Investors in PepsiCo, (PEP 1.34%) especially those fond of reinvesting dividends, should have few complaints about the consumer goods multinational so far in 2014. The company's stock performance is outpacing giant snack food peers like Mondelez International, as well as beverage arch-rival Coca-Cola, while also floating well above the broader market in a year-to-date, total-return comparison:
PEP Total Return Price data by YCharts.
Is PepsiCo's stock ready to return to the middling performance of its peers, or will it continue to climb in the near future? Below, we'll discuss three reasons which support the possibility of further appreciation.
1) Challenging Peltz's principles
For much of this year, PepsiCo has operated looking over its shoulder at hedge-fund operator Trian Partners and its CEO, Nelson Peltz. Through Trian Fund Management, L.P., Trian Partners owns a $1.2 billion stake in PepsiCo, and has advocated splitting up the snacks and beverages businesses, most notably in a detailed white paper issued earlier this year.
Trian Partners argues that each business would be more profitable, and thus of more value to shareholders, if operated separately. Peltz believes that the snack business, which includes multiple billion-dollar brands in its Frito Lay and Quaker Oats segments, would benefit from a spinoff and subsequent merger with snacks behemoth Mondelez.
Trian has made a cogent case that PepsiCo's before-advertising earnings before interest and taxes, or EBIT, margin has lagged that of its peers in recent years. The hedge fund blames this on the inefficiency of two very different types of businesses housed under one roof. PepsiCo management, unsurprisingly, sees the current model very differently, and frequently points to its "Power of One" concept, which originally described the benefits of cross-selling its snack and drink products in retail venues, but now appears to apply to the company's operational model, as well.
In 2014, the company has managed to grow organic revenue by 4%, not an easy number in the current global economy. It's doing so through the "Power of One" idea as originally formulated: pairing and cross-selling snacks and drinks.
The summer launch of two complementary products created for the 7-Eleven Chain, the "Doritos Loaded" snack and a drink named "Solar Flare," is emblematic of this strategy. The products will be marketed together, pushing up potential co-purchases. Similarly, the company has seen a 21% increase in co-purchase transactions within Dollar General stores due to its "Doritos and Dew" promotion. Through its NFL advertising program, PepsiCo promotes "Pepsi and Tostitos." These pairings are more than just cute mashups created to satisfy refreshment cravings; they're at the center of PepsiCo's revenue and profit mixes:
Image: PepsiCo 2013 Annual 10-K SEC filing.
Take a look at the blue wedges in each chart: the acronyms PAB and FLNA represent "PepsiCo Americas Beverages" and "Frito-Lay North America," respectively. PepsiCo's greatest concentration of revenues and profits lies in North American Frito-Lay snacks and North and South American beverages. Thus, the "Power of One" cross-selling of salty snack and liquid refreshment combinations here in the Americas is a core strength of the company's business model, and fertile ground for future growth.
2) Counter-intuitive revenue strategies
Runaway inflation in Venezuela and Argentina has many consumer goods multinationals seeking to limit their exposure in these countries. Last year, PepsiCo took a $111 million writedown to revalue its assets due to the depreciation of the Venezuelan bolivar. You would think this might cause PepsiCo to scale back its ambitions in Latin America, at least in those countries with hyper-inflationary environments.
On the contrary, PepsiCo continues to sell into these economies, where it has appreciable market share. During the company's most recent earnings call, CFO Hugh Johnston described the company's strategy, which is essentially to match pricing to inflation, thus somewhat limiting the foreign exchange impact. In the last quarter, both snacks and drinks in Venezuela grew by "strong double digits," according to CEO Indra Nooyi.
Also, it helps to take last year's charge against earnings into context: Venezuela accounts for roughly 1% of net revenue and 2% of PepsiCo's operating profit. This translates into approximately $660 million in annual revenue, and $194 million in profit. Long term, especially if the company can "take pricing," the $111 million charge to revalue assets within Venezuela can be chalked up to the cost of doing business.
3) A breakup may be inevitable
While PepsiCo has steadfastly defended its "Power of One" metaphor, and despite the retail success discussed above, shareholders may expect that "one" will be divisible in the near future. Management asserts that breaking up the company would result in $800 million to $1.0 billion in dis-synergies -- new expenses incurred from the breaking up of shared operating costs -- if the snacks and beverage businesses eventually part ways.
Yet, Trian Partners points to PepsiCo's $1.45 billion of unallocated overhead in 2013 as a partial answer to the question of dis-synergy. Outside of a few small items, such as accounting for investment gains and losses and the Venezuelan currency devaluation charge, "unallocated overhead" represents costs that can't be apportioned to any of PepsiCo's six reportable segments.
Trian Partners sees this as an inefficient use of resources; but since Pepsi lumps $1.25 billion of this total into a category called "Other," no outside investor can say whether the costs represent value-added corporate functions, or corporate bloat and duplicated functions. As an example, we know that PepsiCo's R&D budget is contained within the unallocated overhead line item; but Trian rightly questions why R&D costs don't rest directly within business divisions. It does seem inefficient for research and development to be funneled through corporate office decision makers, rather than being directly expensed at the divisional level.
Whether one agrees or disagrees with the Trian thesis, it seems apparent that some of PepsiCo's 2014 rise is owed to shareholders betting that the company will eventually undergo some type of restructuring. Moving forward, this may be the most prominent reason driving buying interest in PepsiCo in the near term.
