By Sam Jaffe The past year has been something of an annus mirabilis for Pepsico (PEP) shareholders. The company gained slightly in market share vs. rival Coca-Cola (KO), which is enduring a painful reorganization in response to slower growth. Pepsi also had a stunning return on equity of 32% for 2000, and it completed a $12 billion acquisition of Quaker Oats on Aug. 10. Yet those accomplishments haven't translated into stock-price gains. Its shares have picked up only 3% in the past 12 months, to close of $45.05 a share on Aug. 13.
Still, Pepsi has squeezed about all the growth it can from the sale of fizzy drinks. Although it has room to expand some of its marginal soda brands, such as Mountain Dew and Sierra Mist, it will soon reach the global saturation point in terms of cola sales. At the same time, sales could begin dropping as medical studies that link soda consumption to childhood obesity start to make their mark on the public's appetites. The only way to continue long-term growth is to wrest a larger share of a shrinking market from Coke -- and the only way to do that is to engage in a price war, which would probably make a casualty of profit margins.
Pepsi's answer to cola-market saturation is its purchase of Quaker Oats. Although the venerable food company has a whole portfolio of products, its crown jewel is Gatorade. The fluorescent sports drink, which started out in 1965 as a nutritional supplement for University of Florida athletes, has become an American icon, with sales of $4 billion in 2000 and average annual growth of 13% over the past four years.
IT'S ABOUT GROWTH. That's the type of growth Pepsi wants to harness, and that's why it was willing to top Coke in a bidding war for Quaker in 2000. "This merger isn't about rationalization, it's about growth," says Pepsico CEO Steven Reinemund. Pepsi didn't buy Quaker Oats solely for market share, but for the growth potential of the Gatorade brand.
Nevertheless, Pepsi has a gnawing problem with its growth-through-Gatorade strategy. The beauty of the cola business is selling the most profitable portion, the syrup, of an easy-to-duplicate product. You leave the messy business of adding water and carbonation and then shipping the product to other, lower-margin companies. That's how Pepsi can produce operating profit margins of 24% for what's essentially a commodity product.
Gatorade is different. It doesn't sell concentrate to subcontractors. It's set up as a complete beverage company that mixes the drink, fills the bottles, and then distributes them. As a result, the average operating profit margin on Gatorade is little more than half that for Pepsi, about 13%. The purchase of Quaker Oats will essentially lessen the earnings power of Pepsico overall, even though it should add a needed boost to future revenue growth.
UNBUNDLING, PEPSI-STYLE. Some of the more obvious synergies between Quaker Oats and Pepsi won't happen for a while. To overcome the Federal Trade Commission's fears of monopolization of the sports-drink market, Pepsico agreed not to bundle Pepsi and Gatorade in contracts with merchants for 10 years. It also agreed not to allow its bottlers to distribute Gatorade, which would have been an easy and cost-effective way to ship Gatorade to smaller stores.
"We estimated that vending and 'mom-and-pop' opportunities might have enabled as many as 40 million additional cases over the next two years," writes Deutsche Banc Alex. Brown analyst Marc Greenberg in a recent report. Greenberg has a buy rating on the stock. Forty million cases would be enough to increase revenue by as much as one percentage point. Greenberg thinks that such a significant concession to the regulators could prove to be a major obstacle to integrating the two companies.
U.S. sales are only part of the plan. Although Gatorade has been a success story in America, Quaker could never replicate its sales growth in Europe and Asia. "We simply did not have the tools or the size to build the brand to its potential in other countries," says former Quaker CEO Bob Morrison, who is now a vice-chairman of Pepsico. Pepsi certainly has those tools.
GLOBAL EDGE. After a global reorganization in 1999, which included shutting down certain overseas operations and concentrating on areas that were more profitable, Pepsi International has enjoyed double-digit sales growth. On a volume basis, Pepsi produced almost as much concentrate for international markets as for the U.S. Its distribution and logistics operations in Europe and Latin America, as well as its seasoned local sales forces, should go far in building up Gatorade sales overseas.
Also, the 10-year waiting period before U.S. Pepsi bottlers can start shipping and selling Gatorade doesn't apply overseas, which means a significant and established distribution arm is already in place.
The Pepsico story is more than just Pepsi and Gatorade. In fact, 71% of premerger Pepsico's revenues come from its giant Frito-Lay snack-food division. Quaker's increasingly popular chewy bars and hot-cereal products will be added to that mix. And Frito-Lay's elaborate distribution system will eventually be invaluable for shipping Gatorade cheaply to grocery and convenience stores.
JUICE JOLT. The other reason to be optimistic about Pepsico's ability to add value to the Gatorade brand is its experience with Tropicana. It bought the orange-juice giant in 1998 only to watch as sales estimates for the entire juice market declined. But under Pepsi's ownership, Tropicana, which sold $2.3 billion worth of goods in 2000, created new products -- like orange juice fortified with calcium -- and rebuilt the subsidiary's distribution network.
As a result, operating income for the Tropicana unit soared to $220 million -- more than double what it had been just two years before. If Pepsico can recreate its Tropicana success story with Gatorade, chances are that investors in years ahead will see the $12 billion acquisition as a bargain. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column
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