Chit Chat Stocks - PepsiCo (Ticker: PEP) Not So Deep Dive

Episode Date: April 25, 2023

PepsiCo Inc. (PEP) is a multinational food and beverage corporation with popular brands like Pepsi, Frito-Lay, and Quaker Oats, but is facing inflationary pressures and supply chain disruptions. At the end of the month, we will publish an Arch Capital episode that will cover the company: Nintendo. Listen closely as Brett and Ryan go through the history, financials, and future prospects of PepsiCo. Enjoy the show! ****************************** This episode is sponsored by Stratosphere.io, a web-based terminal for financial data, KPIs, and more. Try it out for FREE or use code “CCM” for 15% off any paid plan. Sign up here: https://www.stratosphere.io/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:15) Industry | (12:09) Management & Ownership | (15:26) Earnings | (19:22) Balance Sheet | (24:37) Valuation | (26:47) Our Analysis | (28:58) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chit Chat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. Today is our Tuesday, not-so-deep-dive episode, where we analyze

one stock by covering its business model, ownership, financials, future growth opportunities, and much more after listening to this episode and all of our not-so-deep-dive episodes. We hope you get a better perspective on the company and stock that we go over. And today we are covering PepsiCo, one of the largest companies in the world. I think every single listener is aware of this company.

If not, kudos to you. You don't watch any advertisements and you might just be in some books all day or something and then on your podcast app. But I doubt that is the case. I think every single one of our listeners know about this company, and we're going to get into all they own because they actually own more brands than you would even think. It kind of is a Russian nesting doll of brands that they have under their umbrella.

But before we get to this episode, today's sponsor is Stratosphere.io, the best web-based research terminal for company-specific metrics like KPIs and segment revenues. Ryan is pulling up right now the PepsiCo dividends paid chart, and they've paid a dividend, a growing dividend. We'll talk about this and whether it has been the secret sauce and keeping them on the straight and narrow over the last 50 years. But they've paid a growing dividend for, what is it, 51 years, Ryan, right? That is correct. That is accurate. That is accurate, yeah.

but if we look at this chart which stratosphere offers to its premium subscribers we can get data all the way back to 1989 and we can see that the dividends paid yearly have grown at a compound annual growth rate of 10.3 percent since 1989 which is highly impressive it's actually available to free subs is it oh okay it is available to free subs uh segment yeah and yeah and that's That's the best part about Stratosphere is their free tier offers tons of tools that anyone can offer, anyone could use. So I would go ahead, check them out. They have some upgraded paid plans with a lot of segment KPIs, a lot of other tools

that I think professional investors and individual investors alike will enjoy and find use of. Go ahead and check them out either for free at stratosphere.io or use promo code CCM to get 15% off one of their paid plans. okay ryan there are a lot of brands under this company so best you can what does pepsi do what do they own and then go through their comprehensive history as best as possible yeah and i'll uh i will say this was quite the homework assignment because pepsi had a 500 page 10k which for people that don't commonly read 10ks spoiler on yeah spoiler we did not read it all no i mean a lot of it is just like boilerplate legal stuff or like very, very boring ways of describing their

business. Like there just really wasn't a lot of color throughout the 10K. You find a lot more color through a lot of the presentations that management does, a lot of the earnings calls, stuff like that. And there were a lot of those as well to look at. But Pepsi is, as most people know, a leading global provider of convenient foods and beverages. They got their start in the cola category or the soda category, as most people are probably familiar. However, today, 58% of their sales come from convenient foods and 42% come from beverages. So they are now predominantly a foods-based business, despite the name. And as Brett alluded to, they do own a vast portfolio of different products. I was trying to think of the best way to go through

these, but they don't break out the sales by every product or every brand. So I'm just going to rip through all the popular ones. So when we think about convenient foods, and I'm doing this in alphabetical order, there's Cheetos. And whenever I say Cheetos or something like that, think of all the extensions, Cheetos Puffs, Flamin' Hot Cheetos, that kind of thing. So Cheetos, Captain Crunch, Cracker Jacks, Doritos, Fritos, Grandma's Cookies, Lay's, Quaker, Rice-A-Roni, Ruffles, rolled gold, Stacy's, SunChips, Tostitos, and tons more basically own the snack aisle, you could say. I think it's what, 9% of the convenient foods market share. That is correct. I'll be covering that in the industry section shortly.

Yeah. So really staggering breadth in terms of product offering within convenient foods. Same thing goes for beverages. So they've got Aquafina, they've got Bubbly, which is kind of the Sparkling Water, which has grown in popularity as of late. They've got Mountain Dew, Gatorade, Life Water, Mug Root Beer, Muscle Milk, Pepsi, Propel, Rockstar, 7-Up, Sierra Mist, and SodaStream. SodaStream, I guess you could say it's like hardware plus some, or not hardware. It's the way to make, it's a machine.

