Not being inside PepsiCo (NASDAQ:PEP), it is fair to say my observations may appear to be like the golfer wandering into the weeds looking for his ball and carrying a putter. Knowledgeable observers might comment what is on display is either extreme confidence or incredible stupidity. I chose confidence, as this article is grounded in my business experience; which is not to be confused by my time in academia, where faculty never allow their lack of practical business knowledge to get in the way of researched based opinions. But I digress.
A little grounding to aid in a strategic view of growth
The future has a range of potential outcomes, each with constraints subject to randomness and each requiring individual decisions affected by variables. That means suggesting the future is based on a single point forecast may well find things do not turn out as expected. And, this can happen to experienced management for the very best of companies.
For example, on the basis of a single-point analysis, IBM (IBM) forecasted sales of 295,000 personal computers (PCs) for the decade of the 1980s. IBM then made the strategic decision to completely move away from developing personal computers. Based on that decision, the company outsourced their microprocessor to Intel (INTC), outsourced their operating system to Microsoft (MFST), and focused on developing mainframe computers. (Eventually selling their PC business to Lenovo (OTCPK:LNVGY) in 2004, followed by its server business in 2014.)
The single-point forecast was off slightly, to say the least. As it happened, about 25 million personal computers were sold in the 1980s, or roughly 85 times IBM’s forecast. That single-point forecast and the company’s subsequent course of action had significant ramifications and, while IBM is a notable cloud service and software company, today they do not sell computers.
And IBM is not alone in its ill-advised attempt to reduce uncertainty through single-point forecasting. One reason single-point forecasting can be so risky is that the current competitive business environment is more uncertain than at any time since before World War II. In fact, research analysis of business forecasting for the past decade has found that even two-year forecasts usually fail to capture market change within that relatively limited specific time frame.
As such, when we hear about business growth, we should question from whence it will come. For example, Anheuser-Busch InBev (BUD) beat analysts forecasts thanks to an unexpectedly strong demand in non-US markets that included Mexico. Is that sustainable or merely a one-time earnings event? Based on those results, how does one plan growth? This is where seasonality, unhelpful policy shifts, government transitions, or natural disasters in countries where a company has product markets or suppliers can interfere with the best projections. One only needs to recognize that Proctor & Gamble’s (PG) expansion into Egypt was interrupted by the overthrow of Hosni Mubarak, or that the supply chain for General Motors (GM) and Ford (F) were disrupted by the Fukushima tidal wave.
Then there are emerging markets and developing markets, some like Viet Nam, Thailand and Indonesia, that offer new opportunities for some businesses and others, long determined to have exponential growth opportunities, like China and India, are thought to provide unending growth until they do not – as today’s tariff wars may indicate. So, to suggest growth is unending is folly; as anyone who bought a house leading up to the Great Recession. Rather, companies need to have not only geographic markets but product markets that enable growth.
Economics affecting consumers discretionary income
In the US, inflation remains about 2.6%, yet according to the US Bureau of Economic Analysis (WSJ July 31, 2019), disposable income and employee compensation rose 4.5% in 2017 and 5.0% in 2018.
Consumer spending makes up 68% of the U.S. economy, with about one-quarter of consumer spending tied to choices on groceries and clothing. In that spending are efforts to maintain the “middle-class” lifestyle that include buying some costly items, like cars that have caused auto debt to increase 40% over the last decade (this despite cars begin to lose their value even as you drive them off the lot). In fact, ease of access to capital born of lower interest rates has enabled many to buy homes (which at least have the chance to escalate in value over time). Then there are healthcare costs that are a variable for many and a notable burden for others.
Still, the debt burden for Americans is not at the same level as during the Great Recession, when households devoted 13.2% of disposable income to debt service. Today that number has dropped to 9.9%, freeing up cash for disposable spending.
Within the remaining dollars, as part of discretionary food purchases, is the ability to purchase drinks and snacks that consumers will spend more on when they feel comfortable with their economic situation, or when they seek to assuage their stressors.
Indeed, drinks and snacks are small guilty pleasures that help provide a moment of comfort and US consumers continue to spend money, irrespective of concerns of a broader global economic slowdown. In fact, when reporting recent quarterly sales increases, the experiences of companies seem similar if the approaches are not different.
Food makers Hershey (HSY) and Mondelez (MDLZ) have used price increases to drive revenues (mechanistic), while others like Nestle (OTCPK:NSRGY) and Unilever (UL) have experienced organic sales growth. However, all recognize the need to tweak their portfolios that allow them to capture growth prospects from products that appeal to changing consumer tastes.
