PepsiCo (PEP) has reported better than anticipated results for the second quarter and emphasized that its mixed portfolio played an important role in the performance, thereby underlining its determination not to separate its snacks and beverages businesses. The Americas food division, which is the largest division by sales, experienced higher price realizations in addition to a 2% increase in volume. Revenues also grew in other parts of the world such as in Europe, Asia and Africa because of higher volumes. The beverages unit in the Americas continued to underperform as price increases could not offset the impact of a 3.5% decline in volumes.
The decline in carbonated drinks was in mid-single digit figures and the decline in non-carbonated drinks was in low single digits. The company hopes to offset the decline by reducing calories through the use of natural sweeteners. Pepsi has lost market share to Coca-Cola (KO) in recent times but unlike Coca-Cola which is a beverage company only, Pepsi derives around 50% of its revenues from snacks and foods such as yogurt and oatmeal. Revenue grew by 2% to $16.81 billion, slightly more than the consensus analysts' estimate of $16.79 billion. For the quarter, the company posted earnings of $2.01 billion, EPS of $1.28, compared with $1.49 billion, or $0.94 per share, in the same quarter of the previous year though the previous year figures were affected by one time charges in China. Excluding one-time items EPS was $1.31 per share compared to the analysts' estimate of $1.19 per share.
The beverages business
The increase in price realization was more than offset by reduced volumes though the company was able to show earnings growth because of the higher prices and increased productivity. The company has pointed out that the declining volumes were being offset by enhanced value through pricing and innovation. I believe that this may work in some categories of the market such as beverages when the company has premium brands such as Gatorade. However the scope of this strategy is bound to be limited in the sparkling drinks category. Moreover, I think that the tradeoff between volume and pricing could prove to be risky in the long term unless it is executed very carefully.
The Peltz proposal
Nelson Peltz, the activist investor who has sizable stakes in both Pepsi and snacks company Mondelez International (MDLZ), has recently suggested that Pepsi should acquire Mondelez in an all stock transaction worth around $67 billion (at a price between $35 and $38 per share). This suggestion is worth considering seriously because Peltz has an impressive track record in turning around food and beverage companies. Snacks are definitely a growth business and though Europe is the largest market in value terms, there is plenty of potential for growth in low income but large markets such as Eastern Europe and emerging markets such as India and Indonesia. Pepsi is already the largest salty snack manufacturer in the world and Mondelez would add considerably to its portfolio with top notch brands such as Cadbury and Oreos. Shareholders are also likely to benefit from the increased focus on the growing snacks business and the reduced emphasis on the declining beverage business.
Arguments against the Peltz proposal
One of the key arguments in the proposal is the creation of sizable synergies because of the beefed up distribution network and the enhanced economies of scale. However, there are sizable integration risks involved because Mondelez has been a standalone company for only a short period of time after the spinoff of its North American grocery business, which is now known as Kraft Foods Group (KRFT). Another part of the proposal suggests the divestment of the beverages business, especially since Pepsi management is convinced that the company benefits from the diversified product portfolio. As it rightly points out, half of U.S. consumers also buy a beverage when they buy a salty snack and the cross selling opportunities are potentially limitless. Finally, many of the large existing institutional investors in Pepsi are not convinced that the move will add value to shareholders.
The bottom line
Pepsi management has made it clear that they are not for the moment considering large acquisitions or getting rid of the beverage business. However, the stock should be carefully watched because there would be considerable upside if the beverages business can be fixed and snack foods continue to grow.