Yeah, it hasn't gotten really mainstream yet, but it's kind of interesting that they acquired them because it is a way to make soda or bubbly drinks in your house and you know they might buy

a lot of other Pepsi products beverage products along with that so that's a nice little business they got for them as well

they actually did impair the goodwill related to that right related to that acquisition so maybe that's right

that's right but tax write-off you know yeah I suppose but if you're reading the financial statements you'll see

sort of a different method of reporting they break it out into seven different groups but I thought it was kind of a funky way to report because they do three, they do Frito-Lay North America, Quaker North America, and Pepsi North America. And then they go like four different

other geographies, which is like rest of the world. But really, I think it's better to kind of just break it down into their foods-based businesses and their beverage-based businesses. And then just keep in mind that 39% of their revenue comes outside North America. So about, I think it's $34 billion worth. So there's going to be a lot of foreign exchange headwinds with Pepsi's business. Maybe not as much as some other companies, but still a decent chunk. And then on the logistics side, they've developed a pretty complex or holistic distribution network over the years. As most people can probably imagine, this is something that has constantly evolved over probably a hundred years in terms of how they serve and how they go to market.

But the primary way that they deliver their products is via their direct store delivery network. So this means that Pepsi delivers the products directly to the retail stores and actually merchandises the items themselves. We looked at Monster, for example, where their biggest distribution method is going through Coca-Cola. A lot of other companies go through regional distribution networks and Pepsi does some of that too, depending on the geography where it makes sense, but there's also some e-commerce channels. Ultimately, I think that direct store delivery network is a big advantage for them because a lot of other brands can plug into that and partner with them to get that easy access and then Pepsi can leverage it. But I'll talk about

that a little bit later. That's the basics of the business. Really, Frito-Lay and Pepsi are the two and Quaker are really the three big, most important segments. Frito-Lay has been a real shining spot for the company. It's been just this incredible pricing power business and has constantly grown volumes, but we'll talk about that in a bit. History, there is a ton of history here. I'll go back to the original roots. In 1898, a pharmacist from North Carolina named Caleb Bradham developed a soda formula in hopes of replicating Coca-Cola's success. He named it, surprise, surprise, Pepsi-Cola. And after some solid success, he officially formed the company in 1902. They did pretty well up until about World War I. Just after World War

I, they started to struggle. And in 1931, a guy named Charles Ruth acquired the trademarks, the assets and really kind of established Pepsi into what has become the modern company. And it was really the 30s when Pepsi became a true rival to Coca-Cola. And so their campaign that was really successful during the Great Depression, they ran this 5-cent, 12-ounce Pepsi campaign, and it had tons of success. And that's kind of what vaulted them into the sort of upper echelon with kind of a duopoly, I guess you will, especially in America with Coca-Cola. And then the company added to that success in the fifties. I think they grew their revenue or maybe it was earnings 11 fold when

throughout the fifties, because a former VP of Coke became the CEO. And he had this like really kind of impressive marketing plan that worked out. And then in 1965, they merged with Frito-Lay. That's really what's- Amazing. We'll talk about that business later. One of probably the most important mergers in the CPG business over the last hundred years, probably. Maybe the most important. Yeah, maybe number one. But they've also made tons of acquisitions since, including at several different points in time. They bought Pizza Hut, Taco Bell, and KFC, and they've since divested those into what's ultimately become Yum! Brands. And that's actually done well. That spinoff has done well for shareholders also. And then the last real big acquisition was in 2001 when they purchased the Quaker Oats Company for $13 billion. I think it was an all-stock deal. But Quaker not only owned their famous oats-based products like Chewy and the typical rolled oats, but they also owned Gatorade. They owned Snapple, which I think has kind of teetered off, but a bunch of other brands. The Gatorade is huge. The Gatorade purchase is very important.

Yeah, absolutely. And then just kind of for context, because I think this is fascinating. Since 1994, which was the year that Berkshire completed its purchases of Coca-Cola stock, I'm not exactly sure when they first bought. I think it was either 1990 to 1992 time period, because it takes them a while to accumulate positions. Pepsi has outperformed Coca-Cola. From 1994 to today, it's up 17-fold in total return versus Coke, which is up 11-fold. But if you take it from the initial purchase, Pepsi has still outperformed, but both of them have done substantially better. I think those first couple of years that Buffett was buying Coca-Cola, the businesses had a huge resurgence and probably a little bit of multiple expansion too. So yeah, I mean, it's a long history. It's a very durable business that's been around for a long time and a vast portfolio of brands. Yeah. And it is one that, yeah, we'll talk about all of them and what have been the most important over the years and

what are the best businesses within this portfolio, but let me hit industry and competition first. Like Ryan mentioned, you can separate the PepsiCo business into two categories, drinks and snack foods. I think a good presentation for people to watch is an insightful slideshow presented at a recent consumer conference, which we'll link in our sources in the newsletter. Again, that's a good reminder here. Subscribe to the newsletter to get the charts, show notes, and further sources to go along with every Not So Deep Dive episode. The link to that is in the show notes. So yeah, they have a lot of good stuff on basically their industry sizes, their geographical sizes and their market share. Funny enough, both the snack foods and drink categories

are around the same size globally at about $600 billion in annual spending and are growing at approximately 5% year over year. In convenient foods, PepsiCo has an 8% market share and then a 9% market share in global beverages. So pretty even there. If we look at competitors, there are a lot, right? We don't really need to go through all of them, but there's Coca-Cola, Monster Beverage, Starbucks, Mondelez, many other food and drink companies. Like when we talked with Monster Beverage, if you listened to that episode, which if you haven't, I would recommend going listen to that one. That's a very fun case study. PepsiCo is competing for really what consumers choose to eat, and then in this case, or excuse me, drink, and then in this case, both eat in