I trust none of this is lost on PepsiCo.
PepsiCo’s growth buckets
A little research on their history makes it clear PepsiCo’s growth falls into one of three “buckets” that can be described as either: mechanistic, organic, or synergistic. Let’s talk about each…
MECHANISTIC
In 1965, Pepsi merged with snack maker Frito-Lay to provide a complementary product mix of drinks and snacks. Today PepsiCo possesses 22 separate billion-dollar products with global distribution. The company has grown to its size through acquisitions and, to the extent of addition by subtraction with the spinoff of what is now YUM! Brands, PepsiCo has continued to acquire brands that help complement their existing product lines or extend them, even as they enter new geographic markets through acquisitions of regionally known products, such as with Sabras in Mexico. In fact, earlier this year, PepsiCo announced it plans to invest $4 Billion in Mexico between 2019-2020 with partner Grupo Gepp and create around 3,000 new jobs. Part of the investment will go toward a new $109 Million plant in the central state of Guanajuato, which should be operating at full capacity by 2025.
In April 2019, shoring up beverage offerings, PepsiCo announced it bought the CytoSport business from Hormel Foods Corporation (HRL) for $465 Million and it includes the products Muscle Milk and Evolve brands.
In May 2019, PepsiCo announced its intention of investing $1.2 Billion in Pakistan, in an effort to capture a consumer market with 100 million people below the age of 30. Likely this action was in no small part because Coca-Cola (KO) expects to make a $200 Million investment there in the next two to three years.
In July 2019, PepsiCo announced they are close to striking a new deal in the U.K. with the Lavazza Group to make a ready-to-drink iced cappuccino product. Not sure what their US partner Starbucks (SBUX) thinks about that (though PepsiCo did say Starbucks was not able to work with them in Europe due to various constraints). But that’s life in the competitive fast lane.
Further, in late July 2019, PepsiCo made a move to build up its business in sub-Saharan Africa, with the purchase of South Africa’s Pioneer Foods Group for $1.7 Billion and plans to use the company as the basis for geographic expansion across the continent, as they leverage complementary product portfolios across the region. They also seek to take advantage of synergies in manufacturing and marketing to tap into the growth across many countries; which will include the expansion of sustainable farming using local farmers to boost crop yields that will improve PepsiCo margins through cost reductions.
Not to be lost among the beverage acquisitions is that PepsiCo sought to improve its healthy for you snacks and foods.
In May 2018, PepsiCo acquired baked fruit and vegetable snack maker Bare Foods Co., in an effort to strengthen its healthy snack portfolio. Bare Foods stands out as its chips are sold alongside fresh produce, making them visible to more shoppers since fewer people browse the center grocery aisles.
"Bare premium baked fruit and vegetable chips are an exciting expansion of Frito-Lay's better-for-you snack offerings," says Vivek Sankaran, President and COO for PEP's Frito-Lay North America unit.
In October 2018, PepsiCo acquired the company Health Warrior, a nutrition-forward company that makes plant-based products including nutrition bars and other food trend offerings.
On that purchase, PepsiCo announced, "We continue to position ourselves at the forefront of changing consumer preferences and trends. This acquisition helps us increase our presence in the nutrition bar category, which is an attractive growth space," says PepsiCo North America CEO Al Carey.
And, lest we forget, in August 2018, PepsiCo acquired SodaStream for $3.2 Billion, giving the company a new line through which it can reach customers within their homes.
That deal was the last bold move made under CEO Indra Nooyi, consistent with the announced strategic move away from sugary sodas to healthier beverages and snacks.
ORGANIC
PepsiCo has effectively sought revenue growth from existing products and markets. The most recent look at their performance is as notable as it is consistent. PepsiCo reported organic revenue growth of 4.5% in Q2. And it added FY2019 Guidance to include: Organic revenue growth: 4%; Core EPS: $5.50; Tax rate: ~21%; Net capital expenditure: ~$4.5 Billion; Cash flow from operating activities: ~$9 Billion; Free cash flow: ~$5 Billion. PepsiCo also declared a $0.955/share quarterly dividend, in line with previous dividends.
Notable were that developing and emerging market organic revenue increased 8%, driven by particularly good growth in a number of their key markets. Mexico and Russia were up “high-single digits,” Brazil was up more than 20% (in part reflecting the benefit of lapping last year’s transport strike), China grew strong “double digits” and India increased “mid-single digits.”
