Markets & Finance

PepsiCo: Still Plenty of Fizz


By Richard Joy Following its recent merger with Quaker Oats, PepsiCo (PEP) is now the fifth largest packaged food and beverage company in the world, and second only to Kraft Foods in the U.S. The company is a dominant player in many large, fast-growing, high-margin categories focused on the rapidly growing consumer demand for convenience foods.

The Purchase, N.Y.-based company has more than $25 billion in sales and includes 13 powerhouse brands that generate more than $1 billion in retail sales, including such household names as Pepsi, Mountain Dew and Diet Pepsi soft drinks, Lay's and Ruffles potato chips, Gatorade sports drinks, Tropicana Pure Premium juices, Doritos and Cheetos snacks, Quaker cereals and snacks, and Lipton Teas. Standard & Poor's ranks the shares as 5 STARS (buy), its highest investment ranking.

PepsiCo derives its diverse earnings streams across several segments of the food and beverage industry that are less sensitive to shifts in economic fortunes, with operating income contributions as follows: domestic snack foods (44%), international snack foods (12%), domestic soft drinks and water (19%), sport and juice drinks (12%), international beverages (4%) and cereals and non-snack foods (9%). As a reliable generator of substantial free cash flow in good times or bad, the shares have particular appeal during economic slumps. S&P sees additional positive attributes supporting the stock over the next six to 12 months as well.

GATORADE BOOST. The company continues to experience strong profit growth for its core beverage and salty snack franchises despite the slowing economy, reflecting volume and pricing growth, operating leverage benefits and efficiency gains. The company's North American beverage business has successfully undertaken major marketing initiatives which has resulted in larger market shares across its beverage businesses. The company's Frito-Lay business continues to be a major growth driver, with new products and aggressive international expansion leading to strong operating profit and cash flow growth.

The addition of Quaker's Gatorade sports drink franchise, with some $2 billion in global sales and an 80% share of the domestic sports drink market, gives PepsiCo a strong growth platform in the fast-growing non-carbonated beverage market. This merger yields significant production and distribution scale to the company, and added to the company's already substantial portfolio of flavored non-carbonated beverage brands, we at S&P feel Gatorade gives PepsiCo a competitive advantage over the Coca-Cola system.

While much of the focus of this merger was on Gatorade, Quaker also has a fast-growing snack food business which includes granola bars, fruit and oatmeal bars, and rice cakes. We expect these products to complement the company's Frito-Lay offerings and provide further growth once added to PepsiCo's extensive distribution channels. We believe that putting the Quaker snack brands through the Frito-Lay distribution system could generate incremental annual revenues of $200 million within five years. We believe Quaker's hot cereals, ready-to-eat cereals and non-snack foods, while good cash generators in the near-term, will likely be sold in two years after the non-divestiture period related to pooling of interests transactions has passed.

STAYING STRONG. For the "new" PepsiCo, we expect annual revenue growth of 7% to 8% over the next 3 to 5 years, operating profit growth of 11% to 12%, and annual earnings per share gains of 13% to 14%. Operating cash flow remains strong, and is expected to increase by some $1.5 billion to $4 billion by 2005. Cost synergies and higher pricing should allow operating profit margins to widen by approximately 300 basis points to 20% over the next four years. Return on invested capital is expected to be 25% by the end of 2001, rising to 30% by the end of 2005.

The company suspended its share repurchase program in December 2000 in order to qualify for pooling-of-interests accounting treatment for its merger with Quaker Oats. However, the company was permitted to repurchase shares last week under the terms of the emergency relief order issued by the SEC following the World Trade Center disaster. PepsiCo aggressively repurchased its shares last week, and planned to spend up to $2 billion on its common stock.

PepsiCo is currently trading at about 25 times our 2002 EPS estimate of $1.90, a slight premium to the price-to-earnings multiple for the S&P 500 Index, but a discount to the p-e's for its global beverage and consumer product peers despite our expectation for superior annual EPS growth of 13% to 14% for the next three to five years. The company is also currently trading at approximately 13 times our 2002 EBITDA estimate of $6.2 billion, compared to 12 times for its global food peers and more than 16 times for its global beverage peers.

Using comparable ratio analysis and assigning an appropriate multiple to the expected free cash flows by division, our sum-of-the-parts analysis suggest a price of $56 to $58 per share. Additionally, our discounted cash flow analysis puts a value on the shares in the low-$60's range, suggesting appreciation potential in excess of 30% from current levels. Given PepsiCo's consistent and predictable results, exceptional growth prospects, strong management and brand franchises, accelerating free cash flow and defensive appeal, we are recommending purchase with a 12-month price target of $56. Joy is an equity analyst for Standard & Poor's


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