their day-to-day lives. It's not necessarily like there's three people they're competing with, although people might put it in that perspective when they say, oh, are you going to choose Pepsi or Coke, really, are you going to choose Pepsi or any other drink, even water? Yeah. And the only, in terms of distribution, I think the only business that really rivals them is Coca-Cola, maybe Hershey's, but Hershey's goes through- Nestle. Nestle. I would say Nestle probably too. Some of the food. Nestle. But a lot of those, I'm looking at Hershey's right now. I just double-checked. 28% of their sales went to McLean Company, which is one of the largest wholesale distributors in

the US. So they're not doing a lot of the direct distribution themselves. They're going through kind of someone else. I think Coca-Cola and Pepsi really kind of have that, I guess, advantage in that they go to all the retail stores themselves. Yeah. And Coca-Cola is somewhat different because they have the distributors that are separate publicly traded companies in some cases, but this is not a Coca-Cola episode. Last thing, I have an industry in competition. According to the proxy filing this year, the company gained a share in the food category in both the United States, Brazil, the United Kingdom, China, and India in 2022. And then in beverages, they gained share in Mexico, Brazil, Australia, China, and India. Importantly there, they did not

say the United States. So I think beverages have lagged a bit versus their food stuff within the US compared to someone like Monster Beverage, Red Bull, or Coca-Cola. However, I think seeing these market share gains are great signs for growth, especially when we look at Brazil, places like Brazil, China, India. I mean, think about how many people are in China and India that can buy Frito-Lay products and Pepsi products. I think it's really important to track that as they try to gain market share outside of North America. However, let's move to management and ownership. Keep this one short because, frankly, I think the executive team at a company like Pepsi is not the most important thing to focus on. This is one of those businesses that is so good,

it can almost run themselves. There's really one question you want to ask for a CPG stalwart. Are they, I guess I wrote he, I should write they, it could be a woman, and it was a woman before the current CEO. Are they being smart and rational with their capital allocation, dividends, buybacks, acquisitions, investments. And we'll talk about maybe they are. Maybe they are being pretty smart right now. The current chairman and CEO is Ramon LaGuarta, who rose through the ranks since joining the company in 1996, and he became the CEO starting in 2018. If we look at, again, I was going through the proxy statement, I was looking at stuff like executive compensation. They have this thing called PEP Plus, which is kind of their ESG

stuff that I don't think we need to cover. We can go over that. It is very funny corporate talk. If you enjoy when companies speak about world-class excellence and whatever they are, and I don't know, all that stuff. They have their digital transition that they hype up. And there's many other things that these executives may talk about on conference calls. But when I look at that, especially at a company of this size, it's not going to move the needle whether the CEO gets paid $50 million a year, $70 million a year, or on what basis. However, credit where credit is due, Pepsi has accelerated revenue growth since LaGuardia took over. In the newsletter, I'll include a chart of their organic revenue growth. They compared in their

latest investor conference I mentioned, they compared 2016 to 2018 compared to 2019 to 2022. too. And in both convenient foods and global beverages, they're growing at a significantly higher rate. I would say that maybe he should thank inflation for that, but it's still pretty impressive the way he was able to change up some things. If we look at executive compensation, it's very complicated. Just the boilerplate compensation consultant philosophy you'd expect at all these Fortune 100 companies, really no concerns there. I mean, annual bonuses are based on constant currency revenue growth, free cashflow, constant currency earnings per share growth, constant currency net income growth, and other things. And then they have long-term

stock awards, again, as you might guess, that are all performance-based. And they're based on three-year earnings per share growth, three-year organic revenue growth, and three-year total shareholder returns versus industry peers. Nothing crazy, very boring. And then perhaps, and I'll have a link to the whale wisdom here. Ownership table. That is the full one on, I forgot to put. Okay. I'll finish that for the newsletter. That's a sidebar. They have one of the most boring shareholder tables I've ever seen. I might click on it right now. If we look at our executives and directors, they have meaningless ownership. It's 0.15%. If we pull up whale wisdom, which is one of the slowest sites in the world. So I'll talk slowly. Let's do this. Okay. Here's

the list. Vanguard, BlackRock, State Street, Morgan Stanley, Bank of America, Geode, which is a huge management firm, Royal Bank of Canada, Charles Schwab, Northern Trust, JP Morgan, Capital Research Group, Bank of America, Bank of New York Mountain. I could go on and on and on. Who's selling this thing? It seems it's the entire thing is an index. What do you think, Ryan? Yeah. I think at this point, the majority of owners are pension funds, index funds. Yeah. Who is- Just everyone probably has exposure without knowing it. I mean, obviously the stock can go down, but why would the stock go down? Who is going to

put selling pressure on this thing? But of course, obviously that could happen. It could, yeah. I don't see an activist stepping in here, but let's talk earnings because it's maybe a little more exciting. I think ownership, people probably knew that at this point, once you've had 20 CEOs throughout your history, you're not going to have a lot of insider ownership. Earnings though, they did $86 billion in revenue in 2022, which is a huge amount. It was growing 9% year over year. However, if you exclude, so there was a foreign exchange headwind. There were some acquisitions and divestitures involved there. And then there was a 53rd reporting week. They have basically this organic growth figure, which is, it's

