Monday, August 10, 2015

Pepsico's CEO: On the "Hot Seat"

Despite excellent results and strong cash flows, Pepsico's CEO Indra Nooyi faces a big agenda.
If you follow the stock of Pepsico, you notice the price bouncing around like a rubber ball in a box--up and down and around and sideways.

Investors sometimes don't know what to make of it, beyond the fact that it pays a  comfortable dividend, and the company board is committed to keep paying it indefinitely. (A most recent share price hovered just below $99/share, but prices over the past year have roamed about $95/share like a sine curve.)

The company performs well, produces lofty returns for shareholders, and generates predictable, stable operating cash flow above $12 billion/year. And to its credit, it competes fiercely and often successfully against its competitors (Coca-Cola, most notably, and Dr. Pepper).  Yet CEO Indra Nooyi, who launched herself into a  prominent business career after receiving her MBA training from Yale, a Consortium school, is still and seems always to be on the "hot seat."

The company gives gifts to shareholders every year in the way of high ROE's (over 25% consistently) and cash set aside to pay attractive and reliable dividends (over $3.5 billion each year). Yet shareholder activists and other critics haunt Nooyi and Pepsico's management team with a barrage of questions:  How will management grow the company? How will it boost flat revenues? From where will growth come? How will it be achieved? And how must it confront the biggest risk of all--the health concerns tied to its major products (high-sugar cola beverages and salty snacks)? Will these concerns and risks eventually knock the company flat and result in depressed earnings and declining sales?

Pepsico's returns are outstanding (the gifts it gives to shareholders every year). And the company, for a long time, has responded to consumers' growing concerns about health by diversifying its operations, introducing new products, and addressing health questions with a sense of urgency. Some activists and market watchers say it hasn't done so fast enough. The company generates total sales of $66 billion year after year in robotic fashion.  They want revenue growth, want it immediately, and pound on the CEO's door looking for quick solutions regarding growth and health risks.

Despite the whining from outsiders and demands for answers, Pepsico does what it can to keep shareholders happy.  The company has paid an average of $3.3 billion in dividends the last four years (almost $13 billion in total) and repurchased almost $10 billion in stock--financial maneuvering that causes ROE to surge and leads to short-term bursts in the stock price. That totals about $23 billion in cash. That's cash that could have been used to reinvest in new businesses and new products, but cash that Pepsico is compelled to distribute out, not retain.

The company has also increased debt (by about $5 billion net the past four years) to add to the cash pool to pay out shareholders.  As a result, despite strong performance and billions in cash flow, debt-to-equity ratios have increased.  Book equity has declined.

Why would activists and others still want more? The inherent DNA of activists, however, is to push for more, ask for more, and demand more to ensure a long-term, secular increase in the market value? How does the company get the stock price to $110/share and get it to stay there indefinitely?

If the company has a clear path and defined plan to boost annual revenues toward, say, $80 billion, then perhaps shareholder voices would dissipate.  Some market analysts are aware, too, that the annual high ROE's have been achieved in part from modest financial engineering (more debt, less equity) and not from organic growth.

So what should Nooyi do?

1) Draft a credible strategy and game plan regarding health risks.

The long-term, harmful effects of certain beverages are a looming concern and risk at Pepsico and Coca-Cola.  How does Pepsico management perform the near impossible: Boost revenues and stock prices, while finding a long-term solution to the risks of the product. And do so without jeopardizing earnings, risking a sudden sinking in revenues, and altering the tastes and enjoyment consumers have for the product. And don't risk a downgrade in credit ratings, the same high ratings that permit the company to borrow whenever it wants and needs to. (Ratings agencies rate Pepsico single-A.)

Nooyi and team know the challenges they confront and have tweaked business lines and introduced new products. Yet the same cola products that are embedded with the greatest risks are the same products that help generate $12 billion in annual cash flow in predictable fashion. Year after year.

(Coca-Cola, in August, announced a strategy that will encourage consumers to devote more time to exercise to off-set health risks from drinking its products.)

2) Ensure shareholders are happy with their dividends.

Shareholders, as mentioned, clamor for more, despite the 25%-plus ROE's, the stock buybacks and the dividends.

Pepsico, therefore, must retreat into laboratories and invest cash in new products and new ideas, yet still appease its owners by siphoning some cash flow to pay $3 billion-plus in dividends and do occasional buybacks.  In order to do all of that and more, it must be prepared to use incrementally more debt.  The marginal increases in its debt burden contribute to cash stockpiles to do all things at once (reinvest, make acquisitions and pay shareholders).  Leverage and the recent reductions in equity explain why book ROE's at least look superb, too.

The billions in cash flow also rationalize why it can handle greater levels of debt. If it didn't pay dividends or repurchase stock, cash from operations could pay down all debt in less than three years. Or differently interpreted, cash from operations could still handle a debt load of over $40 billion without too much ado.

In recent years, borrowing was a cheap option, an easy decision. Who wouldn't be enticed to borrow at record-low interest rates to pay down more costly equity capital?  In the few years ahead, borrowing will be conducted cautiously with all the expectations that rates will rise.

3) Keep costs under control and tweak the bottling-company model. 

Management at any level worries about costs.  Pepsico has managed costs consistently and sufficiently. It does so, too, to squeeze out expenses and achieve income growth in a company where revenues have hardly budged the past half-decade.

Beverage companies like Pepsico and Coca-Cola often improve cost efficiencies by tampering with the bottling-company business model.  As many have said before, they have a "love-hate" relationship with their independent bottlers, franchisees who distribute the final packaged product that most of us drink. If Pepsico presumes it can distribute the product better and reduce related costs, then they will likely repurchase some bottling companies that exist under their auspices.  If Pepsico presumes bottlers can do it better or will have more success in designated markets, then they permit bottlers to operate independently.

The back-and-forth ties to bottlers help Pepsico maintain strong, consistent profit margins. The business model hasn't been replaced and likely won't. It just evolves or fluctuates from time to time.

4) Diversify the business in novel ways.

Expand and diversify is always an important business strategy for a global company. The seniors at Pepsico know that and are obsessed with trying to do it the right way.  Do Nooyi and staff diversify within beverage products? Do they diversify among consumer snacks? Do they diversify among market geographies?  Pepsico, in many ways, has done all of that.

Do they diversify by leaping aggressively into other ventures? What will that entail? Tough calls, big risks, a likely mega-acquisition, and the long timeline it would take to decide, acquire, finance, invest, and execute. Should Pepsico expand into businesses for which it has minimal expertise and experience and which could result in consumers becoming confused about the brand?  (Decades ago, its rival Coca-Cola dared to experiment with diversification by acquiring a movie studio, Columbia Pictures.)

Or should it remain committed to the success it has had for generations and retreat to labs to invent a health-risk solution for its beloved products, while accumulating mounds of cash, parts of it to be shared with anxious shareholders.

It may be able to do just that, as long as shareholder factions give Nooyi time.

Tracy Williams

See also:

CFN:  Will Yahoo Ever Rebound? 2015
CFN:  Is Shake Shack Worth a Half-Billion? 2015
CFN:  Radio Shack's Doomsday:  No Surprise, 2014
CFN:  Who's Betting on Blackberry? 2013
CFN:  Alibaba's IPO, 2014
CFN:  Verizon Rescues AOL, 2015
CFN:  Twitter's IPO, 2013
CFN:  Will HP's Split Help Stock Values? 2014
CFN:  Why Did Dell Go Private? 2013

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