Wednesday, December 5, 2012

Pepsico's Strategy Lacks Coherence

The food and beverage sector is interesting because its leading players seem to be pursuing different types of strategies in dealing with the same problems. The North American mass consumer remains highly cautious with spending, but the economy is improving; meanwhile, emerging market (EM) growth is moderating and it’s unclear how its consumers will react in terms of spending on food and beverage. The answers to these questions will not only shape their operational strategies but also their structure, and I think this is a critical year for decision making at these corporations.

Pepsico’s Power of One

At Pepsico (NYSE: PEP), it’s not entirely clear whether the ‘power of one’ represents a coherent business plan meant to leverage economies of scale or if it is a reference to Indra Nooyi’s role as Chairman and CEO. Whichever it is, it is unlikely to change the game plan of piecemeal engineering with its powerful brands combined with investments in EM. For Pepsico, the former is much more important than the latter because North Americas still makes up the bulk of its profits.

Essentially Pepsico tied its colors to the North American mast when it split from Yum! Brands (NYSE: YUM), and the latter is a great example of a company that has chosen to chase emerging market growth in China. The difference is that Pepsico has more leeway to adjust its strategy now. Meanwhile, Yum is firmly set on a path of expansion in China while trying to optimize its operations in the US by restructuring. In a sense, Yum’s mind is already made up, but Pepsico could decide to replicate Kraft (NASDAQ: KRFT) by splitting its operations in order to release value and create more management focus in the separate parts. The market liked the Kraft split idea, but should Pepsi be pushed to do the same just because the market thinks so? I happen to think it should.

Pepsi’s Gone Flat?

Politicians are assiduously taught never to say sorry or admit any mistake however minor or trivial it may be. The reason for this is that it is an implication of weakness, and their opponents will endlessly exploit this in campaigning against them. And if Pepsico was running for a election, its opponents would have a field day reeling out old tape of its forays into bottled water, its mistakes with Gatorade and its relative failure to take advantage of the trend towards energy drinks. Indeed, management specifically ruled out any M & A activity directed towards the energy drink sector.

Of course the last two points are interlinked because Pepsi admits it shouldn’t have marketed Gatorade as a general hydration drink when energy drinks were starting their acceleration in popularity. It also shouldn’t have chased volume growth at the expense of profitability, and its management articulated a willingness not to do so in the future. All these issues are being addressed, as is the ongoing difficulty of convincing politicians that sugary carbonated drinks are not the new tobacco.

All of this is wonderful, but investors are entitled to ask what happened to the ‘power of one?’ Chasing volume and category growth is surely an intrinsic part of a strategy devoted to developing a coordinated approach to selling beverages and snacks together. In other words, enacting piecemeal restructuring and cutting back on chasing unprofitable growth is one thing, but developing profitable growth by category expansion is another. It strikes me that Pepsico is trying to do both right now. It reported 5% organic growth, of which 1% was volume growth and the other 4% was pricing. Again, this is a sign of a company maximizing profits rather than looking for scale.

The Other Guy Blinked

As ever, investors will compare Pepsico with its beverage rival Coca-Cola (NYSE: KO), and the contrast in strategy and performance is notable. Both companies had issues with FX, but Coca-Cola seemed to do relatively better in the US. Moreover, it has been taking market share in water (a market that Pepsico has struggled in) and investing in buying bottling operations in emerging markets.

As detailed above, Pepsico is still primarily a North American focused company and performance in the quarter softened with the usual story of sales channels in the US shifting to discount stores. The challenge going forward will be to carry on trimming underperforming assets in the US and hoping that Pepsico’s low ticket items will be immune from any moderation in growth within emerging markets, a particular concern given the investment in the Tingyi alliance in China.

Where Next for Pepsico?

It is a facet of investing that sometimes companies appear attractive for the wrong reasons. It’s hard to see that the company’s core strategy is being applied, so it’s hard to judge it on that.  Pepsico has very strong brands, but the ‘power of one’ hasn’t been working particularly well in maximizing profits or growth. No matter. The stock remains a dividend play, and with the US economy slowly getting better, it’s hard not to think that conditions might not get easier for them.

The investment in China with Tingyi offers growth prospects within emerging markets. Prospects do look better, but the stock doesn’t look cheap, and I’m not a fan of buying companies because you hope the management will change direction. In addition, there is probably better value elsewhere for the macro assumptions you would have to make before buying the stock.

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