bolster the beverage business.
Pepsi says it spent 7.6% of beverage revenue on sales and marketing in 2006, but that was before it acquired its bottlers, which added $20 billion to revenue. The percentage fell to 5.9% thereafter. The company denies that ad dollars have been shifted from Frito-Lay to fuel beverages.
Pepsi currently trades for 18 times 2015 estimated earnings of $4.96 a share. Trian's model envisions that a stand-alone snacks business would achieve a 23 ratio, while beverages would fetch 18.5. That gets the shares to $105. To achieve the $144 that Trian has estimated in a spinoff, it models a 3.75% dividend yield -- the stock currently yields 2.9% -- as well as accelerated cuts in corporate overhead and increased investment in the brands. Trian would reduce costs, in part, by consolidating Pepsi's four headquarters -- two in New York and one each in Chicago and Plano, Texas -- into two.
Ali Dibadj of Bernstein agrees that there are $2 billion to $3 billion more of costs that can be cut beyond the $5 billion that have been mandated. But cost-cutting only goes so far. At some point, he says, an improved strategy must be put into place.
Pepsi maintains that synergies as a single company save it $800 million to $1 billion a year. Trian counters that the opportunities to cut corporate costs greatly exceed the synergies.
FAR FROM ABANDONING BEVERAGES to focus on the more lucrative snack business, Trian has said it sees "great potential to expand margins in a stand-alone beverage business." Trian would buy more shares in the beverage company and be willing to join its board. A slimmed-down beverage business that doesn't have to support corporate overhead could be a far more formidable competitor to Coke, Trian has said.
Powers, of UBS, agrees. "To some extent, the beverage business has been starved of investment, and on the flip side, it has been subsidized and propped up by a really strong Frito-Lay North America business," he avers. "Its sense of scrappiness to try to compete with Coke and win on its own merits arguably has been compromised."
Moreover, "the benefits Pepsi has been able to achieve by being together are somewhat dubious," he says. He notes that the businesses differ culturally and don't intersect beyond the executive level, although they enjoy some overlap in the purchase of things like advertising, packaging, and raw materials.
"The current system isn't ideal," says Dibadj of Bernstein. "Our view in the past five years has been that Pepsi should either integrate its business more or split them."
Also lining up in favor of a split is the California State Teachers Retirement Fund, known as CalSTRS, a longtime Pepsi holder and an investor with Trian. "The reason for the stock's recent performance is Trian," Aeisha Mastagni, a CalSTRS investment officer, told Barron's.
Dissatisfied with Pepsi's longer-term performance, CalSTRS wrote to the company's lead director, Ian Cook, the CEO of Colgate-Palmolive (CL), earlier this summer, seeking to give Trian a say in the boardroom. Mastagni says the board responded, but neither she nor PepsiCo director Daniel Vasella, with whom Barron's spoke, would comment on the response.
A former CEO of Novartis (NVS), Vasella told Barron's that the directors "really care about having an open communication" with shareholders, but the board "very clearly supported the view of management that it's best not split." He wouldn't comment on the possibility of Trian gaining a seat on the board, but noted there is a clear procedure for nominating and voting a director onto the board, whether recommended by a shareholder or an insider.
Still, Mastagni says, "Trian has made a good argument for separating those two businesses." She adds that it is still to be determined whether they can succeed as one.
"I'm confident Pepsi would be in a better position two or three years from now if a Trian member were on the board," she says.
NOT ALL INVESTORS THINK Pepsi should be split up. Robert Burnstine, president of Fairpointe Capital in Chicago, has seen his shares appreciate nearly 50% since he established a position in the stock in 2011. "Common sense would suggest a lot of synergies between the two businesses," he says, adding that a spinoff would put a lot of stress on the company and wouldn't be so easy to accomplish.
Burnstine expects that cost savings and increased scale, as well as innovation and global growth, will generate top-line growth in the mid-single digits and earnings growth in the high single digits, enabling management to achieve its targets. He thinks the franchise is worth $110 a share in the next 12 months.
Joe DePinto, CEO of 7-Eleven, and a longtime customer of Pepsi, also advocates keeping the company intact. Pepsi is "in tune with what's going on with the consumer, and has been able to deliver on snacks and beverage solutions in a seamless way," he says. He cites increased innovation, with products such as Doritos Loaded -- a hot, cheese-filled snack wrapped in Doritos -- as well as healthier options such as Naked Juice as helping 7-Eleven achieve 15% compound annual sales growth in four years from such products. Pepsi has said it plans to increase sales of healthier foods to $20 billion by 2020 from last year's $13 billion.
PEPSI RECENTLY BEAT second-quarter earnings guidance and raised its outlook for 2014 earnings growth to 8% from a prior 7%. The company was No. 1 in the second quarter among the 30 biggest food suppliers in sales growth at U.S. retailers. Analysts expect Pepsi to earn $7 billion, or $4.59 a share, this year, on revenue of $67.1 billion.
Johnston, the CFO, notes that the company has performed better than peers in the past two years, a time when consumer spending has been challenged. In this span, Pepsi boosted earnings per share by an average of 9% a year, compared with 3% for its megacap peers.
Pepsi has stepped up new-product introductions this year, bringing to market Gatorade flavors such as Fierce Green Apple and carbonated offerings like the tropical-fruit-flavored Mountain Dew Solar Flare. At the same time, Frito-Lay has launched more adventurous concoctions, including Lay's Cheddar Bacon Mac & Cheese potato chips, and heavily spiced Cheetos. PepsiCo introduced nine of the top 50 new food and beverage products in the U.S. last year, including Mountain Dew Kickstart and Tostitos Cantina Tortilla Chips, according to the company.
The U.S. and other developed markets account for 65% of PepsiCo's sales. Frito-Lay, however, is far more skewed to domestic sales than is Pepsi, generating 50% of revenue in the U.S. Management argues that Frito-Lay will build on Pepsi's more global presence, particularly in emerging markets, where beverages pave the way with lower-income consumers. If Frito-Lay weren't a part of Pepsi, a company spokesman says, it wouldn't be a global company.
WE AGREE WITH PELTZ that shareholders probably would be better off if Pepsi and Frito-Lay became stand-alone corporations, and that cost-cutting at each company would more than offset their current synergies. Either way, as one large investor put it, Peltz effectively is holding a gun to management's head, and the pressure is on to perform.
Or, as CalSTRS' Mastagni says, "It can be a win-win situation."