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Why PepsiCo will get its fizz back

Snacks business holds spinoff potential. And the cola business could offer a sweet chaser

From Tuesday's Globe and Mail

18:56 EDT Monday, June 25, 2012

PepsiCo Inc. has lost its fizz, many believe.

After all, a couple of years ago the company's signature offering ceded the No. 2 spot among soft drinks in the United States to Diet Coke, giving arch-rival Coca-Cola Co. the top two best-selling carbonated beverages.

But investors' focus on the cola wars may have distracted them from the continuing success of PepsiCo's snacks business, which counts the Lay's and Doritos chips brands among its mega-sellers. PepsiCo's North American snacks segment contributes about one-fifth of the company's sales. With all-time high margins, it generates more than one-third of the company's operating profit.

Analysts say that PepsiCo's snacking success, combined with current Wall Street pessimism, suggests two positive outcomes for investors: If PepsiCo executes a turnaround in its cola business, shares would rise. Or, if PepsiCo's drinks continue to lag, pressure could build on the company to spin out the snacks business, unlocking shareholder value.

Many companies would be thrilled to have PepsiCo's problems. It has managed to double its revenue and earnings per share over the past decade – an impressive feat for a such a giant firm. It continues to churn out a healthy dividend yield of 3.1 per cent.

Fortune magazine senior editor Geoff Colvin argued in a recent article that Wall Street's poor perception of Pepsi has much to do with some unfortunate timing. CEO Indra Nooyi took the helm in 2006 at a time when PepsiCo shares were richly valued, and Coca-Cola was emerging from the wilderness. Over the next five years, Coke shares surged, making PepsiCo look like a laggard. In fact, PepsiCo kept pace with the Standard & Poor's 500 during that period.

That now means, however, that Coca-Cola boasts richer multiples than PepsiCo, with Coke's trailing price-to-earnings multiple a hair under 20, versus 17 for Pepsi, according to Standard & Poor's CapitalIQ.

Perhaps in recognition of the disparity, Ms. Nooyi and her team announced a plan in February to cut headcount, boost marketing spending and jump-start product innovation.

"Currently, the market appears fixated on problems in the company's beverage business, and is ignoring its dominant position in snacks," says Morningstar analyst Thomas Mullarkey, who puts PepsiCo's "fair value" at $72, a few dollars above its recent high-$60s levels.

Mr. Mullarkey also notes that PepsiCo's "good for you" business – Tropicana orange juice, Quaker oats and Gatorade – has grown from $2.2-billion to $13-billion over the past decade.

While he believes Coca-Cola should trade at a higher multiple based on its dominant sales in restaurants and its emerging-market positioning, "we believe that the valuation gap between these beverage and snack giants has grown too wide."

For now, potential PepsiCo investors have to take the beverages with the snacks, as the company has been steadfast in insisting its "Power of One" strategy – one company, selling beverages and snacks to its retailing customers – is the way to go.

However, analyst Caroline Levy of Credit Agricole Securities upgraded PepsiCo in May from underperform to outperform and raised her target price from $66 to $75 in the belief that some sort of spinoff or separation is "more likely than not ."

She adds: "Like many investors, we have been dissatisfied with 'power-of-one' initiatives and believe PepsiCo is more valuable in its parts."

Ms. Levy's target price is 16.7 times her 2013 earnings estimate of $4.50, and is also the midpoint of a sum-of-the-parts valuation range of $74 to $76.

Bernstein Research's Ali Dibadj – who rates PepsiCo an "outperform" with a $75 target price – is more skeptical, saying that his late May meetings with PepsiCo management suggested that split-ups and spinoffs are "off the table."

"Management remained resolute that they had studied the prospect comprehensively in the past and that it did not make sense due to various factors," he said.

"To be clear, we do not see a 'split' as something that needs to be immediately pursued, but should PepsiCo's current plans fall short of their objectives, we would be inclined to at least re-examine it (and we expect most investors and at least some inside PepsiCo today would agree)."

And that, it would seem, would put that fizz right back in the shares.

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