PepsiCo: On M&A, The Hunter, Not The Hunted

| About: PepsiCo Inc. (PEP)

Summary

The recent failed takeover attempt by Kraft Heinz of Unilever raised questions about whether there might be another takeover target. A number of analysts suggested PepsiCo as a target.

PepsiCo has long been an acquirer of firms, with a track record of successful integration of the acquired business; reflected by increasing product and geographic market reach.

If past history is evidence of future actions, PepsiCo will continue to grow through strategic acquisitions and the introduction of new products.

Anathema to its growth strategy, PepsiCo will not allow itself to be acquired.

Introduction

The impetus behind writing this article is the recent commentary by various analysts indicating PepsiCo could be an acquisition target for Kraft Heinz, following the aborted takeover bid for Unilever.

Such commentary suggests assumptions unbounded by certain realities in evidence, as this article will hope to make clear. It is, by virtue of their employee and managerial talent, their organizational culture, and their historical performance, that PepsiCo has shown itself to be a capable acquirer of businesses; a practice that has helped them attain notable growth in product and geographic markets. With this understanding, the article seeks to refute the notion that, in the face of the Kraft Heinz - Unilever dustup, PepsiCo might be an acquisition target for Kraft Heinz. The reality is that as a successful acquirer of businesses, PepsiCo has historically been the hunter, not the hunted.

Allow me to offer evidence in support of that position.

An Abbreviated Strategic Analysis

Let's start with a form of strategic analysis because it helps provide contextual grounding that identifies the capabilities of a company and infers or implies how they interact with the competitive environment, to enable or prevent success.

To that end, I offer a short form of SWOT analysis. At the risk of being obvious, it should be made clear what is meant by SWOT analysis. Specifically, SWOT is a strategic analysis of an organization's Strengths, Weaknesses, Opportunities, & Threats, with strengths and weaknesses reflecting the internal analysis of the organization, and opportunities and threats the external analysis. This analysis should serve to provide a clear understanding of factors contributing to business success or failure. The point is to inform future actions the company might undertake to take advantage of the competitive market place, based on organizational capabilities and competencies.

Although SWOT is a contextual analysis that changes with time and events, it helps provide some understanding of the challenges a firm may face and its ability to meet those challenges.

Because of the methodological simplicity, SWOT can be used to analyze any type of scenario across any competitive environment and is commonly used by firms to determine the viability of mergers, acquisitions or divestitures under consideration. Since doing a complete SWOT analysis on PepsiCo could be the basis for an entire article, it is best to keep this analysis short and to the point.

Strengths: Comprehensive product portfolio with 100 brands, twenty-two of which have sales exceeding $1 Billion; triple bottom line focus that shows corporate social responsibility; competencies in M&A; marketing capabilities; existing distribution networks; employee talent; cash flow

Weaknesses: Brand awareness globally not as good as Coke; reliance on soda brands; weakened profit margins

Opportunities: Increasing demand for healthier options; demand for bottled water; emerging markets; global snack growth; expansion through tuck-in acquisitions

Threats: Water safety & scarcity; government regulation; legal requirements to disclose nutritional information of products; strong dollar; intense global competition from smaller, local brands

PepsiCo expects growth in emerging markets over the next six years to move from twenty-four percent (24%) to thirty-six percent (36%), a fifty percent (50%) increase that demands an established and effective supply chain that will improve both capabilities and efficiencies, as it reduces costs associated with distribution and enhances brand association.

Through various mergers, acquisitions, and partnerships, PepsiCo's product mix has become greatly diversified and reflects a broad basket of differentiated consumable goods that have changed in response to consumer tastes.

In fact, we see the sales of food and snacks having increased over time and are now PepsiCo's larger revenue producer compared to beverages. With the ability to access new consumers and channels for distribution, PepsiCo has moved toward a more balanced geographic breakdown of sales, as fifty-one percent (51%) occur in United States and forty-nine percent (49%) outside the country.

Also of note is that, over the past five years, capital spending is down and they have experienced a thirty-six percent (36%) increase in free cash flow. So, combined with the current cash in hand, PepsiCo has the funds to acquire other firms they deem to be a strategic fit to enable growth.

