Many investors have urged PepsiCo, Inc. (NYSE:PEP) to split into two companies over the years. One of the most vocal has been Nelson Peltz, the billionaire head of Trian Fund Management, which in 2014 disclosed it owned $1.2 billion worth of PEP stock.
Peltz then released a letter urging Pepsi’s board of directors to split the company into two, using the proceeds from spinning out beverages towards buying Mondelez International Inc (NASDAQ:MDLZ).
Peltz didn’t get very far.
PepsiCo passionately defended the status quo, saying the company’s size helps give it clout with big retailers like Wal-Mart Stores Inc (NYSE:WMT). Having both soda and chips under one corporate roof makes it easier to gain display space. And management is convinced splitting the company in two would lead to negative synergies.
Some of those arguments are valid, but one simple fact remains: Pepsi stock holders would be made richer if the company split in two.
The Case for a PepsiCo Split
PepsiCo currently divides itself into six different operating divisions:
- Frito-Lay North America
- Quaker Foods North America
- North American Beverages
- Latin America
- Europe and Sub-Saharan Africa
- Pacific and Northern Africa
Pepsi operates a little differently in North America versus the rest of the world. In North America, Frito-Lay, Quaker Foods and Beverages are all essentially separate companies. They have different sales teams and different offices, and share little in resources. The three divisions work together in various promotions, but that’s about it.
Operations in the rest of the world are much different, with chips and soda delivered on the same trucks in many different places.
For the sake of this article, let’s assume the two North American food companies would form one new company, leaving everything else as the other company.
Now we have to look at valuation. In 2015 (the latest fiscal year in which full results are available), PepsiCo as a whole earned $8.35 billion in operating profits. Add back in unusual expenses — which mostly included a $1.4 billion write-off of Venezuelan assets — of $1.59 billion, and PEP posted $9.94 billion in normalized operating profits.
PepsiCo has a current market cap of $153 billion, putting PEP stock at a price-to-operating income ratio of about 15.
Once we dig a little deeper into the numbers, a theme starts to emerge: Food is a better business than soda.
The Value of Food
The North American Beverages division posted an operating income of $2.75 billion on revenue of $20.62 billion in 2015, good enough for an operating margin of 13.3%. In comparison, the combined Frito-Lay and Quaker North American divisions delivered operating profits of $4.89 billion on sales of $17.33 billion — an operating margin of 28.2%.
In short, the soda business is dragging down the real performer: PepsiCo’s food business.
There is no other major food company in the United States that has 28% operating margins. Most are in the neighborhood of 15%, just like PEP as a whole.
There is one that gets close, however. The Coca-Cola Co (NYSE:KO) posted 23% operating margins in 2015. It trades at 18 times operating earnings, but shares are flirting with a 52-week low.
If we value a combined Frito-Lay/Quaker company at 20 times operating earnings, it alone would be worth $97.8 billion. That valuation gives it a premium versus Coca-Cola, but not an excessive one. Then if we value the rest of Pepsi at 15 times operating income, it’s worth $75.8 billion.
Add the two divisions together, and Pepsi split into two is worth $173.6 billion — or 20% more than the value of PEP stock today.
Bottom Line on PEP Stock
One thing is certain. Frito-Lay chips, Quaker Oats and Aunt Jemina syrup are great businesses. Making food is much more profitable on a per-dollar basis than soda.
Every PEP stock holder knows the company owns Frito-Lay and Quaker. Many don’t know how good those businesses are. If PepsiCo’s management spun those two divisions out into a new company, it would highlight just how good the food business really is.
It also would attract investors who don’t want to invest in soda.
As of this writing, Nelson Smith did not hold a position in any of the aforementioned securities.