Nelson Peltz has become quite famous for unlocking potential shareholder value from large consumer goods companies. At the beginning of this year, he invested significantly in both Mondelez International Inc (NASDAQ:MDLZ) and PepsiCo, Inc. (NYSE:PEP). The global investment community rumored that he would try to merge or spinoff different businesses of the two companies. Recently, Nelson Peltz’s fund, Trian Fund Management, released to the public his detailed proposal for the two companies.
Trian said that PepsiCo, Inc. (NYSE:PEP) has underperformed its peers, including The Coca-Cola Company (NYSE:KO), since the current leadership team took over. Since 2006, PepsiCo has delivered the total return of only 56% while the total return of Coca-Cola was much higher, at 123%. During the same period, its EPS growth was also much lower at only 36%, whereas Coca-Cola experienced 70% in EPS growth. Trian also pointed out that PepsiCo’s expected EPS growth for the full year 2013 has come in at only 7.3%, much lower than its long-term guidance of high single-digit number and lower than peer average of around 9.3%.
The two different businesses
Currently, PepsiCo, Inc. (NYSE:PEP) derives most of its operating profits, $6.3 billion, from the snack business while its traditional beverage business, which ranked second globally, generated only $3.9 billion in operating income. Nelson Peltz argued that PepsiCo has a lot of challenges in managing two “fundamentally different businesses.”
The snack business is very profitable, with 18% EBIT margin, much higher than the operating margin of Mondelez International Inc (NASDAQ:MDLZ), at only 10.4%. In contrast, the beverage business generated only 12% EBIT margin, much lower than The Coca-Cola Company (NYSE:KO)’s operating margin at 22.3% and the margin of the snack business. Nelson Peltz considered that the beverage business, after acquiring bottling operations, has demanded lot of capital expenditure.
The snack business and the beverage business have different cultures and priorities. While the snack business requires less innovation, the beverage business should be consumer-led innovation with the fast-moving culture. The main driver of shareholder returns for the snack business is its consistent organic growth, while the shareholder returns of the beverage business is cash returns and cost management.
Consequently, PepsiCo, Inc. (NYSE:PEP) has underinvested in beverage business in order to support the snack business. Afterwards, the snack business was “over-earned” to reinvest back into the beverage business. Those lead to low EPS growth compared to its peers.
Following Trian, PepsiCo, Inc. (NYSE:PEP) has generated very low return on invested capital. Since 2009, the company has spent around $33 billion in capital expenditure, restructuring and acquisitions, equivalent to 103.7% of the cumulative operating cash flow. However, its EPS growth has stayed at only 5% during the same period. The return on capital was extremely low at only 5%.
Unlocking PepsiCo’s potential shareholders’ value
In order to unlock the potential shareholder values, Trian suggested two strategic alternatives for PepsiCo, Inc. (NYSE:PEP).
The first is to merge with Mondelez International Inc (NASDAQ:MDLZ) and separate the beverage business. The merger with Mondelez would create a global snack leader with the potential of $6 billion synergies of cost and revenue. Mondelez is the global food business focusing on developing markets. In the first quarter, Mondelez experienced double digit growth in three of the most important markets including India, China and Brazil. For the full year, Mondelez expected to deliver 5%-7% organic growth, with the operating EPS staying in the range of $1.55 to $1.60 per share.
The second alternative is to separate the snack and the beverage business into two different companies to create two play companies, preserve the global brands and maximize the strategic moves in the long run. Nelson Peltz prefers the spinoff of the beverage business.
At $86.80 per share, PepsiCo, Inc. (NYSE:PEP) is worth $134.23 billion on the market. It is valued at 12.73 times its trailing EBITDA (earnings before interest, taxes, depreciation and amortization).
Mondelez International Inc (NASDAQ:MDLZ) is trading at $30.60 per share, with the total market cap of $54.60 billion. The market values Mondelez at as much as 13.64 times its trailing EBITDA.
Nelson Peltz suggested that PepsiCo, Inc. (NYSE:PEP) should merge with Mondelez International Inc (NASDAQ:MDLZ) at around $35 per share in an all-stock deal. The $35 per share represented a 14.4 times its trailing EBITDA, a discount to historical food EBITDA multiple average of 16. With a $3.7 billion cost synergies and Mondelez margin increase, the deal would be valued at around 8.6 times its 2013 EBITDA.