A Bit of History

In 1893, Caleb Bradham, a North Carolina pharmacist, created a beverage to enhance his pharmacy sales. He claimed the beverage improved the digestive process of those suffering gastrointestinal problems. However, recognizing the consumer market created by Coca-Cola (NYSE: KO), in 1898 Bradham marketed the product to the general public under the name Pepsi-Cola. The effort got traction and, in 1905, Bradham started up a network of bottlers. Perhaps a better pharmacist than businessman, Bradham goes bankrupt. After a series of misadventures in business development, the Pepsi-Cola Company finally emerges on the national stage in 1941; which was a bit too late to take advantage of the effort to give US Armed Forces a taste of Pepsi. In fact, Coke would greatly benefit from that effort and the post-war rebuilding. Not to get too far afield, but the war and its aftermath permanently established the global brand and reach of Coca-Cola; a reach one Pepsi executive noted would never be overcome short of WWIII or pure idiocy by Coke executives.

In 1965, Pepsi merged with snack maker Frito-Lay, as their complementary products of snacks and drinks were expected to grow and flourish from a unified distribution chain. And grow it did. Today, PepsiCo is the second largest soft drink maker, the second largest food and beverage business in the world, and the largest in the United States. It also possesses twenty-two (22) separate billion-dollar brands. And, relevant to the premise of this article, PepsiCo got that big through multiple acquisitions among food, snack and drink businesses.

In fact, as a result of mergers, acquisitions and partnerships pursued by PepsiCo in the 1990s and 2000s, its business has shifted to include a broader product base of foods, snacks and beverages; with the product mix being fifty-three percent (53%) food/snacks and forty-seven percent (47%) beverages. Amongst the products are twenty-two separate billion-dollar products; broken down into six (6) main divisions: North American Beverages; Frito-Lay North America; Quaker Foods North America, Latin America; Europe & Sub-Saharan Africa; Asia, Middle East & North Africa. Growth in all regions is born of a mix of licensing, contract manufacturing, joint ventures, and affiliate operations.

With its highly diversified portfolio of products, PepsiCo's market cap passed its long time soft drink rival (and occasional competitive foil) Coca-Cola in December 2005. Acquisitions remain part of their growth strategy and money is not an issue; PepsiCo has the cash. It appears that, at least in the minds of management, the question will be the right company, for the right price, that offers the best strategic fit.

Acquisitive Growth over Time

The merger of Frito Lay and PepsiCo in 1967 was, in no small part, a reflection of a changing competitive landscape that saw the national development and expansion of supermarkets. So it is that PepsiCo's remarkable successes in the 1960s and 1970s were the result of five (5) distinct policies, all of which management pursued diligently. This included: 1) unprecedented advertising on a massive scale; 2) the introduction of new soft drink brands; 3) packaging innovations to increase economic choices for consumers; 4) overseas expansion; and 5) acquisitions that allowed a diversification of their snack and beverage product lines.

Building on the famous Soviet market entry, PepsiCo negotiated a trade agreement with the U.S.S.R. in 1972 and opened the first Pepsi plant there two years later. Gains were also made in the Middle East and Latin America, though Coca-Cola has retained its dominant position in Europe and throughout much of Asia.

This is not to say that all has gone well. Evidence suggests that, for all its expertise, PepsiCo simply does not have the managerial experience required to run businesses outside the food and drink industries (e.g., North American Van Lines, which was acquired in 1968, Lee Way Motor Freight, and Wilson Sporting Goods, acquired in 1986). A van line, a motor freight concern, and a sporting goods firm were indeed odd companies for a soft drink and snack enterprise; so the company sold them, vowing never again to go hunting unfamiliar businesses. Rather, they decided to take a maniacal focus on what it knows.

D. Wayne Calloway replaced Donald M. Kendall as chairman and chief executive officer in 1986. Calloway had been instrumental in the success of Frito-Lay, helping it to become PepsiCo's most profitable division. The new chairman realized that his flagship Pepsi brand was not likely to win additional domestic market share from Coca-Cola, so they shifted focus on international growth and diversification.

From 1985 to 1993, PepsiCo introduced, acquired, or formed joint ventures to distribute nine beverages, including Lipton Original Iced Teas, Ocean Spray juices, All Sport drink, H2Oh! sparkling water, Avalon bottled water, and Mug root beer. Many of these products had a light and healthy product positioning, in line with consumer tastes, and higher net prices.

During the 1970s, in an attempt to improve distribution channels, PepsiCo acquired two well-known fast-food restaurant chains, Taco Bell, in 1977, and Pizza Hut, in 1978. The PepsiCo's 1986 purchase of Kentucky Fried Chicken (KFC) and 1990 acquisition of the Hot 'n Now hamburger chain continued its emphasis on value-priced fast foods; not to mention that KFC offered the company its first foray into China; a position used to leverage KFC expansion, as well as the introduction of Pizza Hut and other snacks and drinks into the country.

