Dueling Fools
Cola Wars
April 21, 1999

Pepsi Bull's Pen
by Warren Gump ([email protected])

Let me start off this battle by giving my competitor a gracious nod. Coke is a much stronger worldwide soft-drink brand than Pepsi, and probably always will be. That being said, it is important to realize that Pepsi and its other soft-drink brands are extremely valuable entities that should enjoy substantial profit growth in the years ahead. More important for investors, though, is that PepsiCo is much more than soft drinks. In fact, 63% of the company's profits last year came from Frito-Lay, the world's leading snack chip company.

Frito-Lay, in fact, has much more dominant brands in its key competitive categories than Coke does in the soda business. Frito-Lay brands include the best known chips in the world: Lay's, Doritos, Ruffles, Tostitos, Cheetos, Fritos, Rold Gold, and WOW!, among others. The company controls 73% of the U.S. tortilla business, 54% of the potato chip market, and 86% of the corn chip market. Aggregating these market shares, Frito-Lay has a 60% share of the $13 billion U.S. snack chip market.

Frito-Lay also has a significant international presence, although the company only sells its chips in 42 counties. This should provide an opportunity for significant growth in the years ahead as expansion into new geographical regions continues. In addition, the company has been and will continue pursuing "fill in" acquisitions to expand penetration into existing markets. While Frito-Lay's dominant worldwide market position is attractive, the lack of another significant multinational competitor makes it even more appealing.

Frito-Lay is not the only top brand controlled by PepsiCo. Late last year, the company acquired Tropicana beverages, the world's largest maker and marketer of branded juices. In the $2.7 billion chilled orange juice segment, Tropicana boasts a 41% market share that is more than double the share held by its closest competitor, Coca-Cola's Minute Maid. This acquisition will further PepsiCo's relationship with consumers in the morning, when soda consumption is fairly low.

Looking at Pepsi Cola, the company is one second fiddle I'm more than proud to own. The company has a 31.4% market share in the U.S. During fiscal 1998, the company generated operating profit of $1.2 billion on sales of $8.3 billion, yielding an excellent operating margin of over 14%. (For those comparing margins among competitors, note that Pepsi owned a huge, low-margin bottling operation last year while its main competitor did not.) Earlier this year, the company sold a majority of its bottling operations to the public, raising cash and taking this less attractive business off its balance sheet.

PepsiCo has been significantly transformed over the past few years. In addition to the acquisition of Tropicana and the sale of a large portion of its Pepsi Bottling Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PBG)") else Response.Write("(NYSE: PBG)") end if %> stake, the company spun off Tricon Global Restaurants <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: YUM)") else Response.Write("(NYSE: YUM)") end if %> in late 1997. While KFC, Pizza Hut, and Taco Bell are excellent brands, the business did not mesh well with Pepsi's objective of being a leading consumer packaged-goods company. Owning Tricon also strained PepsiCo's soda and chip relationship with other restaurateurs since it was a major competitor. Those issues have now been eradicated.

PepsiCo management has understandably been distracted as these changes were implemented. Now, however, the company is where it wants to be. Having shed the restaurant and bottling businesses, management can focus its attention on increasing the value of its Frito-Lay, Pepsi Cola, and Tropicana brands. Although earnings have been strong in the past, the future has really never looked brighter for this company.

Analysts project that both PepsiCo and Coca-Cola will grow earnings about 15% per year going forward, yet Pepsi trades around 29x current year estimates and Coke trades at 45x this year's earnings. Some people might argue that the strength of the Coca-Cola brand justifies this difference. While Coke is undeniably a stronger brand than Pepsi, remember that PepsiCo derives a majority of its profit from the dominant Frito-Lay brand. These products have as much, if not more growth opportunities as Coca-Cola. For investors seeking the most substantial long-term appreciation potential, I would unhesitatingly select FritoLayCo... err, PepsiCo.

Next: Coca-Cola Bull Responds