PEP harris - Analyst Note 05072009 We are maintaining our...

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Unformatted text preview: Analyst Note 05072009 We are maintaining our fair value estimates for PepsiAmericas PAS and PepsiCo PEP following the announcement that the bottler has rejected Pepsi's offer to acquire its outstanding shares. This follows Pepsi Bottling Group's PBG decision Monday to reject a similar proposal from Pepsi. We are disappointed by PepsiAmericas' decision, because we think Pepsi's offer of $23.27 per share represented a fair price for the firm. We are also disappointed by the company's decision to adopt a poison pill, which would not be in shareholders' best interests if it fends off a takeover at an attractive price. However, fairly solid firstquarter results and the recent rally in equity markets have strengthened PepsiAmericas' hand in its negotiations with Pepsi, and we think these moves are an attempt by the bottler to hold out for a higher takeover price. We expect Pepsi to raise its bids for both bottlers, and that ultimately, the deals will be completed. However, it appears there are more rounds of bargaining to come, and we are concerned that if Pepsi values the bottlers at prices significantly above our fair value estimates, the firm could destroy shareholder value. Thesis 04222009 We assign a wide economic moat to PepsiCo because of its economies of scale, its dominance in the snack category, and its leading beverage brands. The direct store delivery system allows the firm to leverage its impressive portfolio of brands and should ensure that PepsiCo maintains its strong returns on invested capital over the long run. However, the economic downturn is creating some head winds that are likely to restrain the company's nearterm performance. Although longtime competitor CocaCola KO may have won the battle for the leadership of the cola industry, PepsiCo is winning the war in the broader snack and beverage market with a group of brands that hold leadership or second place positions across several categories. Collectively, these products give Pepsi control of around 39% of the U.S. salty snack market and a leading 23% share of the market in Western Europe, according to the firm's annual report. The North American snack business is Pepsi's most profitable segment, generating 33% of the firm's total revenue in 2008 but 44% of its profits. In addition, PepsiCo has an impressive record of developing or acquiring products that are aligned with emerging consumer trends. Through bringing to market healthier baked snacks, partnering with Starbucks SBUX to distribute readytodrink coffees, and acquiring popular noncarbonated brands like Gatorade and Naked, PepsiCo has demonstrated an ability to recognize shifting consumer preferences and adapt its portfolio to meet those changes. Its heavy investment in research and development and marketing have helped the firm to stay one step ahead of most of its competitors, particularly in the snack industry. We think one of the primary sources of PepsiCo's moat is its direct store delivery system, which acts as a barrier to new entrants because it would be costly to replicate. The firm has leveraged this extensive distribution network to broaden its offerings of nonPepsiCola products and grab share in adjacent snack categories. PepsiCo has been particularly successful at doing this in its nonbeverage categories, where its strong brands have been successful in grabbing market share from weaker competitors. Despite these competitive advantages, PepsiCo faces some shortterm head winds. The increasingly cautious consumer is becoming more likely to buy on promotion, trade down to private label, or simply reduce total spending on snacks. In addition, volatile commodity costs present the firm with another challenge. However, we think the positioning of the brand portfolio puts PepsiCo in a better position than most of its rivals to weather the storm, and we like the firm's longterm prospects. Valuation We are lowering our fair value estimate of PepsiCo to $68 from $71 in light of the firm's offer to acquire its leading two North American bottlers. We expect the firm's nearterm results will continue to be hurt by the strength of the U.S. dollar and slowing demand, particularly in the carbonated beverage business. Our forecast assumes no movement in exchange rates from current levels. We forecast revenue to be flat in 2009, as we expect the soft global economy to weigh on sales volume and a stronger U.S. dollar to hurt the firm's reported overseas performance. We expect revenue to recover in 2010, as the economy picks up and Pepsi stabilizes its market share, and we forecast a longterm revenue growth rate of 4% per year from 2013. We expect the acquisition of the bottlers to lower the firm's operating margins by around 200 basis points to around 17% in 2009, but beyond that, we expect cost savings and volume leverage to help Pepsi expand its operating margin to around 19% in the long term. Risk PepsiCo's sales and profitability could be negatively affected more than we forecast in our model by the economic downturn and volatility in commodity prices, particularly for raw materials such as sugar, corn, and oranges. With almost 48% of revenue generated outside the United States in 2008, the firm is subject to currency risk and geopolitical risk in the overseas markets in which it operates. Sales of PepsiCo's carbonated drinks and snacks could be hurt by negative publicity regarding the health concerns associated with junk food and sugary soft drinks. See Previous Analyst Reports Close Competitors TTM Sales $Mil Market Cap $Mil * * * * * PepsiCo, Inc. CocaCola Company Kellogg Company Nestle SA General Mills, Inc. Kraft Foods, Inc. 43,181 31,734 12,822 89,627 14,517 41,551 77,186 98,966 16,393 139,030 17,406 37,113 * Morningstar Analyst Report Available | Compare These Stocks Data as of 033109 Strategy The firm plans to leverage its direct store delivery system to grow internally through innovation, as well as by strategic partnerships and acquisitions. PepsiCo has been expanding into adjacent categories, such as nuts and seeds, concentrating on growth categories and international markets. The firm has made offers to buy the outstanding equity of its two largest North American bottlers. Management & Stewardship Overall, PepsiCo has a high standard of corporate governance. Chairman and CEO Indra Nooyi has been at the helm since October 2006, and in that time, the firm has created returns to shareholders that have outstripped those of its peers. We are impressed by the credentials of the directors and the level of independence in the boardroom, though we would prefer to see the roles of CEO and chairman split between two individuals, as this would allow the board to set its agenda independently from management. Executive compensation appears to be reasonable and contains a satisfactory balance of salary and incentivebased awards. The metrics used to assess executive performance are clear and, in our view, align the interests of management with those of the shareholders. PepsiCo does not have a poisonpill policy or any other takeover defenses. We applaud the firm for its adoption of majority voting, allowing shareholders to vote against the election of a director, but we think allowing cumulative voting would further enhance the rights of the small shareholder. Profile PepsiCo manufactures, markets, and sells a variety of salty, convenient, sweet, and grainbased snacks, as well as carbonated and noncarbonated beverages and foods. The firm's organizational structure constitutes three primary business units: PepsiCo Americas Foods, PepsiCo Americas Beverages, and PepsiCo International. The company's broad portfolio of brands include Pepsi, Gatorade, Tropicana, Lay's, Doritos, and Quaker. Growth During the last five years, PepsiCo has generated annual revenue growth of almost 10%, though this includes the beneficial effects of a weak dollar and several acquisitions. We think the firm can achieve an annual internal growth rate of 4% in the long term as it benefits from faster growth in emerging international markets. Profitability Although input costs are likely to resume their upward trend when the global economy recovers, we expect PepsiCo to be able to leverage its increasing scale to maintain operating margins of around 19% in the long term, up from 16% in 2008. Financial Health We expect the acquisitions of its bottlers to increase Pepsi's leverage. However, we still expect the firm's free cash flows to be sufficient to meet its repayment schedule. ...
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