Trian Partners 31 page white paper on PepsiCo, Inc. (NYSE:PEP) split
February 19, 2014
Mr. Ian M. Cook, Presiding Director
PepsiCo, Inc. (NYSE:PEP)
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Investment funds managed by Trian Fund Management, L.P. (collectively “Trian”) beneficially own approximately $1.2bn of PepsiCo, Inc. (NYSE:PEP) common stock. We appreciate your and Lloyd Trotter’s willingness to meet shortly after our first communication to PepsiCo’s Board advocating for structural change in early November 2013. We also appreciate our dialogue with CEO Indra Nooyi and members of her management team. Both management and the Board have been cordial in our dealings. However, it is clear we have vastly different views on the best path forward for PepsiCo. It appears that PepsiCo views structural change as a sign of weakness, an admission of failure and an untenable break with past traditions. Trian views structural change as the best path forward to generate sustainable increases in shareholder value.
As you know, we are extremely concerned about PepsiCo’s extended period of underperformance relative to its food and beverage peers. The deteriorating trends in North American Beverage, questionable quality of earnings in 2013 and disappointing 2014 guidance reinforce our view that now is the time for decisive action. We believe the best way to ensure improved performance at PepsiCo is to separate global snacks and beverages, putting the future of each business in the hands of empowered and focused management.
We were highly disappointed last week with the results of PepsiCo, Inc. (NYSE:PEP)’s strategic review, especially in light of another quarter of uninspiring performance and, most disturbingly, weak 2014 guidance. Management and the Board’s conclusion that the “current structure maximizes value” is at odds with many years of subpar operating results.i
We also find management’s rationale for maintaining the current structure highly subjective, full of platitudes and lacking strong supporting analytics, such as:ii
- First, management argues that pairing beverages and snacks provides critical scale that makes PepsiCo more relevant to its customers and provides synergies in areas such as procurement, customer insights, advertising, coordinated national account activity and international expansion. We ask: what is the benefit of scale and synergies if PepsiCo loses market share in critical segments and delivers lower margins, earnings per share (EPS) growth and total shareholder returns than peers over an extended period of time?
- Moreover, we believe that the $0.8-1.0bn of dis-synergies that management highlights can be more than 100% offset through the reduction of PepsiCo’s $1.1bn of unallocated corporate costs and a “blank sheet of paper” process to drive leaner cost structures at the operating divisions.iii We also note that shareholders pay a heavy price for the integrated strategy. If you multiply the company’s $1.1bn of unallocated corporate costs (which would be eliminated if the businesses were separated) by 11x (PepsiCo’s multiple of enterprise value / 2014 earnings before interest, taxes, depreciation and amortization), it costs shareholders $12bn of value, or $8 per share, to have beverages and snacks together in a holding company structure. If you also added the portion of corporate costs actually allocated to the segments (not publicly available but we estimate at least as much as the unallocated cost), the cost per share is likely much greater than $8. We would be willing to pay that per share cost in return for PepsiCo consistently delivering better growth and margins than competitors in each of its businesses. However, given PepsiCo has delivered inferior results over many years, we believe the holding company structure should be eliminated along with the related costs. These savings can provide standalone management with funds to reinvest in the brands and drive profits, creating a multiplier effect in building long-term shareholder value.
- Second, management argues that a separation would forfeit value creation from sweetener technology and productivity savings. It is important to understand that we never advocated a sale of the business. Rather, we recommended a spin-off so that shareholders can participate in future upside. Moreover, we believe the probability of productivity hitting the bottom line and sweetener technology having a material impact increases if there is a standalone management team with “no place to hide.”
- Third, management argues that U.S. cash flow from the beverage business is necessary to provide cash returns to shareholders. We question the accuracy of this statement on several grounds. Most notably, we believe two $30bn+ standalone snacks and beverage companies anchored by large North American businesses (Frito-Lay North America and Americas Beverages) would each generate sufficient cash flow to pay dividends and invest for growth.
