Why Is Pepsico Buying Its Bottlers?

PepsiCo (PEP) announced over the weekend that it has offered about $6 billion to complete its stakes in its two largest bottlers, Pepsi Bottling Group (PBG), of which it already owns 33%, and PepsiAmericas (PAS), of which it already owns 43%. The offers, made up 50-50 of cash and stock, value both firms at a 17% premium to Friday's closing prices.

I am a long-term holder of Pepsico as a superlative dividend-growth stock. The company has paid dividends since 1952 and raised them for 36 years. One of the attractions for me has been that Pepsico does not own its bottlers. So I am curious about the decision to purchase the bottlers.

Here is some background: For years, bottlers have been PepsiCo's customers. The soft drink business is unique in that the brand-owning companies do not perform the majority of manufacturing and distribution. They produce syrups and concentrates. Historically, they believed that their greatest growth would come from fountain drinks. Thus, they sold off the bottling rights, which turned out to be a good move in keeping the companies asset-light and less capital-intensive. The beverage companies just produce the concentrates and syrups. Bottlers do the manufacturing and distribution, usually with exclusive rights within a defined geographic region.

The bottlers are generally less profitable and more capital-intensive than the beverage companies they serve. They always face face strong operational challenges. Early estimates are that PepsiCo's reported results in 2008 would have had operating margin cut to 13% from 16%, and its returns on invested capital to 41% from 42%, had it owned the bottlers last year.

So why is PepsiCo buying its bottlers? To streamline and enhance its already formidable distribution capabilities and to gain ripple-effect benefits from that. PepsiCo's news release positions the offers as "strategically transforming."

As you probably know, PepsiCo is much more than a carbonated soft-drink provider. It has been moving more heavily into non-carbonated beverages as its customers' tastes change, and well over half of its sales come from snacks and other non-beverage products. PepsiCo produces, markets, and distributes myriad salty, sweet, and grain-based snacks and other foods. Among the company's many top non-beverage brands are Aunt Jemima, Cap'n Crunch, Cheetos, Cracker Jack, Doritos, Frito-Lay, Fritos, Golden Grain, Lay's, Life, Quaker, Rice-A-Roni, Ruffles, and Tostitos. PepsiCo's dominance in many of its lines give it pricing power. Last year, it pushed through price increases at Frito-Lay North America that did little to detract from volume growth. It often executes price increases by reducing the weight of individual packages rather than by actually increasing the price per package.

PepsiCo's direct store-delivery network is second to none. That said, it may be able to make it even stronger with the addition of its bottlers.

• There will be chances to cut costs through the integration of some of its distribution channels and consequent elimination of duplicate jobs. Pepsico states that the combination will create a fully-integrated supply chain and business model positioned to accelerate revenue growth. It estimates synergies of over $200 million per year, and that when these synergies are fully realized, the acquisitions will be accretive to earnings by at least 15 cents per share. Upon completion of the acquisitions, Pepsico will handle distribution of about 80 percent of its total North American beverage volume, including both its direct-store-delivery and warehouse systems. (The company did not say how long it expects the integrations to take.)
• The company also expects to gain more control over the distribution of non-carbonated beverages and niche products. The carbonated-beverage market is declining in this hemisphere, which has led PepsiCo to offer more non-carbonated beverages. But these usually have smaller volumes, and there has been resistance to them from the bottlers, whose business models rely on large production runs and heavy volume. Full ownership of the distributors would eliminate small-product conflicts, allow PepsiCo to experiment more, and improve its ability to bring product and package innovations to market more quickly.
• PepsiCo's statement also refers to improving the speed of decision making and increasing strategic flexibility. Beside the expanded freedom to create and experiment with new products, PepsiCo will be able to present a more unified face to its customers and to provide customized solutions when necessary, including bundled food and beverage offerings and improved national account coordination.

Also, making this move now, with valuations lowered, may be allowing PepsiCo to pick up valuable resources at relatively low cost. Given the 50-50 stock-cash makeup of the offer and its strong balance sheet, PepsiCo does not see any financial contingency to this acquisition.

Pending further review of the financial outcomes, I find the qualitative benefits of this move to be convincing. It does not change my opinion of PepsiCo as a superior dividend-growth stock.

Disclosure: Long PEP.