important to pay attention to. Organic growth was up 14% year over year. However, 14% of that was from growth and pricing, or sorry, it was, there was 14% growth in pricing this year and 0% growth in volume coming from price increases this year. I went back the last two years and it was still predominantly pricing increases that have driven revenue growth, but there was a little more volume growth those years. And it was actually even like Q4 of this year. So the most recent quarter was even more accelerated. I think it was 16% growth in pricing and 2% volume declines. So they are starting to see sort of a headwind, I think, with the consumers. But 53% gross margins. This has basically been flat for the last 15 years. $11.5 billion in operating income. Interesting note, operating margins have come down a little bit. It was 13% operating margins, but it's usually – in the last couple of years, it's been trending downwards.

there was a $3 billion Goodwill impairment this year. And there was actually, I think, a couple of Goodwill impairments. Part of that was related to SodaStream, but there was a number of other businesses that were impaired or written down. So that was one of the contributors that led to the operating income decline despite revenue growth accelerating. And then cash flow, they've had a little bit of a working capital buildup, partly because inventory continues to rise, but also someone asked about this on the conference call and basically said, why have you had the working capital buildup? Is that a timing thing? And I think it was some executive vice president gave a kind of a boring answer, not a whole lot of color, but he said, we basically had a timing issue on something we were doing with some IT implementations, which is, I think you get that sometimes with these big CPG businesses, kind of temporary fluctuations in either inventories or payables and stuff like that. And so it can really kind of lead to big discrepancies between cash flow and gap operating income. But I would just look at it basically on an operating income basis.

They did return $8 billion to shareholders this year. 6.2 of that majority of it was in dividends. Then if they have excess cash flow that they feel inclined to return to shareholders, they'll do it with repurchases. Interesting stats. They've increased their dividend for 51 consecutive years. I think that's just absolutely remarkable. Then the current dividend yield was about 2.5%. I put a chart in here and people that are listening aren't going to be able to see this, but I'm going to run through some of the long-term numbers because I think it's good for

context, especially when you get these businesses that have been around for so long. It's really important to look at the long-term averages. Since 1994, I kind of chose that as a random update. And all this data is on Stratosphere, by the way. Revenue has compounded at 4% annually, operating income at 4.5% annually, and earnings per share at 6.5% annually. So maybe not as high as I would have thought, but the earnings per share figure, it's been very steady. And I think there was maybe some elevated numbers in that 94 to 96 range. It was basically flat from 96 to 07. So any thoughts there on the historical numbers? Yeah, I think it's important here to look at, well, one, they've had a little bit of multiple

expansion, which has helped. But when you have a slow growing business like this, and yeah, it's slow, but consistent, revenue and operating income, pretty consistent there. I think the capital returns can be so important. You have the dividend payout that's been growing, and then the buybacks. Plus, I think maybe this chart with the divestitures is a little tough. I can't remember exactly when they divested from young brands, but that would have a big impact and might be misleading a bit here. But either way, I do think the capital returns are quite important

for a mature company like this where they're not burning it in whatever you might want to burn it in. Anything random would know that has no good return on invested capital. Yeah, that was a good point. divestitures. I think that big drop from 96 to 97 was related to that Yum! Brands divestiture. But if we look at the balance sheet, just over $5 billion in cash. Inventories increased 20% this year. So that's one of the leading contributors to the difference in cash flow from GAAP numbers. And then they generated about $13 billion in EBITDA this year. The reason I say

that. It's just, and I say this on pretty much every show, but shareholders shouldn't care about EBITDA. But if you've lent them money, you care, especially when adjusted EBITDA. You don't care what stock-based compensation is, which it isn't that high for a company like this anyways, but you care about cash that they can pay back to you as your lender and EBITDA is a decent proxy for that. So $36 billion in long-term debt, $3.4 billion in short-term, almost all of it is fixed rate. This is, by the way, I think one of the better balance sheets I've ever looked at. Weighted average interest rate on their debt is currently 2.6%. Might be the lowest rate. Those green bonds, whatever they're investing in there, I don't know. But yeah, those help out.

Yeah, and there's an interesting line here from the 10K. It says, a one percentage point increase in interest rates would have decreased our net interest expense in 2022 by $48 million due to higher cash and cash equivalents and short-term investment levels as compared with our variable rate debt. basically, in case that was confusing, they have so little variable rate debt, everything's fixed rate and locked in at that weighted average number that I pointed to, that if interest rates rise, they're going to make more money on their current cash than they would have increases in their variable rate debt. So it's a huge benefit for them actually, at least in terms of earning interest on their cash balances. In total, basically $34 billion in net debt. So just kind of keep that in mind when you're looking at the market cap, there is a sizable net debt position, but net debt to EBITDA is about 2.6 times. So really not too crazy at all and

