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Summary

  • PepsiCo should listen to recent calls to spin-off its beverage business.
  • Based on its current valuation PepsiCo is fairly valued at current levels, so something needs to be done to unlock more value.
  • If a spin-off were to occur a potential acquisition of another snack & food company would make sense.

In this article, I will estimate the fair value of shares of PepsiCo (NYSE:PEP) and look at a strategic plan, where PepsiCo would spin off its soft drink business, and maintain its position in snacks, sports drinks, water, and juices. Nelson Peltz, who is an activist investor, is trying to convince PepsiCo to spin off its beverage business, but so far PepsiCo has been strongly against it. While the idea to spin-off the whole beverage business is a good idea, I think spinning off just the soda business only would be better.

Business case for divestment

The first reason why I believe that spinning off the soda business of PepsiCo is a good idea is to get ahead of a scenario where businesses stop selling soda because of the health concerns. Just this year CVS Caremark (NYSE:CVS) decided that it would stop selling its products at its stores, and I believe soda will share the same fate. I believe this because more and more consumers & states like New York are coming to the realization that soda consumption is not good for you and I believe soda companies like PepsiCo, and Coca-Cola (NYSE:KO) will be viewed like cigarette companies. If CVS is doing this with cigarettes now, and soda has health consequences, I think it will not be long until businesses stop selling soda.

The second reason I believe a divestment is a good ideas is if in fact soda companies were viewed like cigarette companies, then the second reason divestment would be a good idea is I would expect soda to follow a similar path to cigarettes, which most likely means a tax on soda to discourage consumption. What happened with cigarettes is consumers have either to pay ever-increasing costs, or substitute for other tobacco products. In the case of soda the most likely substitutes would be other drinks like sports drinks, water, and juices, which PepsiCo has strong brands in all three of those categories. The substitution effect is the reason why I believe that spinning off the soda business only would be better than the whole beverage unit as Nelson Peltz has advocated for, because if consumers do switch from soda they are likely to switch to one of the PepsiCo brands of beverages that are healthier.

Based on the two reasons I outlined above, I believe PepsiCo by spinning off its soda business would get in front of the trend of decreasing soda consumption, and take advantage of the shift to increasing consumption of healthier beverages. Below I will detail my strategic plan for PepsiCo to spin-off its soda business, and become a company focused on snacks, healthy beverages, and quick at home meals.

Valuation

Value

To value PEP I will be using a DCF calculator, with data for earnings and growth coming from Zacks.com, benchmark data from longrundata.com, and CPI data from the BLS. The DCF table shows shares of PEP have an estimated fair value of $81.25, which is slightly below its current price of $82.59, therefore based on this method of valuation shares are fairly valued at current levels. To unlock value and make a stronger company going forward, I will detail my strategic plan below.

EPS [ttm]: $4.37

Long-term Growth Rate: 7.71%

Earnings grow for next: 5 years

Level off: to 1% after

Benchmark return: 10 yr annualized SPY return of 7.12%+1.10% inflation= 8.22% benchmark

Strategic Plan

Step #1: Spin-off

The first step would be for PepsiCo to spin-off its soda business only! PepsiCo would keep its snacks business along with its sports drink [Gatorade], juice [Tropicana], and water [Aquafina] businesses to create a company that focuses on snacks, and healthy beverages, which are higher growth businesses than the soda business going forward. The chart below from Trefis shows that in 2013 the soft drinks division accounted for 24.6% of total revenues for PepsiCo, which represents revenues of $16.48 billion for the soft drinks division. [24.6% *$67 billion total revs. for 2013] Once the spin-off is complete, the next step for PepsiCo would be to find a company to acquire to make up for the revenues that would be lost in the spin off, which is what I will cover in the next step.

(click to enlarge)

[Chart from PEP Trefis]

Step #2: Acquisition

To make up for the revenues that would be spun-off, the idea I had to replace those revenues would be to acquire ConAgra Foods (NYSE:CAG). ConAgra like PepsiCo has many noticeable brands like Slim Jims, Healthy Choice, Hunts, Chef Boyardee, Orville Redenbacher, Pam, and the list goes on. ConAgra would be a good fit for a post soft drink spin-off PepsiCo, because ConAgra has snacks, but they also have a large number of products that can be cooked at home. In addition, ConAgra would be a good fit with PepsiCo because in the trailing twelve months ConAgra had total revenues of $17.9 billion, which would replace the revenues lost by spinning off the soft drink unit.

After the great recession, more & more people are staying home to eat rather than go out, and according to the US Travel Association in 2012, the percentage of people taking leisure vacations with kids dropped to 26% from 31% in 2008. The reason why this is important is that I know whenever I went on a trip when I was a kid snacks were always on my list of food I wanted to take. A ConAgra acquisition would fit because they have products that consumers can cook and use at home, and thus diversify its food business away from just snacks, to snacks and meals that can be cooked at home.

ConAgra Valuation

I will use the same process as I used above to value PepsiCo. I will be using the DCF calculator, with data for earnings and growth for CAG coming from Zacks.com, benchmark data from longrundata.com, and CPI data from the BLS. The DCF table shows shares of CAG have an estimated fair value of $40.19, which is 29.73% above its current price of $30.98. Based on this method of valuation, ConAgra is undervalued at current levels and presents a potential attractive opportunity for PepsiCo.

EPS [ttm]: $2.21

Long-term Growth Rate: 7.18%

Earnings grow for next: 5 years

Level off: to 1% after

Benchmark return: 10 yr annualized SPY return of 7.12%+1.10% inflation= 8.22% benchmark

Closing Thoughts

In closing, I believe PepsiCo should spin off its soft drink business & acquire ConAgra, to move towards a company focused on healthy beverages, snacks, and quick at home meals. By taking the example of when H.J. Heinz (NYSE:HNZ) was purchased at a 19.03% premium, PepsiCo could purchase ConAgra for $36.87/share. [(1+19.03%)*$30.98= $36.87] The estimated purchase price is slightly below the 52-week high for ConAgra of $37.28, therefore somewhere between $36.87 and my estimated fair value of $40.19, I would estimate would be the offer price. Finally, I believe soda will be the "cigarettes" of the 21st century, and by spinning off the soft drink unit, PepsiCo "Snack Company" would be better off, and the "Pepsi Soft Drink Co" would be a cash flow generating machine, and would be just like Cigarette stocks, which are bought for yield & share repurchases.

Disclaimer

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: My PepsiCo Valuation And Strategic Plan