- Fourth, management argues a separation would “jeopardize [PepsiCo’s] ability to grow in foodservice.” As the largest shareholder of The Wendy’s Co (NASDAQ:WEN), we have seen first-hand how PepsiCo has been outmaneuvered by The Coca-Cola Company (NYSE:KO) in the foodservice market. The most glaring example is the Coke Freestyle machine which allows customers to customize their beverages with 100-plus flavor options. Meanwhile, Pepsi’s version of a Freestyle machine has yet to materialize, even though Nelson was told by the CEO in mid-2012 that 1,000 technologically competitive units would be in the market by the end of 2012. This is another example of PepsiCo’s “connected autonomy” slowing down innovation and negatively impacting the ability to compete.
Finally, a reason cited by some as to why snacks and beverages should not be separated is that a standalone PepsiCo beverage business cannot compete effectively against Coca-Cola. We disagree and would note: a) PepsiCo has not competed effectively against Coca-Cola for many years, even with snacks in its arsenal; b) Dr Pepper Snapple Group Inc. (NYSE:DPS) Snapple has shined since it was spun-off from Cadbury in 2008 (in the middle of a financial crisis) and has outmaneuvered both Coke and Pepsi over the past five years. In fact, Dr Pepper Snapple grew EPS more than PepsiCo in 2013 and forecasts similar growth to PepsiCo in 2014 despite a weaker portfolio, no exposure to snacks and more exposure to N. American carbonated soft drinks; and c) PepsiCo has some of the best beverage brands in the world (e.g., Gatorade, Tropicana, Mountain Dew, Pepsi, Starbucks and Lipton, among others).
The beverage business generates strong, stable free cash flow today and we believe can generate far more cash flow under focused leadership. Freed of allocated corporate costs and bureaucracy, and able to be nimble and lean, we believe a standalone beverage business will not only compete, but thrive. Trian has so much conviction in the value of a standalone beverage business that we would buy additional shares and be willing to join the Board of the newly formed beverage company to help lead it going forward.
In the end, the wisdom or fallacy of an integrated portfolio is quantifiable. While management says “holistically, this portfolio provides a platform for balanced growth, margin and return improvement…all of which leads to top-tier total shareholder return,” it simply is not true.iv The results are unambiguous: during the CEO’s seven-plus year tenure, PepsiCo’s total shareholder return of 47% has grown at less than half the rate of the Consumer Staples Index (103%) and competitors like Coca-Cola (115%). PepsiCo’s EPS growth has also significantly trailed that of peers.v
Management will inevitably defend performance by questioning our timeframes. They argue that if you go back further, PepsiCo’s performance looks better. However, we did not choose our timeframe arbitrarily. We did so because 2006 marks the beginning of current management’s tenure. As importantly, it also coincides with the transformation of “Power of One” from a marketing slogan with limited operational impact to a pervasive strategy that increased the influence and control of corporate. We view this strategy – now described euphemistically as “connected autonomy” – as largely responsible for a diminished PepsiCo culture and deteriorating performance. We believe that separating snacks and beverages would create a clean structural break that would eliminate corporate bureaucracy, return power and autonomy to the operating divisions, increase accountability and re-energize division management.
Last week’s earnings announcement and 2014 guidance reinforce our view. Backing out the benefits of a lower-than-expected tax rate and a one-time Vietnam refranchising gain that has no place in “core” earnings, EPS grew only 5% in 2013.vi That follows a major EPS re-set in 2012 that was supposed to have re-ignited growth. The Company’s share price underperformed the
Consumer Staples Index by 500 basis points (bps) during the next two trading days.vii Meanwhile, guidance for 2014 was weak. Despite plans to buy back 4% of the shares during 2014, a lower share count to begin the year, what should be a lower initial cost base given last year’s $1bn of supposed cost savings, another $1bn of promised cost savings planned for 2014
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