Our team took a read of Barron’s cover story over the weekend on Pepsi (PEP) that goes into activist investor Nelson Peltz’s thesis for breaking up the firm into two pieces: a soda group and a snacks group. Nelson Peltz’s Trian Partners holds ~$1.2 billion of Pepsi’s shares, so he has a relatively large voice on the future direction of the company.
Barron’s seemed to take the opinion that a break-up makes sense, but after reading the article, we were left with little economic reason to believe that a split should be pursued. For background, the thesis on breaking up Pepsi goes something like this:
“a split would allow both beverages and snacks to operate more entrepreneurially. ‘The goal is to keep corporate overhead down and enable the businesses to live up to their potential, by empowering operating management and eliminating corporate bureaucracy…’ Trian thinks Frito-Lay can shine brighter by putting more advertising and marketing dollars behind the brand…Peltz’s firm asserts that Pepsi has been siphoning off advertising dollars to bolster the beverage business…Pepsi currently trades for 18 times 2015 estimated earnings of $4.96 a share. Trian’s model envisions that a stand-alone snacks business would achieve a 23 ratio, while beverages would fetch 18.5. That gets the shares to $105. To achieve the $144 that Trian has estimated in a spinoff, it models a 3.75% dividend yield—the stock yields 2.9%—as well as accelerated cuts in corporate overhead and increased investment in the brands. Trian would reduce costs, in part, by consolidating Pepsi’s four headquarters—two in New York and one each in Chicago and Plano, Texas—into two…Bernstein agrees that there are $2 billion to $3 billion more of costs that can be cut beyond the $5 billion that have been mandated…Pepsi maintains that synergies as a single company save it $800 million to $1 billion a year. Trian counters that the opportunities to cut corporate costs greatly exceed synergies…Trian (says) it sees ‘great potential to expand margins in a stand-alone beverage business.’ Trian would buy more shares in the beverage company and be willing to join its board. A slimmed-down beverage business that doesn’t have to support corporate overhead could be far more formidable competitor to Coke.” Source: Barron’s
There are a few basic items that advocates of Pepsi’s split are missing:
Cost cuts (to any degree) can still be pursued within the combined organization. Assuming that all high-return projects are being pursued by the combined entity, as they should be, breaking apart Pepsi will not create incremental economic value as cost cuts (to any degree) can still be pursued within the combined organization. Typically, companies combine operations to reduce costs; companies are not separated to cut costs. Comparing cost cuts to synergies to justify a split is illogical and confusing to investors. A split is not required to cut costs, and certainly a split does not result in more costs to cut. Corporate overhead is unavoidable.
The combined entity would lose synergistic benefits. Synergies associated with the combination not only include back-office corporate overhead and distribution efficiencies, but also consumer association between drinks and snacks, which drives a strong working relationship with Pepsi’s business customers (e.g. 7-Eleven). Under a split, the combined entity would lose synergistic benefits. At the very least, separating the companies would add more costs: two separate entities would need two distribution chains and two back-office corporate overhead teams.
The assignation of arbitrary multiples to the businesses doesn’t make sense. Businesses are valued (and multiples are assigned) on the basis of future free cash flow. Please read more about this topic here. In our view, the market is already giving Pepsi credit for additional cost cuts, and a break-up may add more expenses and complexity to operations.
In Trian’s logic, both of the separated entities would receive higher multiples than the combined firm, an outcome that makes little sense under the view that the combination (not two standalone companies) has the best opportunity to cut the most costs. We also find little support for the connection between a 3.75% dividend yield and a $144 target price. Please read about how dividends impact valuation here.
Businesses are priced on the cash flows they generate, not the cash flows they pay to investors. Trian’s analysis is fundamentally flawed, which is why we believe management hasn’t acted on it (but instead has only politely acknowledged it).
Long-term benefits with respect to the snacks business would be hindered. The soda business offers the company’s snacks business an avenue into developing parts of the world. Without a combination, the snacks business may lose out on its ability to reach the customer in more developing markets. A break up could set the snacks business back years.
We don’t think this is factored into Trian’s financial analysis. A lower long-term growth rate of the snacks business should be assumed under a split, and such a revision may cause the firm’s entire thesis to collapse upon itself.
Wrapping Things Up
We think Pepsi’s shares are worth $79 on a combined basis, and we think they’d be worth less on a separated basis. The market is already recognizing the future free cash flow streams of both the soda and snacks business (and then some). Shares are trading above $90 each at the time of this writing.
This view runs counter to situations where the market is not recognizing the fair value of the entity, as in the case of eBay (EBAY) and PayPal. eBay, for example, continues to trade at a large discount to its intrinsic value, and a split may unlock such value as the market re-prices the entities separately. Splitting apart companies only makes sense when the market is applying a punitive ‘conglomerate’ discount or not accurately reflecting the combined entity’s true intrinsic value, which is not the case with Pepsi.
Another important takeaway is that synergies are augmented when companies are merged together, not when they are broken apart. Trian’s analysis also rests on the assumption that the market will price the firm on the basis of its dividend yield and not on its future free cash flow stream and the risks related to it. This is a risky bet for management to take.
An analysis of Pepsi’s more leveraged position relative to Coca-Cola (KO) cannot be ignored, nor should the heightened competitive environment—as Coca-Cola picks up equity stakes in Green Mountain (GMCR) and Monster Beverage (MNST)—be ignored. Splitting Pepsi would weaken the firm’s ability to wage economic war against Coca-Cola, which is spreading its dominance by scooping up shares of companies leading the most innovative verticals.
Breaking Pepsi apart is a bad idea, and Pepsi’s management knows it. That said, could the market bid up shares all the same, and management be forced into a bad decision? Certainly. But Nelson Peltz still has this one wrong.