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Message-ID: <794826DE8867D411BAB8009027AE9EB907638878@FMSMSX38<
From: "Sama, Anil" <anil.sama@intel.com< To: "'vavrek@haas.berkeley.edu'" <vavrek@haas.berkeley.edu<, "'dasovich@haas.berkeley.edu'" <dasovich@haas.berkeley.edu<, "'guinney@haas.berkeley.edu'" <guinney@haas.berkeley.edu< Subject: FW: DB's Research on Pepsi/Quaker Oats Date: Mon, 9 Apr 2001 10:18:39 -0700 MIME-Version: 1.0 X-Mailer: Internet Mail Service (5.5.2653.19) Content-Type: text/plain; charset="iso-8859-1" -----Original Message----- From: michael.j.napolitana@db.com [mailto:michael.j.napolitana@db.com] Sent: Monday, April 09, 2001 8:44 AM To: anil.sama@intel.com Subject: RE: Help with Research on Pepsi/Quaker Oats Anil, Our firm re-launched coverage right before the acquisition, they issued two First Call notes, no report. I hope these help. How is your handspring stuff coming? Mike PEPSICO INC. [PEP] "BUY" "Actual Results May Vary Materially From Expectations Described Herein" ---------------------------------------------------------------------------- --- Date: 12/04/2000 EPS 1999A 2000E 2001E Price: 43.81 1Q 0.25 0.29 0.32 52-Wk Range: 49 - 30 2Q 0.31 0.38 0.43 Ann Dividend: 0.56 3Q 0.34 0.40A 0.44 Ann Div Yld: 1.28% 4Q 0.33 0.38 0.45 Mkt Cap (mm): 63,240 FY(Dec.) 1.24 1.45 1.64 3-Yr Growth: 13% FY P/EPS 35.3X 30.2X 26.7X CY EPS NE NE NE Est. Changed No CY P/EPS NM NM NM ---------------------------------------------------------------------------- --- Industry: CONSUMER PRODUCTS Shares Outstanding(Mil.): 1443.516 Return On Equity (1999) : 30.0% ---------------------------------------------------------------------------- --- DETAILS: "Quaker Acquisition Meets the Lion's Share of Criterion" Yesterday PepsiCo announced Quaker would be acquired for stock at an exchange rate of 2.3 shares per OAT share with quasi collars around $40-$45 per PEP share. CEO Roger Enrico stated the deal as modeled would boost the "big 4" financial metrics: 1- Top Line to 7%+, 2 - EBIT Growth to 11-12%, 3- EPS to 13-14% and 4 -ROIC + 200 basis points. In our view, this one appears more likely to go 2 for 4 or 3 for 4, with higher returns on our calculations providing the most significant challenge. As we stated in our 11/29 note, the mere act of doing the deal on a pooling basis does not change the fact that $13.5 billion in stock will be floated (@$43.5/PEP share)- thereby boosting the capital base by which ROIC is measured. In addition, we believe earnings accretion relies to some degree on integration savings which may be "un-bundled" as non-strategic food businesses (and their distribution systems) are eventually sold. "Add More To the Core" PEP has long maintained the higher degree of on-the-go food consumption necessitates increased product offerings around Frito-Lay in North America. Quaker's grain based snacks and nutrition bars may fit the bill - but can they produce enough turns to make it inside Frito's vaunted DSD (direct store delivery) trucks? If so, why has PEP not previously attempted to carve its own niche? We expect a volume pop as newly freed up system capacity pushes the new snacks, but do not know whether the Gatorade power bar and Quaker Rice Cakes can produce a sustainable channel presence. For example, in most core products (Fritos, Doritos, Lays) PEP is the undisputed industry leader where a viable number two player really does not exist. Many of the newly acquired "add more" ideas target the morning day part and are likely to face formidable competition from Kraft, General Mills and Kellogg. In short, we believe food expansion outside of salty snacks is laudable (i.e., it may be difficult to growing at the same historic rate as the last ten years), but PEP's impressive supply chain power and value to retailers may not readily overcome significant execution risk and heightened competition. The Gator Gumshoes. The clear-cut winner appears to be the Pepsi bottlers. Management is justifiably muted in defining the Gatorade - PBG/WH opportunity in broad terms, why disprupt OAT's established warehouse distribution? More to the point, we believe management recognizes that much like SOBE, its new, albeit smaller alt beverage brethren, significant