PepsiCo makes its case

by Josh Sosland
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For several months, PepsiCo, Inc. and its chairman and chief executive officer Indra K. Nooyi have been put on the defensive by some shareholders agitating for the separation of PepsiCo’s large beverage business from its even larger snack foods business. Looking to go on the offensive, Ms. Nooyi at the company’s annual meeting and in its annual report had no trouble highlighting successes in PepsiCo’s track record and great promise in the company’s future.

“Last year we met or exceeded each and every one of the financial goals we announced to you, our shareholders, at the beginning of the year,” she said May 7. “Our organic revenue grew 4%, core constant currency earnings per share grew 9%, core gross margins improved by 90 basis points and core operating margins improved by 40 basis points, even while we increased investment in the company.”

Looking at efficiencies, Ms. Nooyi said the company exceeded its target by “capturing more than $900 million in productivity” and was on track toward a $3 billion productivity program established for 2012 to 2014. The company has extended its productivity program for five years with the objective of capturing $1 billion per year in savings.

The company’s cumulative shareholder return over the last five years, at 76%, has lagged the S.&P.500, up 131%. But Ms. Nooyi noted that since 2000, PepsiCo has outperformed the market by 170 basis points per year.

The company raised its dividend rate by 15% (its 42nd annual dividend increase) and expects to make $5 billion in share repurchases in 2014 in addition to $3.7 billion in dividends.

Since 2006, when she became c.e.o., the company has outperformed the market 102% to 75%. Conversely, PepsiCo shares have disappointed during this time by another traditional measure. While the company’s market capitalization moved ahead of its heritage peer The Coca-Cola Co. for a time in 2006, PepsiCo currently lags by 26% — $132 billion versus $178 billion for Coke.

An ‘innovation machine’

While generous dividend rates and large share buybacks may be associated with mature businesses that have only modest growth prospects, Ms. Nooyi’s comments were devoted mostly to steps the company has taken to position itself for growth in coming years as well as dealing with challenges the future may hold.

She expressed pride in PepsiCo’s “innovation machine,” calling 2013 the company’s “best year” in this area. The company accounted for 9 of the top 50 new food and beverage products in the United States across all channels as measured by I.R.I. Worldwide. The products included beverages as Mountain Dew Kickstart and Gatorade Frost Glacier Cherry and food products such as Tostitos Cantina Tortilla Chips and Müller Quaker Yogurt.

Turning to health and nutrition, she said 20% of annual revenues currently fall in this category.

“Building from our positions of strength with four of the most important nutrition platforms and brands — Quaker (grains), Tropicana (fruits and vegetables), Gatorade (sports nutrition for athletes) and Naked Juice (super-premium juices and protein smoothies) — we continued to expand our portfolio of nutritious products across multiple markets and unlock growth opportunities in new product categories, such as dairy, hummus and other fresh dips, and baked grain snacks,” Ms. Nooyi said.

She said the company has taken further steps to reduce saturated fat and sodium levels across its broader snacks portfolio.

Winning in emerging markets

Another step the company is taking to position itself for future growth includes a continued focus on building its business in emerging markets, Ms. Nooyi said.

“The growth rates of developing and emerging markets are expected to continue to outpace developed markets for the foreseeable future,” she said. “And by 2030, experts estimate an additional 3 billion people may join the middle class. These trends present excellent growth opportunities, but will require significant investment and development of the right people, skills and tools to compete. We have already established strong positions in developing and emerging
markets, but need to continue to invest in building our capabilities in these markets to capture these growth opportunities.”

Another change requiring focus from PepsiCo is digital technology and how it is affecting the company’s interactions with its retailers, shoppers and customers.

“Being a laggard is simply not an option,” Ms. Nooyi said. “In a digital landscape that is incredibly dynamic, we are focusing on new digital tools, technologies and retail platforms to allow us to reach consumers differently, shift our advertising and marketing model, improve our analytics and enhance the efficiency of our sales force. Cybersecurity is also a real concern, requiring
focused investment and constant diligence against threats.”

With the company’s large presence in the developing world, PepsiCo needs to view social and political unrest as “the norm, not the exception,” Ms. Nooyi said.

“Income inequality, competition for natural resources and geopolitical tensions and conflict will continue to pose risks to doing business in many countries around the world,” she said. “Doing business in this environment requires continued investment to keep our people safe and protect our supply chain.”