remarkably low rate. So props to them. Yeah. All right. Let me hit valuation quick. They have market cap, $255 billion, one of the largest companies in the world, as you might expect. Add on that net debt, we got an enterprise value of approximately $289 billion. And then if we look at their trailing operating income, which I think is the best metric for looking at the more consistent profitability numbers, I know cashflow is king, but can be a bit wiggly with the way the inventory can work like that. So I like EV to operating income for this company. And right now they're at 25.1. So quite elevated above the market average as any listener who follows the space when no valuations and multiples

are elevated in the cpg space just they have been for the last year i think there's been a little bit of a flight to safety during this tech drawdown and whatever you want to call it a bear market i don't know if we're still in a bear market but either way these type of companies have held up well so right now the valuation is at a premium and i think it's up pretty significantly since the peak of the uh s&p or qqq but i don't have that in front of me i actually want to pull up the trailing let me make sure i got it here the trailing uh what are your historical averages for earnings uh ebitda and e in price to earnings so i'm going to share the screen here and if we look at it historically and don't if you're watching don't the kegger doesn't matter

but right now according to stratosphere pe is about 28 ebitda does about 19.1 and both of these are not at all-time highs. We're in the late 90s. They're kind of a bit higher, but they are a lot higher than I believe the historical average is. So we kind of have in the early 2000s, kind of the low 20s, PE to 20,

and then down into the high teens right after the great financial crisis, EBITDA to EBITDA, and after the GFC was more closer to 10 for many years. And now during the latest bull market, we've gotten closer to 20 on that. So I think we are at the upper range

of the historical earnings multiple. and I would just take that into consideration when pricing in those forward returns. And we'll talk about that during our bull and buyer cases for sure. All right, anecdotal evidence, Ryan, unless you have anything else to add there. No, let's do something a little more fun

for anecdotal evidence. What is your favorite Seco product? I'd say one of the chips for sure. I don't know what, I like, I don't know what lays one I would like the best. I don't know if I can pick one, but definitely within that category. And then maybe Tostitos. I don't know.

Tostitos are good, but obviously you got to have some sort of dip with them. I like both of those as well. Soda, not my thing anymore. What about you? I think I probably agree. A lot of those Frito-Lay products. I like Ruffles. I like the Ridges.

Then also Gatorade. I, I think I, I enjoy a nice Gatorade when I'm tired, but yeah, I think everyone's got some anecdotal evidence with this business. I think the important thing here in my experience, and maybe you can, maybe you're different when I'm buying these products, Gatorade, Celsius, Doritos, Tostitos, I'm really not that cost-conscious. I'm really, maybe with Tostitos, it's a little different. Except at a sporting event.

That's the only time. for me at least right but i'm typically like if i'm going to the grocery store and i wanted uh a very specific gatorade i'm i'm doing it i'm buying it for the brand i'm not buying it because it's a low-cost alternative which i think is the proof is in the pudding that's why they've been able to raise prices so consistently over the years yeah i think i'm in the same choice sometimes you might go oh wow they're really you know selling gatorade for a lot now but in reality it's like three bucks versus two bucks, what it might've been 15 years ago. So you're not going to actually stop buying it because it's not, it's not a wallet cruncher compared to something like a gasoline.

Yeah. You don't think about it too much. And that's, that's the key. I think we've talked about this before. That's the key to the monster energy. It's the key to something like Starbucks. It's the key to something like Coca-Cola and all those products and a lot of even non-consumable CPG products, adding tobacco as well. Um, just because you can, you can raise prices and people don't care because the actual price per unit is so low um but yeah i mean anecdotal for me have anything else in here yeah i i think the only anecdotal evidence i have is i worry that some of the core beverage pepsi customers the cola customers the soda maybe customers in general are eroding ever so slightly where soda is less popular as a day-to-day drink among younger people

it's more energy drinks it's more health conscious drinks but pepsi is disrupting themselves a bit with that with bubbly with some some of their brands there so i think they'll be fine but i that's the only anecdotally from a feeling perspective is that that's where i worry a bit yeah i agree and they have tried they kind of have a partnership with celsius too which that leads into my future growth opportunity um and it was kind of hard to do anything for pepsi because the blueprint for success is so simple but something that they've done a little bit of that I think I like it, although they don't break out the actual economics of this is they will oftentimes partner with other brands that they don't own and kind of just leverage

their distribution network to help them grow. And so there's a couple of examples. They distribute a lot of Starbucks products. So you think about like those Starbucks creamers and stuff like that at grocery stores. Pepsi is, that's Starbucks basically plugging into Pepsi's distribution network. I think they do the same with Dr. Pepper. Dr. Pepper Keurig is like a owned company that they have a similar deal with. And then they just announced one with Celsius. It really is, I mean, that distribution is such an advantage. It's hard to say what those deals do to margins since they don't break it out, but I would have to imagine that it's revenue creative since they're already driving those routes anyways. And a lot of the times you're

basically just changing up what you're stocking in your trucks or adding things to the truck. So I like those partnerships. I think with the Celsius deal specifically, it could potentially end up looking a lot like Coke's 2014 purchase of Monster. Pepsi acquired an 8.5% stake in Celsius. They've had kind of this overall push towards energy drinks. They acquired Rockstar, I want to say, in 2019. And then they had a deal with Bang Energy, but ended up going to court with them over it. And it ended up being this big dispute. And there was rumors that they were going to acquire Monster, but that didn't end up coming to fruition. And instead, they decided to do this partnership

