"Go West, young man!" -- Horace Greeley (most likely) or John Babson Lane Soule (less likely), circa 1853
Reuters and other news outlets reported last week that the company is now planning to pour $850 million into China over the next three years. This is on top of the $1 billion the company has spent there over the last 25 years.
To a $98 billion market-cap company, $850 million may not seem like a lot of money. So let's put it in perspective. Over the last few years, Pepsi has used around $1.4 billion in capital spending, or capital expenditures, each year to drive about $30 billion in sales. Let's say its capex line totals $4 billion over the next three years. This would mean that Pepsi spends more than 20% of its total capex resources in China, where it generates less than 5% of its total revenues (although the company doesn't break out its China revenues, from the news reports it looks like the number is about $1 billion).
So as investors, we have to ask: Is it worth it? It's great to spend money in emerging markets, but only if the return is there. After all, Pepsi management could do a lot of other things with $850 million, like buy back shares, increase the dividend, make strategic acquisitions (although rumors about a GroupeDanone
On one hand, I'm encouraged by how Pepsi has grown its entire international division. Not only is it the largest division, with $9.9 billion in sales last year, but it also is the fastest-growing, showing double-digit growth in revenues and pre-tax operating income for the first nine months of fiscal 2005. While the operating margins are about half of what we see from the North American operations, over the last two years, the company has grown the international margins faster than it has grown the domestic ones.
On the other hand, China has proven to be a challenging market for Pepsi. To be sure, the market opportunity is huge. The Chinese public consumes fewer than one-20th the soft drinks per capita that Americans do (15 liters per capita vs. 358, according to a Rabobank report). Nevertheless, for its first 20 years in China, Pepsi apparently could not turn a profit, even though it had invested a reported $500 million.
Part of the problem is that Pepsi is forced to work with local Chinese partners. Pepsi has more than 30 joint ventures in China, and successfully managing these relationships is critically important to achieving profits. There was an ugly split in 2002 with joint venture partner Sichuan Pepsi, including allegations of phone call record theft (needless to say, the quest for profits didn't go so well in the Sichuan case).
And one can't forget that the Chinese soft drink market is very competitive. Motley Fool Inside Value pick Coca-Cola
Well, I don't think this investment is a waste, but I honestly don't know if Pepsi's China operations will turn a profit in two, 10 or 25 years. I'm hoping that it will soon, and that the company can grow market share from its billion-dollars-plus investments. I am comforted by the fact that this investment isn't really stressing the company's coffers. Pepsi has almost $5 billion in cash and securities on its balance sheet and generates another $4 billion per year in operating cash flow less dividend payments.
If management wants to risk another 5% of the company's cash position on a country housing 20% of the world's population (vs. 4.5% for the U.S.), as a shareholder I can live with that, for now. Indeed, Pepsi says that its China operations generated sales growth of more than 25% in 2005 and that it expects similar growth this year. But sales growth without profits is a losing proposition, even in the world's most populous country and second-largest economy.
Motley Fool research analyst Andy Cross likes eating Quaker Oats oatmeal and chomping on Lay's potato chips, although preferably not together. At the time of publication, he owned shares in Pepsi. The Fool has a disclosure policy.