She cited Egypt, amid its political unrest, as an example where the company’s team there “ensured operations were not disrupted and looked for opportunities to expand the business even in a challenging period.”

Ms. Nooyi also touched briefly on the impact climate change may have on PepsiCo’s business going forward, principally as it may pose a threat to the productivity and availability of agricultural inputs.

Amid such risks, she said the company benefits from “multiple sourcing pipelines” and is working to develop “multiple formulations of various products to be able to cope with changes in raw material availability and price, while 
delivering on taste and quality.”

The pressure builds

Against the backdrop of Ms. Nooyi’s upbeat analysis is the continuing shareholder pressure to break up PepsiCo as a way to generate greater shareholder value. In February, Ian Cook, the presiding director of the PepsiCo board, said management and the board were “in complete alignment” on this issue. They were responding to a Feb. 11 letter from Nelson Peltz, who leads Trian Fund Management L.P., which at the time owned PepsiCo shares worth $1.2 billion.

Mr. Cook said PepsiCo was “confident” in the “conclusion that PepsiCo’s value is maximized as an integrated food and beverage company.”

The response did not satisfy Trian, which has called on PepsiCo to close offices in Purchase, N.Y., and Chicago to reduce costs and allow the two business segments to “grow to their maximum potential.”

“Right now, neither one is capable of doing that because they have an anchor around their necks that’s called corporate,” Mr. Peltz said in an interview. He also expressed skepticism about how the PepsiCo beverage line has done 
competing with its top rival.

“Despite poor performance in recent years, we believe the beverage business has great potential,” Trian said. “The business generates strong free cash flow and has the only North American distribution system that can compete head-on with Coke.”

More recently, in an interview in Fortune, a Trian executive ratcheted up the rhetoric.

Ed Garden, chief investment officer of Trian Fund Management, accused Ms. Nooyi of mismanagement and of building a “huge bureaucracy” and a “culture of sycophants.”

“What they need are honest, dynamic managers,” Mr. Garden said. “Instead they have a spin-machine.”

While PepsiCo has sought to characterize Trian as isolated in its opposition to the company’s management, other major shareholders have expressed support for Mr. Peltz’s analysis.

In a recent interview with Bloomberg Television, Kevin Dreyer, portfolio manager at Gabelli Funds, said, “We are paying close attention” to the debate, and he challenged the idea that the business would be compromised if beverages and snacks were separated.

“They definitely could be run separately,” he said. “Mr. Peltz’s case certainly is compelling from a financial perspective.”

PepsiCo pushes back

In her letter to shareholders in the company’s annual report, Ms. Nooyi did not mention Trian by name but emphasized the complementary nature of PepsiCo’s principal businesses.

“PepsiCo’s portfolio competes in two focused, related categories: foods and beverages,” she said. “Both categories have attractive global growth prospects of 5% or more, and our convenient foods and beverages businesses are fairly evenly balanced, with about half of our 2013 revenue coming from each. More importantly, our categories and products are highly complementary, sharing the same customers, consumers and occasions. It is the ‘related diversity’ of the PepsiCo portfolio that we believe gives us an advantaged position over the competition. The Power of PepsiCo’s Portfolio to Enable the Next Wave of Growth.”

She went on to say shared consumer insights help with the development of products both in snacks and beverages.

“Our portfolio allows us to capture coincident eating and drinking occasions using joint marketing and selling,” she said. “When consumers reach for a Frito-Lay snack, we want them to pair it with a refreshing Pepsi beverage or any of our other diverse beverage offerings. Our scale and relationship with our retailers allow us to create in-store destinations to influence consumer shopping patterns and decisions to increase this coincidence of purchase.”

She also pointed to the great success the company, with its mix of beverage and snack products, has enjoyed recently in food service channels.

“The runaway success of Doritos Locos Tacos, a culinary innovation to drive growth for a PepsiCo food service customer, is just one example,” she said. “Doritos Locos Tacos have exceeded $1 billion in retail sales since their launch in 2012. In 2013, PepsiCo won the Buffalo Wild Wings account, giving us access to more than 1,000 locations, by demonstrating the advantages of our combined portfolio.”

Mr. Dreyer said Gabelli has not yet taken an activist tack and believes the controversy will be resolved over time.

“Either they will improve the performance of the business and the stock will respond accordingly, or they will be forced to split it up,” he said.
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