However, PepsiCo strayed slightly from the "buy what we know" formula with the 1992 and 1993 purchases of such restaurants as California Pizza Kitchen (which specialized in creative wood-fired pizzas), Chevys, a Mexican-style chain, East Side Mario's Italian-style offerings, and D'Angelo Sandwich Shops. Ultimately, the company divested itself of these chains, absorbing losses in the transactions.

Although Pepsi had commenced international expansion during the 1950s, it had long trailed Coca-Cola's overwhelming command of international markets. As a counter effort, in 1990 PepsiCo pledged up to $1 billion for overseas development, with the goal of increasing international volume one hundred-fifty percent (150%) by 1995 year's end. At that time, Coke held fifty percent (50%) of the European soft drink market, while Pepsi claimed a meager ten percent (10%). But PepsiCo's advantage was that it could compete in other, less saturated product and geographic segments. The company's biggest challenge to expanding its restaurant division was affordability. PepsiCo noted that, while it took the average U.S. worker just 15 minutes to earn enough to enjoy a meal in one of the firm's restaurants, it would take an Australian 25 minutes to achieve a similar goal, with the cost even higher in emerging markets. Still, PepsiCo had other options and, in 1992, the company forged a joint venture with General Mills called Snack Ventures Europe; which emerged as the largest firm in the $17 billion market. By 1993, PepsiCo had invested over $5 billion in international businesses, and its international sales comprised twenty-seven percent (27%), or $6.71 billion of PepsiCo's total annual sales.

After taking over leadership of PepsiCo in 1996, Roger Enrico quickly faced major problems in the overseas beverages operations, including big losses that were posted by its large Latin American bottler and the defection of its Venezuelan partner to Coca-Cola. PepsiCo ended up taking $576 million in special charges related to international write-offs and restructuring, and its international arm posted a huge operating loss of $846 million, depressing 1996 profits. Among the moves initiated to turn around the international beverage operations, which faced brutal competition from the entrenched and better organized Coca-Cola, was to increase emphasis on emerging markets, such as India, China, Eastern Europe, and Russia, where Coke had a less formidable presence, and to rely less on bottling joint ventures and more on Pepsi owned or franchised bottling operations.

Thinking Strategically about M&A and Divestitures

During this time, an area of concern was the restaurant division, which had consistently been the PepsiCo laggard in terms of performance. In order to revitalize the snack and beverage businesses and to take advantage of the surging revenue growth at Frito-Lay, which already accounted for forty-three percent (43%) of PepsiCo's operating profits, it needed to divest the restaurants. Hot 'n Now and the casual dining chains were quickly sold off and, in January 1997, PepsiCo announced that it would spin off its three long held fast-food chains into a separate publicly traded company.

The spinoff was completed in October 1997 with the formation of Tricon Global Restaurants, Inc., now known as Yum! Brands, Inc. (NYSE: YUM). The exit from restaurants removed one obstacle facing Pepsi in its battle with Coke: that most large fast-food chains had been reluctant to carry Pepsi beverages, not wanting to support the parent of a major competitor. Consequently, Coke had garnered a significant market share advantage selling beverages in the fast-food industry. Though retaining the bulk of the Yum! Brand restaurants beverage business, PepsiCo made additional inroads when, in 1999, they completed a ten-year deal with the 11,500-plus-outlet Subway chain.

Enrico placed more emphasis, however, on building sales in its core supermarket distribution channel and launched an initiative called "Power of One" that aimed to take advantage of the synergies between Frito-Lay's salty snacks and the beverages of Pepsi-Cola. Power of One harkened back to the original rationale for the merger of Pepsi-Cola and Frito-Lay. For the fiscal year 1999, the effort did help increase Frito-Lay's market share by two percentage points and boosted Pepsi's volume by 0.6 percent.

In 1997, the company launched the Aquafina bottled water brand on a national basis and it quickly gained the number one position in a fast-growing sector. In a move into the non-salty snack category, Frito-Lay acquired the Cracker Jack brand that year, and subsequently bolstered the brand through renewed advertising, a new four-ounce-bag package, the addition of more peanuts, the inclusion of better prizes, and the strength of Frito-Lay's vast distribution network. As noted, in August 1998, PepsiCo opened up another front in its ongoing war with Coca-Cola by acquiring juice-maker Tropicana Products, Inc. from the Seagram Company, Ltd. for $3.3 billion in cash; to that date, the largest acquisition in PepsiCo history.

