Why PepsiCo Is Better as a Single, Diversified Company Rather Than Two Separate Companies

Source: PepsiCo

While PepsiCo (NYSE: PEP  ) is better known as a soda company which competes with the likes of Coca-Cola (NYSE: KO  ) , it is more appropriate to view PepsiCo as a beverages and snacks manufacturer. PepsiCo generates about half of its revenue from snacks and food, with beverages accounting for the rest. It's also the largest snack company in the world, counting companies such as Mondelez International (NASDAQ: MDLZ  ) among its peers.

In February 2014, the board of directors for PepsiCo sent a letter to activist investor Nelson Peltz, rejecting his suggestion of splitting the snacks and beverages businesses. Peltz subsequently responded a month later by saying that he was 'extremely disappointed' and he demanded analytical support from PepsiCo for its rejection decision.

Given the current state of matters, it is likely that PepsiCo will remain a single diversified beverages and snacks company. Hence, it is worth considering if whether PepsiCo is better off as one company rather than two.

The U.S. beverage industry has been facing headwinds recently. In particular, the carbonated soft drinks, or CSDs, market has experienced declining volumes as consumers seek healthier alternatives to sodas. According to research by Beverage Digest, sales of CSDs in the U.S. have fallen by about 12% over the past decade from 10.1 billion cases in 2003 to 8.9 billion cases in 2013.

Current CSD volumes are at 1995 levels, which suggests that the soda makers have almost given up all of the growth they have registered in close to two decades.  Recent trends are equally worrying, with domestic CSD volume declining by 3%, 1.2%, and 1% in 2013, 2012, and 2011, respectively.

There are two bright spots amid the gloom. Firstly, industry giants Coca-Cola and PepsiCo have largely retained their dominance of the CSD market, where they boast a combined market share of over 70% over the past decade.

Secondly, unlike the situation in other consumer-product categories like tissue paper, private label CSDs haven't posed significant threats to soda makers. Private label penetration remains low at below 7% for the past ten years.

Notwithstanding a weak beverages market, PepsiCo enjoys two key advantages over Coca-Cola because of its diversification into snacks. Firstly, PepsiCo's revenues are more recession resistant than those of Coca-Cola because of the contributions from its more stable snacks business.

During the global financial crisis, Coca-Cola's top line fell by 3% in 2009 while PepsiCo's sales remained flat over the same period. From 2004 to 2013, PepsiCo's 10-year revenue compound annual growth rate, or CAGR, of 9.4% also edges out Coca-Cola's 8.3% annualized growth.

Secondly, PepsiCo's beverages and snacks businesses are complementary. According to its internal research, about 65% of domestic retail sales for snacks, breakfast, and beverages relate to common or complementary needs. This suggests that most people pick a beverage to go with their food or vice-versa, which creates opportunities for a diversified company like PepsiCo to capitalize on such demand through brand positioning and the development of complementary beverages and snacks.

For example, PepsiCo tried to drove joint purchases of Pepsi and Doritos (Frito-Lay) among Hispanic consumers with targeted advertising campaigns which emphasized that both products taste better when they are consumed together. The results were encouraging, with PepsiCo delivering sales growth of 25% and 31% for Frito-Lay and Pepsi, respectively, in 10 Hispanic markets.

Meanwhile, while Coca-Cola has remained a beverage company it has pursued geographical diversification, with its focus on generating growth in emerging markets. It laid out its 2020 vision in 2009 with a target of doubling its servings per day to $3 billion. Industry forecasts which point to a 50% increase in the middle-class population and 70% growth in personal expenditures per capita from 2010 to 2020 support Coca-Cola's ambitions.

Furthermore, the penetration rates of Coca-Cola products remain low in emerging countries. In 2011, an average Chinese person consumed 38 Coca-Cola products every year, while an average American consumed 403 products per year. Coca-Cola can also leverage its strong brand name when it expands internationally. While both PepsiCo and Coca-Cola have pursued different diversification strategies, their end results should be positive as long as they extract the appropriate synergies.   

Source: PepsiCo

Both PepsiCo and Mondelez have well-known brands in the snacks and foods categories. PepsiCo boasts brands like Lay's, Ruffles, and Cheetos; Mondelez's brand portfolio includes names such as Cadbury, Nabisco, and Oreo.

Looking at the financial numbers of both companies, PepsiCo boasts profitability superior to that of Mondelez. For the most recent financial year, PepsiCo's gross margin of 53%  was higher than the 37.1% gross margin of Mondelez. Mondelez's operating margin of 11.2% was also inferior to PepsiCo's corresponding margin of 14.6%.

Even if segmental numbers are examined, the operating profit margins for the North American businesses of Frito-Lay North America and Quaker Foods are impressive at 27% and 24%, respectively. In contrast, Mondelez's North American business boasts an inferior operating margin of about 13%.

PepsiCo generates higher margins than Mondelez for two key reasons. Firstly, PepsiCo has tremendous scale advantages in North America as it leverages its distribution network to sell both beverages and snacks. As an illustration, PepsiCo has a significant scale advantage over its domestic peers which is as much as twice that of its nearest U.S. competitor, based on its internal estimates and industry data on retail sales. Therefore, it makes sense for PepsiCo to keep its beverages and snacks businesses under one roof and extract economies of scale from spreading the shared distribution, procurement, R&D, and back-office operations costs over a larger revenue base.

Secondly, Mondelez has significantly more international exposure (80% of sales) than PepsiCo does, so it must make significant investments to customize its offerings to suit the different tastes and preferences of international consumers. In contrast, with half of its revenue generated domestically PepsiCo has the ability to sell more of its products without significantly adapting them.

Foolish final thoughts
Although diversification remains a hotly debated topic in corporate circles, synergies exist between PepsiCo's beverages and snacks businesses in terms of cross-selling and economies of scale that prevent it from becoming a case study for 'diworsification.'  

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Mark Lin

Mark is a private value investor and is the author of website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.

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