Comments

[C.Wayne Borum:]

Excellent research! David's article is dead on. Hard to argue PepsiCo. They are now and have always been a thorough and diligent company when it comes to maximizing profits via distribution. The unknown, the thing you might not hear? Well, it's this. As the bottlers have more often than not found themselves on the front line of "deal making" to market the product to the various "retail" outlets r.e. (shelf space), it equates to simple purchase of the same. Yes, it's true, an outright "pay-ola" to borrow a phrase from yesteryear. All across the land, distributors send out reps with check's in hand to aquire the best and biggest shelf exposure in any given "store". Just who had whom? was always an unknown. Meaning, did the store owner have controll or did the Pepsi rep? In most cases, it broke down to the space on the shelf warranted the cost to aquire it. So, by now you may be asking, what the hell does this have to do with PepsiCo buying it's bottlers? It's this, realizing this practice was a money drain in these ever challenging times to cut costs and remain on top, PepsiCo, seeing this practice was out of controll and a prime reason that bottlers were not showing maximim profits they seize the day. No more "pay-ola". Distributors can now say, "those days are over Mr. Store owner", It's out of our hands now. Translation, the money we've been coughing up to you on a monthly basis since 1950 is now staying in the company till. By the way the other soft drink giants did this years ago as the giant wholesale companies begin to format controll over retail members and scoop up all the money for themselves. This move should be a positive for PepsiCo. One may arque, that this merely puts another problem in corporate's hands but it gives them the choice, on when and where to place their marketing dollars. Just a thought to consider, from an angle not often mentioned outside of inner circles.

Apr 21 10:07 AM

[DonFurio:]

Nice article, I was wondering the same thing, but my guess is PEP sees an opportunity to make their distribution network much more efficient, I hope it works..

Apr 21 10:46 AM

[spinetta:]

Two thoughts:

1. Payola g'waan keep flowing. Twenty years as an independent beverage distributor taught me that shelf space and display space is purchased most efficiently in corporate suites, not in retail aisles. Independent distributors can purchase (or earn - Ha!) shelf space and display space from independent retailers, but there are only so many successful indies remaining. The big money and big market share gains come from purchasing shelf space and display space en masse from chain stores. Once PepsiCo completes the purchase of its distributors, they can speak to Safeway, Kroger, WalMart, and the rest as equals. Payola isn't going away anytime soon. Payola will become more efficient and much more centralized.

2. PepsiCo will introduce its own niche products through its own dsd (direct store delivery) channel and simultaneously create a formidable barrier to entry for smaller producers who do not own (or have access to) an independent distributor. Beverage distribution has become more and more centralized over the past fifteen years, and PepsiCo's acquisition of bottlers is a defensive move against market penetration by upstarts. Does anybody remember Snapple's entry into the market? Such a debut becomes more challenging when there are fewer large, independent distributors.

The article is excellent, and the author is quite insightful. Kudos!

Apr 21 11:13 AM

[maz:]

I agree with much of what is said in the article but I also think that this is a defensive move because bottlers thin margins can easily be erased in a recession. Having them in house avoids public spats or embarassing cash infusions from Pepsico as the parent company is unlikely to reduce the cost of syrups & concentrates to bottlers. I predict that margins will decline & the bottlers will be a drain on free cash flow long term. Corporations always spin an acquisition to be a positive and gloss over the negatives which include paying a premium for the shares.

Still whether accretive (I think it will be marginally accretive but will not give a good ROI) or defensive it would appear to be a reasonable move by the company.

Apr 21 11:16 AM

[altaman:]

I think they are doing it to get a bigger percentage of a smaller pie and the lower margins look better than spending to expand their share in shrinking market going forward. Its an OK move for them to shore-up their distribution, in a time of lowered expectations, but it also signals to me that they are seeing economic contraction going forward.

Apr 21 02:51 PM

[jstratt:]

Pepsi may well find that this is a good time to buy bottlers at an attractive price. They may also find out that the long term advantages are minimal.

My guess is that they will be spun off again in a few years. Few compelling reasons to own bottlers long term have been presented.

Thanks to the author for his insight.

Apr 21 06:24 PM

[T-Rex:]

Pepsi has done very well with acquisitions- Quaker/Gatorade, Stacys' Chips, foreign juice companies, foreign snack companies...etc.

They know beverages- not just cola, they know snacks (and moving to healthy snacks), and they know the importance of distribution.

This clears them to partner with more beverage companies to distribute their products while considering whether to but them out. Pick any energy drink company, any healthy beverage company...and Pepsi can put them on the map, reap rewards of distributing them...and have first chance to buy them out.

Forget about pinching pennies vending their own products, this is bigger than that. This is about expanding distribution and gaining more brands through further acquisitions.

This could be huge for them.

May 11 02:17 PM