Tropicana was the clear world juice leader, led by the flagship Tropicana Pure Premium brand. Tropicana had a dominating forty-one percent (41%) share of the fast-growing chilled orange juice market in the United States. The brand was also attractive for its growth potential; not only were sales of juice growing at a much faster rate than the stagnating carbonated beverage sector, there was also great potential for brand growth overseas. Psychologically, the acquisition also provided PepsiCo with something it very much needed - a dominant beverage position over Coca-Cola.

In 1999 PepsiCo divested itself of another low-margin, capital-intensive business when it spun off Pepsi Bottling Group, the largest Pepsi bottler in the world, in a $2.3 billion IPO. While PepsiCo retained a thirty-five percent (35%) stake, the rationale was to focus exclusively on the less capital-intensive businesses of beverages and snack foods. By the end of 1999, after three and one-half years at the helm, Enrico had clearly turned PepsiCo into a stronger, more focused, better performing firm. Although revenues were lowered by more than one-third due to divestments, earnings were higher by more than $100 million. Operating margins had increased from ten percent to fifteen percent (10-15%), while return on invested capital grew from fifteen percent (15%) to twenty percent (20%), and net debt had been slashed from $8 billion to $2 billion.

In 2001, PepsiCo reached an agreement to acquire a majority stake in South Beach Beverage Company, maker of the SoBe brand. Popular with young consumers, the SoBe drink line featured herbal ingredients and was the fastest growing brand in the growing noncarbonated alternative beverage sector.

An even more tempting target soon attracted PepsiCo's attention: the powerhouse Gatorade brand owned by the Quaker Oats Company. At the time, Gatorade held a remarkable share (83.6%) of the U.S. retail market for sports drinks with annual sales of about $2 billion.

In 2000, PepsiCo entered into talks with Quaker about acquiring the company for about $14 billion in stock, but by early November the two sides had failed to reach an agreement. Separately, Coca-Cola and Groupe Danone quickly came forward to discuss acquiring Quaker and Coke came close to signing a $15.75 billion takeover agreement. However, Coke's board of directors pulled the plug on the deal at the last minute. Groupe Danone soon bowed out as well. At that point, PepsiCo reentered the picture, and in early December the firm announced that it agreed to acquire Quaker Oats for $13.4 billion in stock. Whether the result of better negotiations or a desperate Quaker Oats, it was $2.35 Billion less than Quaker thought it would get from Coca-Cola.

Beyond the much sought after Gatorade, the Quaker acquisition would also add a small but growing snack business to the PepsiCo portfolio, which included granola, snack bars, and rice cakes. Quaker's non-snack food brands--which included the flagship Quaker oatmeal, Life and Cap'n Crunch cereals, Rice a Roni, and the Aunt Jemima branded products, which did not fit as neatly into the PepsiCo portfolio, but were highly profitable and could eventually be profitably divested if desired.

In November 2016, PepsiCo paid about $500 Million for the tuck-in acquisition of KeVita - a sparkling probiotic U.S. drinks company that offers access to a newer type of health conscious consumer, in a market with a seven percent (7%) CAGR and expected to reach $24 Billion in 2017. Combined with the global sports and energy drink market growth expected to move from $86 Billion to $155 Billion by 2024, as well as PepsiCo's global reach, and investment in emerging markets, the company is well positioned to capture sizable growth from consumer demand in expanding geographic markets.

As it relates to acquisitions as a strategic growth platform, PepsiCo has indicated they will not pay high multiples for companies that are a questionable strategic fit. What they have indicated makes sense are those tuck-in acquisitions that help with growth and are judged to be an easier cultural, financial, and strategic fit. This suggests an adherence to what has made PepsiCo successful with the majority of past acquisitions - decisions framed in process rigor.

Vision for the Future

Indra Nooyi, PepsiCo CEO since 2006, has devoted special attention to one particular element of "Performance with Purpose," which is the actual nutritional value and composition of PepsiCo products. Her long-term growth strategy is to transform PepsiCo into a "nutrition business," a surprising term, considering that its revenue is generated by the sale of objectively unhealthy foods and drinks

Nonetheless, in a triumph of hope over reality and as part of "Performance with Purpose," the company's portfolio has been split into three groups of descending "healthiness": the "good for you" portfolio, the "better for you" portfolio, and the "fun for you" portfolio

The "good for you" portfolio, also sometimes referred to as the "nutrition business," includes the snacks and drinks that contain the most fruits, vegetables, nuts, dairy, and grains and features brands such as Naked Juice, Quaker Oats, Gatorade, and Sabra Hummus. The goal here is to eventually triple the revenues brought in by this segment of the company, transforming it to a $30 Billion plus business by 2020. However, the bulk of PepsiCo's total revenues do not come from the "good for you" portfolio, which means that the unhealthier foods, such as carbonated beverages and potato chips, continue to bring in the majority of PepsiCo's annual revenues.

