PepsiCo's Capital Allocation Strategy Does Not Bode Well For Future Returns

Summary

• Although PepsiCo and Coca-Cola are often considered as two very similar companies, they have gone in very different directions.
• PepsiCo seems to be missing out on the coffee business, which could be a costly mistake in the long term as soda consumption declines.
• Masked under the so far well-performing snacking division is PepsiCo's troubled beverage business, which does not seem to be heading in the right direction.
• All these risks would most likely not manifest themselves in PepsiCo's next quarterly results, but could prove fatal for long-term returns.

Source: PepsiCo CAGNY 2020 presentation

PepsiCo (NYSE:NASDAQ:PEP) has been outperforming its major peers over the past decade. As a dividend aristocrat with both stable and high return on capital, the company has become a key component in many retail and institutional investors' portfolios.

Data by YCharts

Although PepsiCo is unlikely to suffer heavy losses over the short term, shareholders holding the company for the long run should not focus whether or not the company meets or beats quarterly estimates. The success of such large enterprises in the stable packaged food and beverages space is not determined by the operational decisions taken on a day-to-day basis. Long-term success depends on making the right strategic capital allocation decisions which could provide tailwinds for share prices for years, if not decades, ahead.

To begin with the stable nature of PepsiCo's earnings and its low risk for shareholders has pushed the company to become one of the most highly-leveraged businesses in its large cap peer group.

Source: Prepared by the author using data from Seeking Alpha and annual and quarterly SEC Filings

The high leverage is not a problem from an operational point of view but it could become one, if the company's long-term capital allocation strategy does not pay off. Down below I will first cover some key differences between PEP and its major peers and will then focus on the key long-term risks that the company is now faced with.

How PepsiCo stacks against its major peers

Although often seen as very similar companies, KO and PEP have become very different businesses over the years. To begin with, half of PEP sales are derived from its snacking business, while KO is a pure play beverage company. The latter is also becoming a much more asset-light business, following the divestment of a large proportion of its bottling operations.

Source: Coca-Cola 10-K SEC Filing

Thus, PepsiCo's high Return on Equity, which is the key driver of its valuation, relies more on the company's high asset turnover while operating profitability has remained much lower than that of its major peer - Coca-Cola (KO).

* Adjusted Asset Turnover - excluding Goodwill and Intangible Assets

** Leverage - Total Assets / Total Equity

Source: Prepared by the author using data from Seeking Alpha and annual and quarterly SEC Filings

On top of its higher asset turnover, which comes as a result of the company's unique combination of large scale beverage and snacking businesses, PepsiCo also achieves its very high ROE through its highest leverage within the peer group. As I said earlier, although this very high leverage does not pose any imminent threats, it should make shareholders very critical of how this borrowed capital is being allocated and whether it sets PEP on the right course over the long term.

The massive share price outperformance of PEP, that we saw above, over the 2017-18 period has been attributed to the company's temporary increase in leverage over that period that drove the company's ROE to unsustainably high levels.

Source: Prepared by the author using data from Seeking Alpha and annual and quarterly SEC Filings

Since then, the gap between PEP and its major peer Coca-Cola has narrowed, as the latter achieved a much higher Net Income margin following its decision to divest some of its bottling operations. Thus, the gap between the two is set to close over the coming years, in spite of the transitional difficulties for KO due to the pandemic.

When looking at cash flow allocation on a 10-year cumulative basis relative to cash flow from operations, PEP and KO once again differ in some key areas. Over the 2010-19 period, PEP has spent a significantly higher amount on strategic acquisitions and dividend payments due to its more asset-light business which requires less capital expenditures and its much higher profitability.

Source: Author's calculations based on data from annual reports

Also if we breakdown stock buybacks, the influence on Berkshire Hathaway (BRK.A) (BRK.B) on KO's capital allocation decisions becomes evident as the company has gradually scaled back its buybacks program as the company's share price became more expensive. Thus, allocating more capital to strategic acquisitions such at the one of Costa Coffee (but more on that later).

Source: Prepared by the author using data from Seeking Alpha and annual and quarterly SEC Filings

On the contrary, PepsiCo kept a significant stock buyback program over the past couple of years when the P/B ratio reached even higher levels than those of KO.

Source: Prepared by the author using data from Seeking Alpha and annual and quarterly SEC Filings

All that hardly qualifies as an issue for a large company such as PEP, however, it clearly illustrates how much the capital allocation decisions differ between the two companies.

