PepsiCo Inc. (PEP) and The Coca-Cola Company (KO) are the two behemoths of the liquid refreshment beverage (or LRB) industry. The LRB market includes carbonated drinks, water, and noncarbonated or still beverages like ready-to-drink teas.
According to Beverage Digest, in 2013, PepsiCo held a 25.8% share of the US LRB market in terms of volume, and Coca-Cola led with a 34.2% market share. Dr Pepper Snapple Group Inc. (DPS) ranked third with a 10.9% share of the US LRB volume.
Nonalcoholic beverage makers like PepsiCo and Coca-Cola are part of the consumer staples sector. You can invest in this sector through exchange-traded funds (or ETFs) such as the Consumer Staples Select Sector Standard & Poors depositary receipt (or SPDR) Fund (XLP). Indexes tracking ETFs, such as the SPDR S&P 500 ETF (SPY), also have holdings in PepsiCo.
PepsiCo’s carbonated beverages
PepsiCo has a strong carbonated beverage portfolio that includes its leading brand, Pepsi-Cola, and other brands such as Mountain Dew and Mirinda. PepsiCo and Coca-Cola together hold about a 70% share of the US carbonated soft drink (or CSD) volumes.
PepsiCo’s noncarbonated beverage portfolio includes leading brands such as Tropicana in the juice category and Aquafina in the bottled water category. The company’s Naked Juice brand comprises premium juices and protein smoothies.
The company also sells ready-to-drink teas such as Lipton and coffee products through joint ventures with Unilever and Starbucks. In the fast-growing sports and energy drinks category, the company owns the popular Gatorade brand.
Because of continually declining carbonated sales volumes and rising health awareness, PepsiCo is looking to expand into healthier beverages. PepsiCo’s Tropicana brand launched three new flavors of Farmstand 100% juice, which is made of one serving of fruit and one serving of vegetables per 8 ounces. PepsiCo’s Naked Juice introduced the Chia Sweet Peach and Chia Cherry Lime flavors, which include chia seeds that are rich in omega-3 oils, antioxidants, protein, and fiber. Naked Juice also introduced the Kale Blazer with green vegetables.
PepsiCo’s business segments
PepsiCo derives its revenues from the following six segments:
- Frito-Lay North America.
- Quaker Foods North America.
- Latin America Foods.
- Americas Beverages.
- Asia, the Middle East, and Africa.
The first three business segments form the PepsiCo Americas foods business unit.
2013 segment performance
The PepsiCo Americas Beverages segment continues to account for the largest proportion of total revenues. It’s been experiencing declining revenues over the past few years primarily due to lower carbonated soft drink volumes and challenging macro conditions. The segment derives its revenues from the sale of beverage concentrates, fountain syrups, and finished goods under brands such as Pepsi, Gatorade, and Tropicana.
The Frito-Lay North America segment comprises branded snack foods such as Lay’s chips and Doritos tortilla chips. Net revenues for the segment grew 4%, driven by volume growth and favorable pricing. The Quaker Foods North America segment, which includes cereals, rice, pasta, and other branded products, witnessed a 1% decline in revenues as higher volumes were offset by an unfavorable product mix. The Latin America Foods segment revenues surged by 7%, reflecting the impact of favorable pricing.
The Europe segment’s net revenues increased by 2% due to higher pricing.
Despite favorable pricing and volume growth, revenues for the Asia, Middle East and Africa segment declined by 2% due to the sale of bottling operations to Tingyi and the Vietnam beverage refranchising.
Among all the segments, the Frito-Lay North America segment is the most profitable, accounting for about 21% of total revenues. In 2013, the segment accounted for 35% of the total division’s operating profits. The PepsiCo Americas Beverages segment accounted for 32% of total revenues and around 26% of operating profits.
This shows that PepsiCo’s snack food business is more profitable than its beverage business. Higher profitability of the snack food business is the result of PepsiCo’s pricing power given its dominant position in the US snack food business, its wide distribution network, and huge economies of scale.
The leading snack food company
PepsiCo Inc. (PEP) is the market leader in the US snack food business. The company derived 52%, or $34.5 billion, of its 2013 revenues from its food business.
Dominant market share
Information Resources, Inc. (or IRI) estimated that PepsiCo held 36.6% market share of the US savory snacks retail sales in 2013, way ahead of competitors like Kraft Foods Group Inc. (KRFT) and Mondelez International, Inc. (MDLZ).
The company’s future prospects also look promising. Euromonitor International estimates the US sweet and savory snacks market to grow at a compounded annual growth rate (or CAGR) of 3% and 1% in constant value and volume terms, respectively, over the 2013–2018 period.
