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February 21, 2014

CAGNY: PepsiCo answers Peltz by highlighting benefit of scale

The US remains PepsiCo's single biggest market, generating around 50% of group sales. However, the company is coming up against some "significant challenges" in the consumer and retail landscape, Brian Cornell, CEO of Pepsi Americas Foods acknowledged this week. PepsiCo plans to use its combined scale to combat these issues and drive growth in a slow-to-no growth environment. Katy Askew reports.

The US remains PepsiCo’s single biggest market, generating around 50% of group sales. However, the company is coming up against some “significant challenges” in the consumer and retail landscape, Brian Cornell, CEO of Pepsi Americas Foods acknowledged this week. PepsiCo plans to use its combined scale to combat these issues and drive growth in a slow-to-no growth environment. Katy Askew reports.

PepsiCo is the largest food and beverage group in North America and its domestic revenues account for more than half of the group’s total sales. However, the company’s financial performance in this important market reads like a tale of two companies.

In its most recent financial update, for the year to 28 December, PepsiCo revealed a 7% increase in revenue at its North American food business and a 6% increase in operating profit. This compares favourably with the performance of its beverages business in the region, where sales are coming under pressure. Organic revenue dropped 1% and operating profit rose 1%, the company revealed.

It is the division between the performances of its drinks and food businesses that has prompted activist investor Nelson Peltz to vociferously insist the company should be divided into two, a suggestion that has been repeatedly rebuffed by the group’s management.

Indeed, earlier this week Peltz’s investment vehicle Trian Fund Management sent a 31-page “white paper” to the PepsiCo board, once again outlining the logic behind a split. According to Trian, the drinks and food businesses are two distinctive business models that would operate more effectively on a stand alone basis.  

The snack business would offer investors strong sales, margin and free cash flow growth, while the drinks unit would provide stable free cash flow “that may be optimised through an effective balance sheet and capital return programme”, Trian argued.

The investment fund, which holds US$1.2bn of PepsiCo stock, said it plans to initiate a “public debate” on the issue. According to the activist investor, the decision of whether to divide the company should lie with PepsiCo’s investors, not management.

In this context, it is hardly surprising PepsiCo took the stage at the Consumer Analyst Group of New York in Florida yesterday (20 February) ready to defend its position that it functions best as a single unit.

According to Brian Cornell, the CEO of Pepsi Americas Foods, like other companies in the sector, PepsiCo is facing a number of issues in the US.

These include “consumer challenges” presented by changing demographic patterns as baby boomers retire and the country witnesses a jump in Hispanic and Asian populations. The group is also responding to “channel challenges” – such as the shift to value and premium retailers and the emergence of e-commerce options such as and Amazon’s fresh food offering.

PepsiCo’s answer to these emerging trends? “Our playbook balance is focus and scale. We believe that in the slow growth North American environment we are going to need to focus on scale and we are going to need to make sure we are focus on operating our businesses to win,” Cornell stressed.

Cornell argued  PepsiCo benefits from significant overlap of its snacks, breakfast and drinks businesses. “We know from our proprietary insights that currently 65% of the addressable US.snacks, breakfast and beverage market addresses common or complementary needs, where snacks, breakfast and beverage brands interact.”

These insights drive product innovation and promotion and allow PepsiCo to “pair” brands to meet divergent consumer needs, Cornell claimed.

To highlight this, he took the example of breakfast – a meal occasion where PepsiCo can pair its Quaker, Naked and Tropicana brands. Meanwhile for “young and hungry consumers” PepsoCo offers Doritos and Mountain Dew – two of the firm’s fastest growing brands which were recently paired through a promotion targeting gamers – Doretos Gamer Pack and Mountain Dew Game Fuel.

“The promise of better together is realised. When we innovate for these common or complementary needs, position our brands as a portfolio to meet different needs and drive home merchandising and co-promotional support.”

Being a combined food and drinks company also allows PepsiCo to forge stronger relationships with retail customers as well as integrate in-store execution, Cornell suggested.

“At the headquarters of our major customers, you’ll find joint business planning processes along with dedicated PepsiCo customer teams… We are routinely recognised by our largest customers for our broad food and beverage expertise and our ability to drive growth across their total box.”

The benefits of being an integrated food and beverage company apparently even stretch to productivity. “All of this is underpinned by our productivity agenda that uses common engines, tools, systems across both snacks and beverage,” Cornell insisted.

Earlier this month, PepsiCo extended its productivity initiative which now looks to reduce costs by US$1bn annually to the end of 2019.

PepsiCo has come out fighting in the face of investor pressure to divide its business. Alongside the announcement of its 2013 results and its new cost-savings plan, the company also said it had decided to keep its North American beverage business.

However, given the challenges facing PepsiCo’s beverage arm, it is likely there are those that will need more convincing.

North American carbonated soft drink volumes are in decline as health concerns prompt drinkers to switch to less calorific options.

At the same time, PepsiCo’s largest competitor Coca-Cola Co. is stepping up its investment in marketing and innovation. Coca-Cola is seeking out new avenues to grow soda sales, such as its tie-up with Green Mountain Coffee Roasters which comes in answer to the threat posed by SodaStream. It is also coming up with dynamic new ways to deliver products – including a new vending machine that allows consumers to mix there own syrups.

One might be left wondering where PepsiCo is in all this.

“We came away from PepsiCo’s presentation at CAGNY appreciative of its strength in snacks, but remain cautious given work remaining for beverages,” Wells Fargo analyst Bonnie Herzog says.

According to Herzog, innovation will be key to PepsiCo’s ability to deliver continued growth in snacks and combat sales declines in beverages. “Given consumer trends, particularly in beverages, we think innovation will become increasingly important for all consumer goods co’s to continue to drive top-line growth. We are generally encouraged by PepsiCo’s innovation platform, and believe if it is able to continue to launch new products in snacks (to sustain growth) and beverages (to turnaround), it will continue to drive sustainable top-line growth.”

It would seem that PepsiCo has much to prove. And with Peltz snapping at management’s heels the need to rejuvenate beverage sales seems ever more pressing.

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