equity deal with Celsius, which I really like. I think Celsius is clearly a brand that's growing quickly. And the energy category has much better growth characteristics than the soda category overall. So I like that diversification. Yeah. And if there is one low light is that they currently don't have a really top-notch brand within energy, which I guess the two big ones are Monster and Red Bull, but they are making some bets. I guess Rockstar has been a bit disappointing. They've been losing market share, but the Celsius could be the third horseman coming to the table. So we'll see. My future growth opportunity is what I think is going to be in general, the most important growth driver this decade, or maybe one of the most important

besides pricing power, if inflation continues to go, to run rampant really high, is growth in Asia, South Asia, Middle East, and Africa divisions. I know they separated out where they have East Asia versus South Asia, but I'd say those four territories are the ones where they're going to have the most growth. I'm going to pull up a chart here that I have loaded. Let's get it right, correct before. Okay. And I'll describe it for all the listeners. These categories have grown since 2017. If we look at just in general, I know they separated out where they have like African Middle East and then Asia Pacific and separate. But in general, if we combine these categories, they've grown their revenue at over 10% since 2017, and that is in US dollar terms.

So they had major foreign exchange headwinds last year, I think, on that proxy statement when they talked about gaining market share in general. But in these categories, I can't really dig into, okay, this product's doing well in this region. I don't think that's really important. The most important thing is, whatever works in these regions, they're going to have the success, they're going to have the distribution network, they're going to have an advantage over local competitors. And hopefully, within big markets like India, China, what are the others? Bangladesh, Nigeria, the places that might have lower GDPs per capita, but giant populations, I think can just be fantastic if we get people habitually. And yeah, it might not be great for their health,

but for this business, if you can get them habitually attached to some of these brands, having anything from a bubbly to a oatmeal to a Pepsi to eating some Frito-Lays at a party when they're watching a cricket match in India. I mean, that's just fantastic. And I think there's a long runway for growth. If we look at the total revenue numbers in 2022, Africa, Middle East and South Asia did $6.4 billion in USD and Asia Pacific, basically East Asia, Australia and New Zealand did 4.8 billion. And I see no reason why those numbers can't continue to compound over the next decade and beyond. Any thoughts on that, Ryan, before we move to highlights and lowlights? No, I mean, it certainly seems like the biggest opportunity. I think in some of those

markets, volumes have declined slightly, at least lately. But I think Latin America is another, you didn't include that one there, but that's still, I think, an underpenetrated market that there's a lot of room for consumption. What do you like and dislike about this business? I already talked about it, but the distribution network I like. There's a quote from the presentation that they recently did where the CEO said, we are the number one supplier to most of the retailers in the US. That gives us a seat at the table in terms of sharing data, joining infrastructure, talking five years out versus just next quarter. I really do think this as an advantage versus a lot of their CPG peers, it gives them the flexibility to, I

mean, for one, you could potentially get better terms. Some of these retailers, you probably have better relationships with them and you can launch new products quicker and get them quickly to the entire country much quicker than a lot of your peers. And so I do think that gives them the chance to kind of experiment and test new products faster than a lot of other companies in the CPG space. And the pricing power, they can say, we're going to give you this price and they can threaten to take every, you know, they kind of do a standoff, right?

Take every shelf. They obviously have a ton of negotiating leverage with the retailers as well. Price and power is obviously pretty evident. I think Frito-Lay is just a wonderful business. The other thing that maybe we haven't talked about as much is the diversification in terms of products. A lot of the other businesses we looked at, Monster, Philip Morris, even- Yeah, not as, somewhat.

It's still mostly cigarettes and energy drinks in those cases. Whereas Pepsi, if soda continues to decline or soda consumption, they have the Frito-Lay business. They have- Bubbly. Bubbly. They have some energy drinks. So there's just a lot of, there's no single product risk with them.

So I like that. And it's just, what is it? What do they call it? The Lindy effect, where it's been around for 50 years, or it's been around for 120 years. I feel pretty confident that they're going to stick around. So if it was purely a bet on durability, this would probably be one of the top businesses in the world for me. Yeah, 100%.

All right, lowlights. They've got some weird initiatives they're investing in. They keep talking about direct consumer platforms. but I just, I really think this is the business where you go through retail channels. There's one quote that stood out to me from the conference call or from that presentation. He said, we are investing a lot in food trucks and more giving consumers the opportunity to buy our products beyond a bag in a much more holistic food experience. I'm not joking. These are just like giant Cheetos food trucks. Yeah. Well, and they put food, they have some, like not just

Cheetos, they sell some sort of hot food along with it. But I did see you caught the highlight of the management team talking about Lay's and Cheetos replacing, or Lay's and Tostitos replacing more and more potatoes or whatever they were talking about, potatoes and corn or something like that. And I was like, that's, you know, maybe. No, maybe I'll find the quote, but it's just, I don't know. That does not feel.