Where PEP is most likely making a mistake however and setting itself for future underperformance relative to peers is:

• missing out on the high growth and high margin coffee segment,
• continued problems in its beverages segment, which has so far been rescued by the Frito-Lay business unit,

Missing on Coffee is likely a costly mistake

In my last analysis of PepsiCo, I covered some of the problems associated with the lack of a solid strategy to enter the coffee segment. To put it briefly, Coffee & Tea has been one of the highest growth segments for the past decade or so.

Source: JDE Peet's Investor Presentation

Not only that, but growth is also expected to continue for the foreseeable future, while profitability (as we will see below) remains one of the highest in the beverages space and is unlikely to come down as demand in Developed and Emerging Markets alike continue to increase and production is threatened by climate change.

Source: Danone CAGNY Conference Presentation 2019

That is why it comes as a no-brainer why large food & beverage companies have been racing to take a share in this attractive business.

Nestle (OTCPK:NSRGY) for example, which has extraordinary long-term capital allocation strategy, derives the highest margins from its Powdered and Liquid Beverages segment, which is mostly comprised of its coffee brands.

Source: Prepared by the author using data from Nestle Annual Reports

Nestle's well-thought long-term capital allocation strategy becomes evident when we look at the areas where the company has been making the most acquisitions. For this purpose, I use the absolute change in Goodwill & Intangible Assets over the past 5 years as a proxy of where the company has been making outside deals. No surprise that its Powdered and Liquid Beverages comes at the very top.

Source: Prepared by the author using data from Nestle Annual Reports

The Nutrition & Health division appearing at the bottom is due to the company's efforts to divest underperforming businesses and grow the overall division in a different direction.

Source: Nestle CAGNY 2020 presentation

The most important implication for PEP, however, is not that Nestle strategy is focused on its most profitable divisions, but rather the company's pivot towards the coffee segment.

Source: Nestle CAGNY presentation 2019

The space has no doubt become very competitive over the recent years, but Nestle's $7.5bn deal to sell Starbucks products globally solidifies the company's existing offerings in the coffee business. It also means more pressure on PepsiCo's ready-to-drink Starbucks' branded products as Nestle makes a stronger push in the U.S. market.

The other major competitor of PEP has also moved in that direction, with the nearly $5bn strategic acquisition of Costa Coffee.

Source: Coca-Cola Q3 2020 Earnings Presentation

After divesting some of its bottling business and dialing down its stock buyback program, Coca-Cola made one of its largest acquisitions ever in the British coffeehouse. The company is also busy scaling the high-margin business of Costa, which fits very well with KO's pure beverage franchise model.

The segment has also seen increased competition from another major competitor of PepsiCo - Keurig Dr Pepper (KDP) and its related and recently-listed company - JDE Peet's, which combines many of the world's strongest coffee brands.

Source: JDE Peet's Investor Presentation

It is also interesting to note that Mondelez (MDLZ), another major competitor of PepsiCo in the snacking business, has a significant stake in JDE Peet's which highlights the strategic importance of that business.

At the same time, PepsiCo's strategy in that regard has been missing the headlines. Although the company has been very successful in the past with its ready-to-drink Starbucks coffee, the company now faces stiff competition from Nestle in this field.

Source: beveragedaily.com

PepsiCo also once again launched a blended Pepsi-Cola and coffee beverage. Surprisingly, the company has historically failed twice to launch such a beverage, which seems strange and begs the question why would this be a success the third time around.

Source: marketingweek.com

PepsiCo also did partner with LavAzza, the largest privately-owned coffee maker, on launching a ready-to-drink coffee in the UK. So far, this effort hasn't produced any meaningful results, but it remains to be seen if PEP will finally accept that it is missing out on opportunities in the coffee segment and make a more meaningful move. In the meantime all of its major peers in the beverage and snacking space are already building solid coffee businesses.

Core Beverages segment is struggling

PepsiCo's North America Beverages segment (PBNA) incorporates many of the company's most iconic brands.

PBNA makes, markets and sells beverage concentrates, fountain syrups and finished goods under various beverage brands including Aquafina, Diet Mountain Dew, Diet Pepsi, Gatorade, Mountain Dew, Pepsi, Propel, Sierra Mist and Tropicana. PBNA also, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink tea and coffee products through joint ventures with Unilever (under the Lipton brand name) and Starbucks, respectively.

