When snack food and beverage giant PepsiCo (NYSE: PEP) was added to the Drip Portfolio back in July, a major factor in the final investment decision was the number of options the company had at its disposal to grow its business in the coming decades. For lack of a better term (or perhaps because Jeff was in the middle of reading an introductory Physics text at the time) these available options were called "levers," which included such things as category-killer products and pricing power. Our analysis left out one big potential lever, however -- purchasing power. Billions of dollars worth of purchasing power.
Last week, PepsiCo put some of its purchasing power to use and acquired fellow food and beverage company Quaker Oats Co. (NYSE: OAT) for about $12.8 billion in stock and roughly $750 million in assumed debt. All told, Pepsi expects to issue some 315 million new shares to complete the transaction, which equates to more than 21% of Pepsi's current diluted sharecount. That's a lot of bottle caps. When such a large percentage of a company is being traded away, shareholders should take notice and evaluate whether the deal makes sense.
As mentioned above, the key to the deal is Gatorade, which is quite possibly one of the most valuable beverage brand names out there today. Over the past 20 years, the franchise's growth has been a thing of wonder. Gatorade was generating a mere $97 million in annual sales when Quaker picked it up in 1983. In Quaker's most recent fiscal year, annual sales had leapt to $1.8 billion. That's a compound annual top-line growth rate of nearly 19% over the past 17 years, which is simply astounding in the traditionally slow-growth food and beverage business.
There is little doubt in our minds about the high value of such a strong-growing franchise. Moreover, there appears to be a significant moat around Gatorade given that both Pepsi and Coca-Cola (NYSE: KO) have tried to supplant the brand's dominance with sports drinks of their own in recent years, but to no avail. According to Quaker, Gatorade's market share remains in the 80% neighborhood, making it the Intel (Nasdaq: INTC) of sports drinks.
The brand's go-go growth rate will likely slow in coming years as the law of large numbers kicks in, but it will nonetheless provide a nice boost to Pepsi's non-carbonated beverage business. Earlier this year, Quaker's management predicted that future Gatorade sales would climb at about half the historical growth rate. That may be a slowdown, but it should be enough growth to provide an additional $1 billion in annual sales just five years from now.
While much of the post-merger excitement by analysts and the press has focused on the impressive value of the Gatorade franchise, the strength of Quaker's management team has been largely overlooked. With the purchase, Pepsi is adding some impressive folks to its managerial bench. Chief among them is Quaker Chairman and CEO Robert Morrison, who will be coming on board as a vice chairman to oversee the integration of Quaker into Pepsi. Morrison's presence could be a crucial asset for Pepsi, as he previously oversaw the blending of the Kraft and General Foods businesses in 1995 when he was at Philip Morris (NYSE: MO).
Such experience could prove invaluable at Pepsi, which might have run into execution problems if it had tried to run Quaker's non-snack food business by itself. Products like Quaker Oatmeal, Life and Cap'n Crunch cereals, and Rice-a-Roni fall outside of Pepsi's traditional core competencies in carbonated and non-carbonated beverages and snack foods. With Morrison's oversight, the Quaker integration has a much greater chance of going off without a major blowup.
So, in terms of the businesses and people that Pepsi is picking up with Quaker, we share the Street's enthusiasm. The biggest potential risk we see has to do with the price being paid. In 1996, the speculation was that the Gatorade franchise might fetch $3 billion to $4 billion in a Pepsi buyout, which was considered "exorbitant" by at least one commentator. Splitting the difference and going with an imaginary bid of $3.5 billion, Gatorade would have been valued at roughly 2.5x the brand's 1996 sales and 22.5x its trailing operating income.
Is that higher or lower than the price Pepsi is paying for Gatorade today? It's not immediately clear how much of the price being paid today is being ascribed just to Gatorade. But we would expect that higher multiples were placed on the sports-drink franchise than Quaker's snack and non-snack businesses. While the food business is no slacker in its own right, it is not growing nearly as fast as Gatorade. Still, there's reason to believe that the price Pepsi is paying for Gatorade is reasonable, or at least in line with the 1996 level.
Why?
Earlier this year, Unilever (NYSE: UN) paid a multiple of 2.3x sales (net of debt) for branded food company Bestfoods. Generally speaking, Bestfoods and Quaker's food unit have had similar operating margins and growth rates in recent years. Applying the same 2.3x revenue multiple to the trailing 12-month results from Quaker's food business, we can determine that about $6.73 billion of Pepsi's $12.8 billion net debt purchase price can be attributed to the food unit. That leaves $6.07 billion or so attributable to Gatorade.
If this valuation assumption is in the right ballpark (and it is just an assumption), then Pepsi is paying about 2.9x trailing sales and 22x trailing operating income for Gatorade. Those multiples aren't far from the presumed 1996 buyout multiples. Further, the price doesn't seem all that "exorbitant" in today's world, especially for a brand with Gatorade's competitive moat, growth opportunities, and future earnings power. At the very least, it seems a better deal than Quaker's disastrous 1994 bid for the far inferior Snapple brand, which was purchased at a multiple of 2.4 times trailing sales and 32 times trailing earnings.
Mind you, this is just our first take on the Pepsi-Quaker deal. Jeff will no doubt have more comments on the merger in future columns. After all, there's no rush. The deal is not expected to close until spring, giving Pepsi shareholders plenty of time to evaluate the business, the people, and the purchase price in detail. In the interim, please post your initial thoughts on the Drip Companies discussion board linked above.