Let the food trucks do that themselves. Yeah. It's just not that bread and butter. Um, the other, the other thing is at least in the last year or so, I feel like they've taken price at a pretty unsustainable rate. Now they've been able to grow price prices steadily for a long time, but in the last quarter, like I said, they grew prices 16% across the board, really, uh, even higher at free to lay and volumes declined by 2% in aggregate.

it. If they're able to keep doing that, that would be great for the business in the short term and probably shareholders, but that just feels very unsustainable to me. Last thing, 5% of their revenue comes from Russia. It looks like they've actually been investing pretty heavily there too throughout the 21st century. They acquired Russia's largest juice manufacturer in 2008. 5% of revenues is a pretty big market for them. It's not the US, but that's a huge market. We just did the same thing with Philip Morris, where it's like, I don't know, how do you think about that? Are they going to try to divest it? Are they going to be shunned by Russian government if they don't invest in the market? That kind of thing.

So yeah, our Western government is going to put more sanctions on the country that prevents almost all companies from operating. Who knows? Yeah. So it's just kind of 5% of revenue that I think is largely at risk. Yeah. All right. I'll hit my highlights. They're very much the same. I mean, clearly a great business speaks for itself. Dividend growth, 50 plus years. You talked about the diversification, which I like as well. I did want to highlight another chart here because again, there's just a lot of fun ones with this company. And let me, oh gosh, stupid Zoom. And they got to change that, whatchamacallit, where they put the, we talk about this every time, where they put the share screen button, it goes right over where you want to put your mouse. Okay. If we look at Frito-Lay North America revenue and Frito-Lay operating income, even though

this is North America, which is their most mature market by far, since 2012, revenue and operating income have both grown at a compound annual growth rate of 5.5%. Last year, Frito-Lay North America did $6 billion in operating income for PepsiCo, which is half, correct, Ryan, of all their operating income? Yeah. Somewhat around, yeah. A little more. Yeah, I mean, that's just their most important business line, and I think that it's just a great business. i would say it's the maybe within food and drink maybe tobacco is the only one that's higher quality

than frito-lay i think it's my number one i think it's better than both the core coca-cola or the core pepsi one i mean who disrupts this and they're disrupting they're trying to even widen their moat by offering these healthy products that makes it even tougher for a competitor to try to squeeze their way in where they have the you know quote-unquote i mean they're not actually healthy, but the quote unquote healthy products, reduce salt, reduce fat, reduce sugar, whatever. And yeah, I mean, I just think it's bulletproof. And look at other highlights. I don't think I had anything else that was different than yours. Yeah. Let me talk about the low lights. I talked about the minimal exposure to the energy drink market. They're a bit late to this game. I think

it's the best spot to be in drinks today. And they're trying this, you know, maybe with Rockstar Celsius. A few others, other lowlights, law of large numbers, excluding inflation. The question I ask is, can this business double over the next 15 years? I kind of, maybe, maybe, but I kind of have my doubts and that with this, obviously that valuation comes into play. We'll talk about that later. And then third, you also had this is the strong pricing power has been a key growth driver for these CPG brands forever. And I wonder if this is one of those things people talk about that Mark Twain quote

that was made famous by the Big Short movie, is the CPG brand pricing power one of those things that you know for sure that just ain't so, right? That sort of quote where we take it for granted over the last 50 years that these CPG brands can raise prices whenever they want.

When do they ever want to run into a wall? I think we run... we might look back in 15 years and say, well, people are going to pay double. They'll pay double in real terms for a bag of Lay's potato chips. But I kind of doubt it. Once it goes up to something like six, seven bucks for a bag of Lay's, that is too much. People will finally start noticing, at least in real terms, right? What do you think on that? Well, Frito-Lay North America increased their pricing by 18% year over year and volumes didn't change. That's a pretty steep

price increase. I know. It's a good business, but eventually it hurts. Eventually it hurts people buying this. Eventually they think about it. This is not as addictive as cigarettes. Well, you can just throw in shrinkflation. You can just start to reduce the size

of your bags. People don't notice as much. You start to put less chips in there, whatever. Inverse price increases. But yeah, I do think there's, I would not be, I feel like throughout probably the last 50 years, it would have been very easy to say, yeah, I know they've raised prices for the last 10, but is it going to, are they going to be able to do that for the next 10?

Probably not at 18% a year, but. Yeah. I mean, they'll be able to raise along with inflation for sure. But I wonder, plus inflation forever, that opens yourself up to competitors, I think. yeah yeah you're probably right um and that quote from the ceo was he said lays can substitute potatoes in many dishes around the world to and he said doritos can be a part of how you make a pizza yeah yeah yeah it's gross but uh it's just to me like that with the food truck stuff it feels like they're they've got maybe plus yeah ambitions that aren't their core competency so i don't know

They have some ambition. Yeah, well, they have a lot of ambition to waste money, I think. Waste a few billion a year on some of these strange things. I like the marketing expansion. They have the capacity to do it. Yeah, I mean, it'll be fine. But the expanded marketing strategy to grow the marketing spend is probably smart. Getting all these athletes, they had like 10 really, really expensive ones on the brand.

I mean, it's great. You see, all you have to do is have them in the commercial, eating the chips. It's quite easy and it works. But some of that other stuff, yes, I think you're totally right. But let's wrap things up. Let's move to bull case. What do you think, Ryan? To be honest, I find it hard to imagine this being a big home run at current prices.