One cannot talk about growth at PepsiCo and not consider that Gatorade delivers 15% of total beverage revenues and, adjusted for total revenues (beverages & snacks), just over 7% company revenues. It is the prevailing reason PepsiCo bought Quaker Oats in 2001; an acquisition made possible by the money saved from spinning off the restaurants in 1997.
However, over the past two years Gatorade sales have fallen off; perhaps, due to consumers taste changing and turning to energy drinks, cold coffee and teas, the ubiquity of coconut beverages that claim to be the new health elixir, and the arrival of Body Armor (in which Coke owns a minority stake and is marketed as a healthier alternative to Gatorade and, of course, contains coconut water).
What this makes clear is the need to grow the Gatorade franchise. While the summer heat in Europe and the US may well provide some growth, PepsiCo executives know that is an event closer to a seasonal anomaly than a matter of sustainable growth achieved through effective planning. As the biggest player in the sports drink market, the future of Gatorade and its organic growth may lie in how PepsiCo can position it in their “better for you” market strategy. This suggests moving away from merely being able to slake the thirst of sweating athlete to rethinking Gatorade as a healthier drink that not only tastes good but is without the sugar and salts that are turning some consumers away. This movement to “healthier for you” has begun with Gatorade Zero, which PepsiCo claimsis the number one Zero sports drink in the country, and continues into a new product, Bolt24; a drink they intend to market to compete with Body Armor with claims of advanced hydration, antioxidants, electrolytes and no artificial sweeteners or flavors.
As to organically growing their water category, PepsiCo’s new carbonated water, Bubly, increased its flavored seltzer market share to 6.5% from 2.3% a year ago during a 13-week tracking period and PepsiCo is touting it as having the potential to be their twenty-third billion dollar product.
Then there was the acquisition of SodaStream that they are seeking to grow as an in-home product. According PepsiCo, SodaStream is doing very well and is exceeding expectations in terms of growth potential and PepsiCo is starting to put more capabilities against the SodaStream business, admitting the product was under optimized in its direct to consumer opportunities. PepsiCo is trying to insert some capabilities while running it as a separate business, in an attempt to be “agile and nimble” and disrupting the bottle business with plastic waste reduction. Having paid $3.2 Billion to acquire it, SodaStream is a big play that PepsiCo has to get right.
Not to be lost in the organic growth area is product packaging, though it is obviously on the margins; but it is organic growth nonetheless.
A recent news story pointed out how, facing public pressure over contributions to plastic pollution, Coca-Cola and PepsiCo are cutting ties this year with the Plastics Industry Association. The beverage giants join other companies like Clorox, Becton Dickinson and Ecolab, which ended memberships with the trade association last year.
PepsiCo aims to have its product packaging to be recyclable, compostable or biodegradable by 2025. PepsiCo is also testing the use of aluminum cans for Aquafina water instead of virgin plastic, while packing LIFEWTR products in 100% recycled plastic and eliminating the use of plastic bottles completely for the Bubly sparkling water brand; opting for cans.
The company says the changes planned for next year are expected to eliminate more than 8K metric tons of virgin plastic and approximately 11K metric tons of greenhouse gas emissions. Indeed, actions consistent with PepsiCo’s triple bottom line commitment to people, products, and the planet.
While we can commend PepsiCo for its social responsibility, the company recognizes that smaller packaging means reduced cost and increased purchase intent; thus, bigger profit margins. So, there is that.
SYNERGISTIC
From 2015 into 2016, Nelson Peltz and his Trian Fund Management LLP bought a 1.3% stake in PepsiCo, a position worth nearly $2 Billion and sought to convince PepsiCo to break up its business into drinks and snacks, based on the belief that they held more value separately. By the way, Peltz thought the PepsiCo snacks would make for a good portfolio addition to Mondelez; a company he had helped create as the instigator behind the break-up of Kraft into Mondelez and Kraft Foods (now Kraft-Heinz (KHC)). Peltz also was involved in Kraft’s purchase and then sale of Cadbury. A then losing proposition for Kraft. Peltz actions alone are worthy of a separate article; but my purpose for mentioning the efforts by Peltz was to frame the discussion about synergistic growth.
As a strategist, I might point out that PepsiCo, with a balanced portfolio of drinks and snacks, is a well-diversified consumer products company unlike Coca-Cola, which is a company that claims to be diversified, but only in beverages. And, as history shows, those companies able to better diversify are more effectively able to withstand the negative effects of market forces and business cycles. PepsiCo, as it is wont to do, considered the Peltz suggestion carefully, then unequivocally declined it. Still, the idea that PepsiCo might break up remains a topic every time it faces negative news.