PepsiCo’s Frito-Lay unit manufactures some of the most popular snacks, including Lay’s potato chips, Doritos tortilla chips, Cheetos cheese flavored snacks, Tostitos tortilla chips and branded dips, Ruffles potato chips, Fritos corn chips, and Santitas tortilla chips. Frito-Lay North America’s joint venture with Strauss Group manufactures Sabra refrigerated dips and spreads.
In 2001, PepsiCo merged with The Quaker Oats Company. Today, the company’s food offerings comprise ready-to-eat cereals, rice, pasta, dairy, and other products. Key brands include Quaker oatmeal, Quaker Chewy Granola Bars, Cap’n Crunch cereal, Life cereal, and Rice-A-Roni side dishes.
With consumers shifting to healthier foods, PepsiCo is focused on developing new products with lower sodium and fat levels. The company is also using new technologies such as air popping to bring out lower-fat products. In air popping, the snacks are heated and pressurized until they pop. Since 2013, the company has introduced the following three air-popped potato chip products: Walkers Pops in the United Kingdom, Smith’s Popped in Australia, and Lay’s Air Pops in the United States. These air-popped chips contain half the fat of regular potato chips.
Branding is vital for PepsiCo
Branding and advertising are crucial for companies in the highly competitive food and beverage industry, and PepsiCo is no exception.
PepsiCo classifies its brands into three categories: Fun for You, Good for You, and Better for You.
The Fun for You brands comprise popular flavors in the food and beverage category such as Pepsi, Lays, Cheetos, Mirinda, and Mountain Dew.
The Better for You brands offer snacks baked with lower fat content such as the Baked Lays product, snacks with whole grains, and beverages with fewer or zero calories and less added sugar.
The Good for You brands comprise nutritious products that include fruits, vegetables, whole grains, low-fat dairy, nuts, and seeds, which adhere to limits on sodium, sugar, and saturated fat. The category includes established brands such as Tropicana, Aquafina, and Quaker.
PepsiCo has 22 brands, each generating more than $1 billion in revenues accounting for more than 70% of the company’s total revenue. The company is focused on brand-building and spent $3.9 billion, or 5.9%, of its total revenue on advertising and marketing in 2013.
PepsiCo’s advertising campaigns include the popular Lay’s “Do Us A Flavor” contest, initially launched in 2012, which invited consumers across North America to submit a flavor they wanted the company to launch.
For its 2014 “Now is what you make it” campaign, PepsiCo brought 19 of the world’s greatest soccer players, including Leo Messi and Sergio Agüero, together for a highly popular commercial associated with the 2014 World Cup.
The marketing efforts of PepsiCo’s peers
The Coca-Cola Company (KO) is the largest producer of nonalcoholic beverages. In 2013, the company spent close to 7.0% of its revenues on advertising and marketing campaigns. Mondelez International, Inc. (MDLZ), a leading food and beverage company with a presence in about 165 countries, spent $1.7 billion, or 4.9%, of its revenues on advertising in 2013.
PepsiCo Americas food and beverage
PepsiCo has a significant presence in the US food and beverage market. The company derives more than 50% of its revenue from the United States alone. The company’s key businesses, PepsiCo Americas Foods and PepsiCo Americas Beverages, are based in this region. PepsiCo Americas Foods division includes the Frito-Lay North America, Quaker Foods North America, and Latin America Foods segments. In the United States, the company’s portfolio includes 19 popular brands, each generating more than $1 billion in revenue.
PepsiCo’s Americas Food and PepsiCo’s Americas Beverages divisions accounted for 69% of the company’s 2013 revenues and 78% of its total operating profit. The region benefits from the company’s most profitable segment, Frito-Lay North America.
Leading US brands
PepsiCo owns leading brands across its food and beverage business in the United States. According to Statista, PepsiCo’s Lays brand was the leading potato chips brand in 2013, with annual revenues of $1.58 billion, way ahead of its nearest competitor Pringles, which generated $0.51 billion in revenues.
According to the Beverage Digest, three of the company’s brands, Pepsi, Mountain Dew, and Gatorade, ranked in the 2013 top ten US liquid refreshment beverages (or LRBs) based on volumes.
PepsiCo is focused on innovating healthier products across its food and beverage business to cater to the shift in consumer preferences toward healthier products. Declining carbonated soft drink volumes in the North America region have made the company focus on low- or no-calorie variants as well as grow categories such as bottled water and energy drinks. In 2013, nine of the top 50 food and beverage innovations in the United States belonged to PepsiCo.
International growth opportunities are key for PepsiCo
PepsiCo Inc. (PEP) and other major companies in the food and beverage industry, including The Coca-Cola Company (KO), Monster Beverage Corporation (MNST), and Mondelez International, Inc. (MDLZ), are looking for growth opportunities in international markets. The growth rates in developing and emerging markets are expected to continue to surpass the growth in developed markets.