The stock has basically tripled over the last 10 years, but a big chunk of that is multiple expansion. So their EV to EBIT has increased by 50% since 10 years ago, whereas earnings per share has only compounded at 5% annually for the last decade. So I think the 5% earnings per share CAGR can continue, but you have to believe that for the bull case, the multiple is going to stay where it's at or that they're under earning right now or whatever because of the goodwill impairments. So I think you have to believe that multiple is going to stay high and they're going have at least that 5% earnings per share tagger over the next decade or so, probably more.

They guided to 4% to 6% revenue growth and EPS tends to trend a little bit above that. So I think it's certainly doable, but it's not a home run for me. It's probably bull case here is high single digit returns over the next decade. Yeah. I mean, you got earnings per share plus dividend and that's it right there. Yeah. That's my same one where you got to think, you know, it trades at 25 times earnings. Is it going to stay there? Yeah. That's your, that's your bet.

But to be honest, my bulk is, doesn't this deserve to trade, to trade at 25 times earnings? I think it does. I think it does. 25 times. Yeah. It's one of the best businesses in the world. Yeah. It's a bond proxy.

Yeah. At that point it is bond proxy. Yeah. I think it's a bond. Yeah. Yeah. You have bond plus small growth, right? If you're buying this as an alternative to treasuries or something, then yeah, maybe it deserves 25 times. I mean, there's still more risk. Even though there is less risk, there's less risk than probably, I don't know, any other equity out there.

there's obviously more risk than treasuries and it feels like you're getting potentially treasury plus one percent maybe return yeah treasury plus some small growth yeah no i know i agree let's move to the bear case what do you think well i do think honestly there's been a little bit of a like flight to safety over the last two years people looking for dividend payers people looking for companies that have grown their dividend over time, stuff where the earnings aren't going to be so volatile, which in Pepsi's case has been, that's been the story. But I mean, multiple compression really is the bear case here. Right now they trade at EV to EBIT, it's 24.8 times.

That's the highest since 2003. their average is like 17 times so if that uh if that shrinks over the next couple years and they get kind of the same earnings per share growth that they've had there's gonna be i mean i don't know it's it's bond minus one percent it's the returns aren't gonna fluctuate that much yeah yeah nah yeah i think that's the issue same with me only bear case i could find because i I think this business is bulletproof from a durability perspective. Yeah, this is a multiple compression, real risk. But yeah, let's move to more or less interested to wrap things up.

Ryan, are you more interested or less interested in Pepsi? A little less interested. Yeah, it's obviously a very durable business, but I'm certainly not interested at this price. And I don't know. I don't think it's going to get cheap anytime soon. we saw that shareholder base it's all a bunch of index funds unless there was some giant crisis like some i don't know some some horrible thing that happened at the company some scandal uh and the multiple got super cheap maybe i'd consider it but i mean not at this multiple

or anywhere near this yeah when's the last time buffett bought coke what are you shooting I would love I would be all over this 65 years old I would not sell this I'm not selling this if I own it I'm not selling it right now right maybe I'd sell it 50 times earnings I mean this is one you kind of

never sell right you know what I mean I don't know if that goes into that category for you but I guess I'd be all over this at 10 times earnings but I doubt it maybe ever gets there unless things get really ugly yeah it's not could get there every index fund owns it yeah i mean who is selling that's what i was saying who

was selling this thing um but that is you know we're just jinxing it i keep thinking whenever we say that type of stuff i always think we're jinxing it but i mean i would certainly revisit it i would revisit it if i if there was some huge drop in the price i'd revisit it because it's honestly you said something about cheetos one time having like some sort of child labor scandal right and obviously you don't want the company to do that but this is one of those situations where they have a scandal that's the opportunity that what what was the opportunity in the late 90s is the new coke thing right i think yeah i don't know what that's the price but yeah yeah or early 90s excuse me um and then also but we're all the international expansion

is just not there anymore we've already juiced a lot of that although i think it can be a growth driver yeah it just does not there's a lot of yeah yeah i mean at this price it does not accept it's got to be since it's such low growth it does not no no it's just not no what if i quoted you let's say i said they trade at 14 times trailing would you be ready to add it i think i think i'd like 12 more because you get a little bit of growth at that point because i like you know no growth businesses at 10 times earnings are pretty solid especially if they're decent capital returns but i think 12 times earnings is where i'd be really that's where it kind of passed my hurdle rate and people might laugh because you know maybe we're in higher

risk stuff that has a bigger risk reward skew but that's just mine i thought yeah yeah i agree it would it would take quite a haircut on the multiple and some of that might just come from the fact that i do think they're under earning with the goodwill impairments but the uh still i think even if you add back the goodwill impairments it's still like high teens yeah yeah definitely look at that if someone's going to do some real work on it because as listener know we do not do complex models at all but let's wrap things up for this episode stock for next week is going to be Nintendo Arch Capital episode. Very excited for that one. As a reminder, if you're a regular listener, subscribe to our free newsletter and get our show notes and charts for each episode.

The link is in the show notes, or you can search Chit Chat Money on Substack. If you like watching these episodes, you can do so on either YouTube or Spotify, where we share the screen and have some good data visualizations there. And if you like the show or like our podcast, please give us a review on either Spotify or Apple Podcasts. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next week.