Yet, it is clear that the revised goals and operations within the company are a commitment to society, as well as a means to further PepsiCo's continued success and survival. Capitalizing on a new niche in society created by the aging global population with its increased focus on health means that products that are nutritiously good or nutritionally better are a growth opportunity.

Because these types of products can be made cheaply, have large profit margins, and are most easily consumed and marketed to shoppers everywhere, it is not surprising that the firm will continue to produce these types of consumable goods for some years to come. PepsiCo's journey into nutrition, which officially began in 2007, seeks to prove the company is serious about these changes to the PepsiCo image by spending millions of dollars to bring nutrition specialists into consultation about new snacks and beverages, hire prominent scientists, build new laboratories, and expand Research and Development's capabilities.

As with many beverage companies, PepsiCo is facing the same issue that its competitors are grappling with; perpetually weak demand for carbonated beverages and challenges of the perception that its products are unhealthy. However, the company has a distinct advantage over its competition because it has the benefit of diversification through food products. This also informs their acquisition decisions.

To that point, PepsiCo agreed to acquire Pepsi Bottling and Pepsi-Americas in August 2009, which consolidated eighty percent (80%) of its North American beverage manufacturing, sales and distribution under its own roof; suggesting the acquisition would provide $400 million in expected annual savings. While the return is still not as anticipated, owning bottling does provide the company with greater control over a vital area of the value chain.

Interestingly, just before PepsiCo's transaction closed, in 2009, Coke CEO Muhtar Kent agreed to his own deal, swapping foreign bottling assets for Coke's North American portfolio and causing the stock to shoot up 33% in a day. Yet one year later, Coke was spinning off the bottling operations once again. This hardly seems a strategic set of decisions; which raises the question - Does Coke really understand the strategic implications of what it's doing, beyond the immediate opportunism? Perhaps that question and others will be addressed more fully by Coke's new CEO James Quincey, who is replacing Mr. Kent, as might the potential that Coca-Cola might be a takeover target for AB InBev (NYSE: BUD). Alas, global market leadership in soft drinks notwithstanding, Coca-Cola suffers from a lack of product diversification outside beverages and it has been suggested there is a need to shake things up. So, who knows?

Conclusion

PepsiCo currently sits at number forty-four (44) on the Fortune 500 list, with no competitor ahead of them and the next competitor, Coca-Cola, at number sixty-two (62). As it currently exists, the Fortune list suggests no logical big company acquirer for a corporation the size of PepsiCo. Since most (70-80%) of all acquisitions fail, a smaller firm or a firm seeking diversification or vertical integration might find PepsiCo an interesting but impossible acquisition to integrate and manage. Why? For the same reasons other acquisitions fail:

  1. The acquirer miscalculates the strategic fit. If the acquisition is too far outside the parent company's core competency, things are not likely to work
  2. The acquirer gets the deal structure or the price wrong
  3. The acquirer misreads company culture and how it would integrate into a newer, larger organization
  4. The acquirer fails to communicate with the target firm clearly or sufficiently, often leading to disaffected employees
  5. Too much focus by the acquirer on integration and not enough on customers and the core business
  6. The acquirer fails to understand the complexities of managing a larger, complex global company

In truth, acquisitions can fail for many reasons including a lack of management foresight, the inability to overcome practical challenges and the loss of revenue momentum from a neglect of day-to-day operations. So it is that, those companies that make effective acquisitions have clarity on what real value is added and where.

Historically, PepsiCo has shown itself to be a company that consistently makes effective decisions about what companies to acquire and exactly how they will help create value. PepsiCo is also a corporation willing to divest companies when the expected value does not materialize.

With that, the question is where might the focus on acquisitions be in PepsiCo's future? Very likely it will remain as it has in the past, with a focus on food and beverage firms in specific product and/or geographic markets, where the acquired company will offer established brand loyalty and would benefit from PepsiCo's distribution capabilities that enable growth in an established market. This means that, not only do they target an acquisition well, it also means PepsiCo knows how to integrate the new companies in order to deliver growth and optimize value.

With its history, PepsiCo is able to make the tough decisions about strategic acquisitions, as they adapt to the competitive environment. This is what makes them unique and why their focus on growth will always make them a hunter and gather of other firms, rather than the target of an acquirer.

Disclosure: I am/we are long PEP.

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.

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