In 2013, PepsiCo’s operations in developing and emerging markets recorded a 10% organic revenue growth, driven by strong performance in China, Pakistan, Saudi Arabia, Mexico, Brazil, and Turkey.
Growing populations, rising disposable incomes, and higher standards of living in emerging economies are some of the favorable factors that will facilitate the demand for food and beverages. The per capita consumption of nonalcoholic beverages is still quite low in emerging economies such as India and China compared to the Unites States. This gives significant growth opportunity for PepsiCo’s beverage business.
Competitors’ international presence
PepsiCo’s closest rival is The Coca-Cola Company (KO). Coca-Cola’s international revenues accounted for 57.7% of its 2013 revenues. Mondelez International, Inc. (MDLZ), the maker of popular brands such as Oreo cookies and Ritz crackers, derived 19.8% of its 2013 revenues from North America and the rest internationally.
Investing for growth
PepsiCo continues to invest in the expansion of its business in developing and emerging markets. For instance, PepsiCo plans to invest nearly $5.5 billion by 2020 in India, one of the company’s key global markets.
PepsiCo is also entering into key alliances and developing products that cater to local tastes and preferences. For instance, in 2012, the company entered into a strategic alliance with Tingyi Holding Corporation, a leading food and beverage company in China. Under the alliance, PepsiCo made Tingyi’s beverage subsidiary its franchise bottler in China. The strong network of Tingyi helped PepsiCo enhance its business in China.
Healthier consumer preferences
Consumers around the world are becoming more aware of the calories in the products they are consuming as well as the health impact of ingredients in their food and beverages. There has been a shift in consumer preference from carbonated soft drinks to healthier options such as tea and water. Even in the food category, preferences for healthy foods such as oats and cereals are on the rise.
PepsiCo’s nutrition portfolio
PepsiCo Inc.’s (PEP) nutrition business has been growing significantly over the past few years. In 2013, the company’s nutrition business represented about 20% of PepsiCo’s net revenue.
PepsiCo has the following four core nutrition brands:
- Naked Juice
PepsiCo is expanding its portfolio of nutritional products and looking for entry into new product categories such as dairy, hummus and other fresh dips, and baked grain snacks.
PepsiCo is also working to improve the health quotient of its existing snacks and beverage products. The company aims to reduce the average amount of saturated fats per serving in key global food brands by 15% by 2020 and reduce the average amount of sodium per serving in food products by 25% by 2020, compared to 2006 levels.
In the beverage category, PepsiCo added many new low- and zero-calorie variants. For instance, PepsiCo Mexico reduced sugar in Mirinda by 25% per serving in 2013.
In September 2014, the three major soft drink makers, The Coca-Cola Company (KO), PepsiCo, and Dr Pepper Snapple Group, Inc. (DPS), pledged to reduce calorie consumption in sugary drinks in the United States by 20% by 2025. The industry leaders plan to achieve this goal through packaging changes, reducing serving sizes, expanding low- and no-calorie drinks products, and using its marketing skills to educate customers.
PepsiCo is also acquiring or entering into alliances with companies that own healthy products. For instance, in 2011, PepsiCo acquired Wimm Bill Dan Foods, a leading Russian company in the dairy category.
PepsiCo’s expansion through partnerships and deals
PepsiCo Inc. (PEP) has partnered with several entities to boost sales of its food and beverage businesses. The company has successfully expanded its presence in food service through some strategic partnerships like the highly successful relationship with Taco Bell, a US restaurant chain. PepsiCo also has some significant deals with sports organizations such as the National Football League and Major League Baseball.
In 2012, PepsiCo joined US restaurant chain Taco Bell, a subsidiary of Yum! Brands, Inc. (YUM), to launch the highly successful Doritos Locos Tacos, a set of tacos with Doritos flavored and branded shells. Since its launch in 2012, Doritos Locos Tacos has exceeded $1 billion in retail sales.
In December 2013, PepsiCo replaced The Coca-Cola Company (KO) as the beverage supplier for the popular Buffalo Wild Wings restaurant chain, which has 975 locations across 49 states in the United States and in Canada. Buffalo Wild Wings expects to benefit from PepsiCo’s marketing and promotional strength such as PepsiCo’s alliance with the National Football League and Major League Baseball to attract more customers. The deal will also contemplate the inclusion of PepsiCo’s snack brands such as Doritos, Fritos, Tostitos, and Ruffles in the chain’s menu offerings.
In September 2014, PepsiCo teamed up with SodaStream International (SODA) to test some of its flavors on SodaStream’s home carbonation machines, providing the company an additional channel to reach consumers.