distribution retooling at the outset risks disruption at retail. However, we expect the system bottlers to create volume opportunities immediately. For example, if only PBG's vending and "up and down" street distribution capabilities were deployed, the incremental case volume contribution could create 2% additional growth points in the first year. Given such new portal potential, we are therefore puzzled by management's 9% guidance for Gatorade sales - nearly 3% lower than anticipated 2000 results. Is the bar being re-set to make numbers? Might the mighty green bottle be facing saturation in existing channels as it closes in on 85% market share? Or might the Pepsi system, looking to improve Gatorade margins by gradually transitioning to lower slotting fees, be anticipating minor volume disruptions? On this last point, we say "minor" because the slotting issue we allude to most likely applies to the convenience and gas channel where Gatorade's indelible brand equity makes it a must stock for retailers. We believe that lower CSD volumes in 2000 are highly instructive: Even the strongest brands face execution risk. Do food retailers really want to empower bigger suppliers? PEP's profit contribution to retail is well documented. Aided by strong brands in three categories and a very efficient distribution system, it is a major provider of returns. Gatorade as well as the non-snack food businesses only augment this role. In this light, management expects it's relatively underutilized Tropicana ambient juice brands (Twister) to get a boost. Pure economics make this one inviting, but from a retailer standpoint, (think Bentonville, Arkansas) does giving up leverage to manufacturers matter? Again, CSD's are illustrative of the potential risk. Faced with an arguably better economic profit from higher CSD prices for the category, certain retailers siezed the opportunity to boost private label shares at lower prices. We note that The Twister portfolio's brand equity is not nearly as strong as Tropicana Pure Premium's, making the logically appealing distribution opportunity somewhat easier for retailers to resist. Coin of the Realm: Why does a company use its stock as deal currency? Because it is likely fairly valued or even overvalued relative to debt based alternatives. If there is such as thing as a "cheap way" to spend $13.5 billion, stock swaps in GAAP world is it. When book value equity is used, PEP return on capital actually rises 50 via the OAT deal. (We impact ROIC for both Quaker's Snapple charge and this deal's anticipated write-off). However, a share issuance, which equates to much more, will be floated. We estimate the consideration of this cost on an economic basis (i.e., what was spent) would negatively impact return on capital by 400 basis points. In addition, while a model based on the present value of future cash flows might produce a more favorable valuation, we see three hurdles to building it: 1- No clear visibility on capital allocation or growth prospects for Gatorade outside the U.S. In our view this aspect of the deal alone may be the ultimate arbiter of success or failure. 2- The integration of much of Quaker's food businesses may be only temporary. 3- Execution issues on the domestic snack and isotonic businesses may yield a bumpy set of cash flows over the next two years. On this last point, we believe PEP's experience in restructuring during the 1997-1999 period bears some consideration. A more brand focussed, horizontal business model would indeed prove superior to a more vertically integrated one that included restaurants and bottling. However, it took investors quite some time to realize stock price appreciation. In the current transaction, OAT also portends strategic value, but the benefits may not be immediate. Maintain BUY rating. For the next 6 months, we see deal integration trumping PepsiCo's many positive operational attributes. We see the stock as range bound between $40-45 until the close in the spring. At that point, many of the margin opportunities should become more apparent. Therefore, we maintain our 12-month price target of $49. ---------------------------------------------------------------------------- -- PEPSICO INC. [PEP] "BUY" PEPSICO: TRIPPING ON THE ELECTROLYTE FANTASTIC--MEETING WITH CFO INDRA NOOYI ---------------------------------------------------------------------------- --- Date: 11/29/2000 EPS 1999A 2000E 2001E Price: 45.38 1Q 0.25 0.29 0.32 52-Wk Range: 49 - 30 2Q 0.31 0.38 0.43 Ann Dividend: 0.56 3Q 0.34 0.40A 0.44 Ann Div Yld: 1.23% 4Q 0.33 0.38 0.45 Mkt Cap (mm): 65,507 FY(Dec.) 1.24 1.45 1.64 3-Yr Growth: 13% FY P/EPS 36.6X 31.3X 27.7X CY EPS NE NE NE Est. Changed No CY P/EPS NM NM NM ---------------------------------------------------------------------------- --- Industry: CONSUMER PRODUCTS Shares Outstanding(Mil.): 1443.516 Return On Equity (1999) : 30.0% ---------------------------------------------------------------------------- --- HIGHLIGHTS: Yogi Knows Best Yesterday, we met with PepsiCo CFO Indra Nooyi, the de facto keeper of the company's rigorous financial discipline. Without the ability to make direct inquiries regarding Quaker, (it only elicits a "no comment" in a Reg. FD world), our discussion helped build the oatmeal/electrolyte mosaic to the point where the company's interest may best be capsulated as a "non-denial/denial". In other words, that great pinstriped poet and philosopher may be right on with PEP/OAT - "It ain't over till it's over." Round Up the Usual Suspects Following the rumored, and in our view, temporarily aborted plays for OAT by PEP, KO and Danone, a faint Swiss whisper is being heard from Nestle. Why not just throw in Cadbury, Kraft and any other food/beverage company with an unlevered pulse? Not a bad thing for Quaker, in our opinion, but after paying so much for Gatorade - we estimate a $105 takeout implies an EBITDA multiple north of 23 times for the green stuff - only a company with a well established global distribution system has any shot at attaining enough return to make it work. That leaves three - KO, PEP and MO (Kraft) with the latter perhaps a tad preoccupied at this time. And if Coke really is done... Framing Deal Criterion in a Place Called Purchase Nooyi remains steadfast that any deal would not dilute earnings or impair return on capital. From our standpoint, here's the rub: these metrics point to stock based pooling which is arguably inferior to a debt based purchase. PEP's significant cash flow and underlevered balance sheet argue compellingly for using debt - the after-tax capital cost is cheaper and it would be free to dispose of non-strategic assets. We believe such an approach would produce more attractive returns, but cause earnings dilution - PEP no-no. Alternatively, a tax-free stock swap may be accretive to earnings while the true capital cost is hidden thanks to the vagaries of GAAP accounting. In fact, equity capital cost in our analysis is higher and the company would be holding a portfolio of food businesses for two years that are for the most part lower returning assets (hot cereal being an exception). Hence, we believe a stock-based play for Quaker faces an uphill battle to value creation. AmBevolution? We discussed Pepsi's burgeoning relationship with AmBev, the Brazilian beer and soft drink giant. Given PEP's relatively small (6%) soft drink share, AmBev's distribution is critical to success. Despite a lower implied profit for AmBev as a Pepsi bottler vs. its own brands, Nooyi sees significant opportunity once market execution matches that of AmBev's leading brands such as Antarctica Guarana. The trump card here may be AmBev's attraction to "Power of One" style initiatives with PepsiCo's snacks operations. Such developments are encouraging, in our opinion, but our Latin beverage team sees domestic beer as AmBev's most compelling near-term opportunity. < -----Original Message----- < From: Sama, Anil [SMTP:anil.sama@intel.com] < Sent: Thursday, April 05, 2001 10:45 PM < To: michael.j.napolitana@db.com < Subject: Help with Research on Pepsi/Quaker Oats < < Hi Mike, < < For our Financial Info Analysis class project, we are looking < for analyst reports on the Pepsi / Quaker Oats acquisition < that was announced in January. < < Would your firm have any analysis/reports on this merger? < If so, could you provide us some of that analysis? < < Thanks, < - Anil.
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