Source: PepsiCo Annual Report 2019

However, if we look at operating profitability since 2012, the PBNA segment has been a very poor performer, while the snacking business under the Frito-Lay North America (FLNA) name has been doing the heavy lifting. The former's operating profit fell by a staggering $758m on an annual basis, while the latter's increased by an impressive $1,612m.

Source: Prepared by the author, using data from PepsiCo's annual reports

The decline in operating profitability seems to be happening very fast over the recent years, which is a problem for such a key business segment.

Source: Prepared by the author, using data from PepsiCo's annual reports

This perhaps explains the company's somehow belated efforts to boost its division's profits through an acquisition frenzy over the last year, after years of no strategic deals at all.

Source: Prepared by the author, using data from PepsiCo's annual reports

What could be even more troubling is that in spite of the continued decline in carbonated drinks consumption, PepsiCo is focusing its acquisition strategy in exactly this field.

One of the largest deals PEP did recently was the $3.2bn acquisition of SodaStream - the company known as the maker of the consumer home carbonation machine.

Source: bevnet.com

Contrary to Coca-Cola and Nestle, which are both expanding into coffee machines, PepsiCo makes a big bet on made-at-home soda.

In the meantime, consumption decline of sugary sodas is spelling a problem for other of PepsiCo's brands in that area.

Source: businessinsider.com

Another sub-segment of the sector, where PepsiCo is focused right now, is energy drinks. During the last quarterly call, the company's CEO Mr. Ramon Laguarta said the following.

Listen, our focus today, 100% focus is getting the energy strategy right, in terms of executing that. I think, as I said earlier, is a multi-vector strategy that requires, both Rockstar doing very well. It requires to do a great job with Bang. It requires innovation in Mountain Dew to move into that space and then do a great job with Starbucks.

Source: PepsiCo Q3 2020 Earnings Call Transcript

Thus, the other major acquisition that PepsiCo did recently was the $3.85bn deal for Rockstar Energy Drink.

Source: medium.com

The Rockstar drink is not expected to have any material impact on PepsiCo's sales and profit, however, the deal most likely led to PEP also winning a distribution deal for Bang Energy drinks. Bang currently holds a large market share and is preceded in sales ranking by the likes of Red Bull and Monster.

However, it is not entirely clear what impact this deal will have on PEP's bottom line while at the same time Coca-Cola was once again first to capitalize on the large growth opportunity in this segment, way back in 2014, with its $2bn stake in Monster Beverage (MNST).

Roughly the same time that KO did its deal with Monster Beverage, PepsiCo launched its Mountain Dew Kickstart energy drink and management seemed very excited about it during the 2016 CAGNY Conference.

Source: Presentation to Consumer Analyst Group of New York 2016

The product was initially doing well.

And we intend to continue to invest behind Mountain Dew. We intend to continue to invest behind Kickstart and the franchise is doing well.

Source: Q4 2016

However, after a number of years of silence on the annual conference call, the brand was mentioned during the Q4 2019 call when Jeffrey's analyst described Mountain Dew Kickstart as follows:

Ramon, can we come back to the energy drink category and kind of get more of an update on the company’s strategy? It’s not an area that PepsiCo has participated in, in a meaningful way. Company’s had a partnership with ROCKSTAR, which is a brand which has lost share over time. Mountain Dew Kickstart hasn’t really gained any traction in the category.

Source: Q4 2019

While PepsiCo is still scrambling to execute on its strategy in the energy drinks field, amid declines in soda consumption, its rival Coca-Cola has been enjoying the benefits of owning one of the strongest businesses in that area for many years now.

Pepsi and rival Coca-Cola have been pushing into energy drinks as soda consumption declines in the U.S. But Monster Energy is far and away the market leader for energy drinks.

Source: cnbc.com

Conclusion

PepsiCo is still a solid and highly profitable dividend aristocrat that could continue to meet its quarterly numbers expectations for the coming months. However, long-term investors should look past these quarterly results and make sure that they do not miss the forest for the trees.

PepsiCo is one of the highest-leveraged companies in its peer group and the company seems to be missing out on one of the most profitable and high-growth areas in the beverages space - coffee. At the same time, the company's recent acquisition spree does not seem to address the long-term problems of its struggling beverages division.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MDLZ over 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.