Competitors not far behind
PepsiCo’s closest rival, The Coca-Cola Company (KO), bought a 10% stake in Keurig Green Mountain (GMCR) for $1.25 billion and entered into a partnership deal to jointly develop the upcoming Keurig Cold at-home beverage system. This deal will give Coca-Cola a new platform to enter the home carbonation market.
Coca-Cola subsequently announced its intention to raise its stake in Keurig Green Mountain to 16% and extend its partnership to offer its select still beverages such as Honest Tea in the Keurig hot brewing system in the United States and Canada.
Productivity measures to improve margins
PepsiCo Inc. (PEP) and its peers in the food and beverage industry are implementing several productivity measures to improve their margins to offset the impact of a sluggish demand in developed markets and declining carbonated soft drink beverage volumes.
PepsiCo’s efficiency measures
In 2013, PepsiCo achieved $900 million in savings as part of its $3 billion productivity goal for 2012–2014. The company further extended its productivity program to the period 2015–2019 with the goal of achieving annual savings of $1 billion. Productivity initiatives include manufacturing automation, optimizing a global manufacturing footprint, and reengineering the distribution network.
PepsiCo’s peers plan productivity initiatives
In its productivity program, The Coca-Cola Company (KO), PepsiCo’s closest rival, plans to generate annual savings of $1 billion through 2019 and direct those savings toward incremental media investments.
In September 2013, Mondelez International, Inc. (MDLZ) announced its $3.5 billion restructuring program, which is expected to generate at least $1.5 billion in cost savings by 2018. Kraft Foods Group Inc. (KRFT) significantly improved its operating margins in 2013 through its cost savings and restructuring initiatives. Dr Pepper Snapple Group, Inc. (DPS) garnered $169 million in savings between 2011 and 2013 through its productivity program that used Lean Six Sigma methods.
Why PepsiCo investors get a higher return on equity
For the trailing twelve months ended 12/31/14, the company delivered a return on equity (or ROE) of 31.3%, which was higher than its peers, including The Coca-Cola Company (KO), Dr Pepper Snapple Group, Inc. (DPS), and Mondelez International, Inc. (MDLZ).
PepsiCo’s higher ROE
Despite Dr Pepper Snapple’s higher return on assets, PepsiCo’s ROE is greater due to the presence of higher financial leverage. Financial leverage, which is computed as average assets divided by average equity, indicates the extent to which the company uses debt to finance its assets.
A company can improve its ROE either by achieving a higher return on assets (or ROA) or by making effective use of its leverage. A higher leverage will have a positive impact on ROE if the company can earn a higher return on assets than the cost of debt.
PepsiCo’s ROA is lower than Dr Pepper Snapple’s
A company’s ROA can be expressed as a function of its net profit margin and asset turnover. PepsiCo delivered lower ROA of 8.5% in 2014 compared to Dr Pepper Snapple’s 8.9%. This is because PepsiCo’s profit margins are lower due to higher costs. As discussed in a previous part of this series, PepsiCo is implementing productivity measures to bring down its costs.
PepsiCo lags behind peer stocks
Over the past five years, PepsiCo has underperformed the broader market represented by S&P 500 Index and peers such as Dr Pepper Snapple Group and Mondelez International. PepsiCo’s stock price increased by 61% since 2010, way below smaller peers such as Dr Pepper Snapple Group and Mondelez International, whose stocks rose by around 154% and 117%, respectively.
Price earnings (or PE) multiple is used to perform a relative valuation of a company and its peers from a shareholder’s standpoint. A stock with a higher PE is generally considered overvalued, unless its future growth justifies such high valuation. Since early 2013, PepsiCo has been trading at similar PE multiples as Coca-Cola. PepsiCo’s revenues increased by 1.4% in 2013, and adjusted earnings per share (or EPS) increased by 6.6%. However, Coca-Cola’s revenues declined by 2.4%, and adjusted EPS increased by 3.5% in 2013.
Impact of declining volumes
Carbonated soft drinks (or CSD), which form a major part of PepsiCo’s beverage business, declined for the ninth straight year in 2013. PepsiCo’s 2013 CSD volumes declined at a double rate compared to Coca-Cola’s. According to Beverage Digest, PepsiCo’s CSD volumes declined by 4.4% in 2013, whereas the volumes for Coca-Cola and Dr Pepper Snapple Group declined by 2.2% and 2.4%, respectively.
A profitable food business
PepsiCo’s diversified business model appears to be its strength. The food business, which contributed 52% of the company’s 2013 revenues, has been able to offset the decline in CSD volumes. As discussed in a previous part of this series, PepsiCo’s presence in the complementary food and beverage categories is a key revenue driver. Also, the company’s snacks business is more profitable than beverages.
To learn more about the nonalcoholic beverage industry and the trends impacting it, you can read our series on the nonalcoholic beverage industry.