At Pepsi, a Touch of Indigestion

Its integration of Quaker Oats is not going as smoothly as some investors would like

Last January, only weeks after PepsiCo Inc. (PEP ) inked a deal to pay $14 billion for Quaker Oats Co., President and Chief Financial Officer Indra Nooyi was eager to begin mapping out the integration of the two companies--one of the biggest food deals ever. And for Nooyi and her boss, Pepsi CEO Steven S. Reinemund, success was personally important as well. Their promotion to the top of the Pepsi ladder had been announced in tandem with the deal. Making it work would be crucial to their reputations in the wake of departing Chief Executive Roger A. Enrico, who planned the acquisition as a major revenue boost for Pepsi. So when a corporate jet carrying the head of North American integration to a Saturday morning kickoff meeting at company headquarters was unable to land because of a severe ice storm, Nooyi wouldn't let them turn back. Instead, she got on the phone with the manager, she remembers, and said: "I'm not cancelling. Forget it."

The plane landed safely, and 45 minutes later, the meeting went on as planned. But it wouldn't be the last storm the top Pepsi execs would have to weather. The integration of Pepsi's latest acquisition has been bumpier than anticipated. A key Quaker Oats executive has left the company, competitive pressures have increased, and marketing snafus have hurt sales. Only five months after the deal closed last August, some investors are wondering if Pepsi can push Quaker's megabrand Gatorade, and the rest of its stable of products, to substantially higher levels of growth. That hope, after all, is what prompted Pepsi to scoop up Quaker after a bid from rival Coca-Cola Co. fell apart--the biggest acquisition yet in Pepsi's drive to diversify its beverage group (table). "It wasn't a purchase of the [Quaker] sales," says Reinemund. "It was a purchase of the opportunity to grow the sales." If he doesn't get that top-line growth, Reinemund will have paid an awful lot for a few years' worth of cost savings.

Pepsi executives say that an artfully managed integration of Quaker Oats can boost the corporation's annual revenue growth by at least one percentage point over its historical 6% growth rate. But to achieve that, Pepsi has decided to merge Quaker's sales-and-distribution channels into its ongoing businesses. It had not done that with prior acquisitions because all of its products had different distribution needs: Syrup was sold in bulk to bottlers. Frito-Lay snacks were shipped by truck to retailers both large and small. And Tropicana beverages, acquired in 1998, used two methods--direct to the warehouses of chains and big users, and, through distributors, to the small fry.

That last model was close enough to Gatorade to warrant combining it with Tropicana. Some Quaker food products will now also go on Frito-Lay trucks. With Pepsi sales staff hawking Quaker Oats goods and vice versa, Pepsi hopes to achieve cost savings while making its brands an easier buy for retailers. "When you're dealing with the people who run Kroger and Wal-Mart Stores, they're going to muscle you for every dollar," says Tom Pirko, president of Bevmark, a Santa Barbara (Calif.) food-and-beverage consultant. "They want [suppliers] to come to them with everything."

So far, the merger is meeting all cost-savings expectations, says integration chief Jim Dwyer. In fact, last August, it raised cost-cutting goals to $400 million annually, from $230 million, as procurement and other efficiencies rose. Yet when Reinemund announced the company's first combined results on Feb. 6, it was clear all the benefits of the merger hadn't yet shown up. Early moves to wring new sales from the merger, such as the loading of Gatorade sports bars onto Frito-Lay delivery trucks, are just starting. Meanwhile, growth slowed last year at Gatorade, Quaker's crown jewel, with $3.1 billion in annual sales and a 74% supermarket share. That largely was result of heavy competition from Coke's Powerade. According to Information Resources Inc., a Chicago-based sales-data collector, Gatorade supermarket sales were up only 7% in the last quarter of 2001--well off the 15% pace of all sports drinks. Pepsi says, however, that the brand recovered and grew 25%, year to year, in January.

Nevertheless, investors were also unnerved to learn that Gatorade's leader, Susan D. Wellington, 42, president of U.S. beverages at Quaker North America, was taking a leave. Wellington had been instrumental in Gatorade's success. A former All American swimmer at Yale University, she had focused with laserlike intensity on what athletes wanted in a sports drink. Although she got on a speakerphone during Reinemund's announcement to reassure investors that the company was in great shape and that her leave of absence was for personal reasons, it still raised a red flag to money managers. Mani V. Govil, manager of Mercantile Safe-Deposit & Trust Co.'s Growth & Income Fund pared about a third of his Pepsi holdings in January, to about 200,000 shares. "Every integration, irrespective of what people say, tends to have hiccups," he says.

There was also disturbing news from the Gatorade/Tropicana division, headed by former Quaker CEO Robert M. Morrison. The effects of a price increase on the juice and a botched sales promotion last fall--the result, Morrison said, of the merger of the Gatorade and Tropicana sales forces--contributed to a 2% drop in division sales. And Bill Schmidt, a buyer for Martin's IGA Plus, an Effingham (Ill.) grocery store, says he hasn't heard from his Gatorade rep since last summer. "I kind of think they're in limbo," he says.

Still, many on Wall Street are betting that Nooyi and Reinemund will get it right. The stock fell 4% in the two days after the quarterly results were released, but has since climbed back, to about $49.50. And many investors believe the fourth-quarter issues are a blip in an otherwise successful run. With its high-impact Britney Spears ad campaign and new hit beverages such as Mountain Dew Code Red, Pepsi has regularly bested arch rival Coke. And its Frito-Lay division continues to pump out cash--56% of the parent company's operating income, or $2.7 billion in 2001. In the two years that ended Dec. 31, Pepsi's sales grew 32%, to $27 billion, and net income rose 30%, to $2.7 billion. During the same time, Pepsi stock jumped 38%, while the Standard & Poor's 500-stock index fell 22%, and Coca-Cola dropped 19%. Says Lehman Brothers Inc. analyst Michael J. Branca: "The key to Pepsi's success is driving growth at Frito-Lay, which ultimately drives Pepsi's value to investors."

It's vital that Quaker's slowdown doesn't become a distraction. Pepsi has a lot on its plate this year: Frito-Lay plans to add $1 billion in revenues from new products--such as mini-Doritos, packaged to make them easier to eat in cars. Reinemund feels confident that given time, Pepsi's problems can be worked out. "I don't know how long that is, but it's not a month or two," he says. Given the company's successes, investors will likely cut him some slack--but he can't keep them in a holding pattern forever.

By Nanette Byrnes in Purchase, N.Y., with Julie Forster in Chicago

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