Fast forward to February 2019 when PepsiCo’s new CEO Ramon Laguarta announced that, after completing a four-month review of its global business, PepsiCo was restructuring the business…but not breaking it up. On that, PepsiCo said it expects to incur ~$2.5 Billion in pretax restructuring charges through 2023, mostly from severance and other employee costs; the company's FY 2018 results included $138 Million of restructuring costs, and it expects to incur $800 Million in related charges during the current year.
It should not be lost on the reader that the timing suggests that, with Laguarta ascending to the CEO role in October (four months prior to the announcement of the restructuring), the review was his first order of business and that it had the blessing of the Board and the former CEO and then Chairman of the Board, Indra Nooyi. As is typical with the ascension of each new PepsiCo CEO, the company reevaluates their businesses and allows the new CEO to structure its future to meet their strategic vision. Such restructuring also means the new CEO gets to place their people in leadership positions. As history should show, this gives the new CEO the reins to structure the company and create the strategies designed for a successful future. This approach has turned out well and no CEO has been harmed in the restructuring (that was humor).
PepsiCo, like all companies when various functions achieve meaningful results, provides more resources that often includes people. Eventually, rather like a bureaucratic application of the Peter Principle, departments get too big and the people eventually engage in overlapping roles that hurt rather than help decision making. However, as has been said, PepsiCo is a “finance company” that sells consumer products and, as a finance company, they understand the cost of doing business and eventually will figure out when there is a need to reduce costs through restructuring, which is always designed around enabling greater synergies among its employees and business units. So it is that this iteration is just a different version of the same tune; they will reduce their operating structure and eliminate people and costs that do not help drive growth. And, as one insider humorously said…They then “burn their office furniture for heat and light.”
A Parting Thought
From a strategist’s view, PepsiCo generally figures things out as it relates to growth. History shows that should be evident. While the aforementioned buckets will always remain works in progress, the company can often surprise with some moves and not all are good, like in the mid-1980s when they bought North American Van Lines and Wilson Sporting Goods; only to sell them off quickly. However, true to form, they did harvest some quality executives from the companies and kept them to lead other PepsiCo divisions.
I would end by making one point about potential growth in a product area that has potential on both sides of PepsiCo’s business. It is one that has captured the attention of many…CBD beverages and snacks.
On October 2, 2018 we saw this headline on Seeking Alpha…
Shares of volatile cannabis companies Tilray (NASDAQ:TLRY) and Canopy Growth (NYSE:CGC) plunged 16% and 6% respectively in today's trade after PepsiCo CFO Hugh Johnston told investors it has no plans to invest in marijuana.
Correspondingly, shares of Aurora Cannabis (ACBFF), which had reportedly at one time had been in talks with Coca-Cola for cannabis infused beverages, fell 4% on the Toronto stock exchange, and Hexo Corp. (HYYDF) sank 8%.
According to the statement, PepsiCo saw difficulties in investing in that category, particularly in the U.S., “where federally these things are still not legal and are quite a considerable challenge," Johnston said on PEP's earnings conference call. "So, we look at everything, but certainly we have no plans at this point to do anything."
Still, if PepsiCo deems the opportunity worthy, it might give it a try but within the confines of its traditional approach to business development. What I mean by that is this…
First, PepsiCo does not engage in unrelated diversification. They do not buy suppliers or producers of commodities and, to be clear, cannabis products are commodities. Rather, PepsiCo has traditionally leveraged their size to improve their buying power and drive production costs lower.
Second, they often try things before jumping into the pool. To wit, we have this...
CBD hits mainstream via Pepsi independent distributors. Xanthic Beverages has been rapidly taking over the mainstream marketplace. Their flagship product, Xanthic CBD Water, is produced by a PepsiCo bottler and is currently being distributed by a network of Pepsi independent distributors in hundreds of retail locations throughout Washington and Oregon.
On the potential of CBD beverages and snacks, I may indeed be wandering in the weeds with a putter, but I have little doubt PepsiCo is following the socio-legal-regulatory environment to see how it shakes out because, it is clear, the demand is there. The public is buying CBD products; ascribing all sorts of valuable medicinal qualities to it.
Still, irrespective of how the CBD product potential plays out, investors should recognize that any future growth for PepsiCo will always be well planned. And, whether they are CBD products or basic drinks and snacks, growth will come in one or more buckets labeled - mechanistic, organic, or synergistic.
