The Business Of

Fast Food | PepsiCo | What Do They Do With Their Profits?

Morning All!

Yesterday we put together PepsiCo’s costs with their revenues. And we’ve covered a fair amount this week. So, let’s have a quick recap…

• Pricing: PepsiCo’s largest customer is Walmart (14% of revenues). But Walmart’s huge size means Pepsi have limited power in negotiations!

• Distribution: There are 60k supermarkets & 650k restaurants in the US. PepsiCo have 3 ways to get product to them - DSD, warehouses, & 3rd parties.

• Shelf Space: It’s pretty crazy. But PepsiCo, Coca-Cola, Wrigley’s - pretty much every brand - pays supermarkets to get the best ‘real estate’ in their stores!

But anyway, let’s move on. And it is a Thursday morning. Which means it’s time to take a look at our famous TBO EBIT Margin ranking! Below, we can see our ranking updated to include PepsiCo. And we can see that it’s not very pretty reading!

But why is this? Why is PepsiCo’s margin lagging so far behind other companies we’ve looked at? Well, we said yesterday that there were 2 factors behind PepsiCo’s margin issues over the last decade. And that’s what we’re going to dive into today.

But before we get into the factors, let’s go through our usual structure of how PepsiCo spends their profits. Because as we’ll see, they’re both very much related! So, without further ado…!

Kind Of Like McDonald’s… But Without The Margin!

Let’s dive right in. So, the chart below shows us that since 2006, PepsiCo have made $156bn in cash from operations (CFO). We can see that dividends ($66bn), capex ($54bn) and buybacks ($49bn) have been the main cash uses. But today, I really want to focus on capex.

First off, what is PepsiCo’s capex? Well, in their 2018 annual report. PepsiCo tell us that they had 285 (food and bottling) plants and 3,409 ‘other facilities’ around the world. ‘Other facilities’ is mainly warehouses and distribution centers. Now, these plants - where the food and drink is manufactured - are not small structures. In fact, last year, PepsiCo started building a 1.2 million square foot plant (pictured below)! To put that in context, Amazon’s fulfilment centre in the UK is ~1 million sq foot. and is one of the largest warehouses in the UK. So 1.2 million is crazy big!

But it’s not just the building of these facilities that make up PepsiCo’s capex. Inside these facilities there’s a lot of investment needed. PepsiCo need to upgrade machinery to make their processes more efficient. They need to change product lines for newer methods of packaging. And all sorts of other investments to get their products manufactured and packaged right!

But I know what you’re thinking - this seems like a lot of work! Having nearly 4,000 buildings! We saw McDonald’s 2 weeks ago operate a super-light asset model. They just signed up franchisees and asked them to invest in the restaurants and operate the buildings. Can’t PepsiCo do the same?

Well, you’ll be glad to know that they do! PepsiCo manage a certain percentage of those ~4,000 facilities themselves. And they find partners to manage the other facilities! Unfortunately, I have no idea what percentage PepsiCo manage! It’s not public knowledge… I even asked ChatGPT without any luck! But as an example, in India, PepsiCo have 36 bottling plants - 13 of which are run by the company. And 23 run by franchisees.

2 companies with a franchising model…

So how do these franchise agreements work? Well, PepsiCo have their great syrup. Maybe not quite as good as Coca-Cola’s… but still great! And instead of doing all the bottling and distributing, PepsiCo ask their ‘bottling franchisees’ to take control of some of their facilities and do the packaging and distributing for them. Franchisees make money from selling to Walmart and restaurants. PepsiCo make money by selling their syrups to the franchisees!

In the UK, one of PepsiCo’s biggest franchise partners is Britvic. The UK-based company is a PepsiCo licensee and does all the bottling/distributing for PepsiCo in the UK. In fact, Britvic is the only PepsiCo licensee in the UK! Now, why do PepsiCo and Coca-Cola give their partners exclusive agreements for a region? Well, one of the main reasons is because bottling is a low margin business.

What does that mean? Well, there’s so many costs involved! Buying the syrup from PepsiCo. Leasing the warehouses. Buying packaging materials. Hiring the staff to run the processes. And as if the costs weren’t bad enough. Who are these bottlers selling to? Huge players like Walmart and Tesco - who have loads of bargaining power like we saw on Tuesday!

And so, the only real way for bottlers to make their business model work and to be decently profitable is to have scale. Which means lots of sales. And how can they get lots of sales? If PepsiCo give them exclusive agreements - which means Britvic get the whole UK market! This way, bottlers can eke out moderate margins. And this is what we’ll come onto now…

Buying Franchisees, Hurting Margins…

So, let’s go back to margins. And answer why PepsiCo’s margins have fallen over the years. Well, the first notable drop in EBIT margin happened in 2010. When margins fell from 18.6% in 2009 to 14.4% in 2010. And the question is - why the sudden fall?

Well, in 2010, PepsiCo bought out their 2 biggest bottling franchisees - Pepsi Bottling Group (PBG) and PepsiAmericas (PA). Now, PBG and PA were massive franchise partners for PepsiCo. PBG in particular - they were actually responsible for 55% of all Pepsi drinks sold in the US! And 32% of the Pepsi sold globally.

And because they were massive, they made lots of revenue! We can see from the revenue chart below that these 2 acquisitions added ~$14bn in revenue to PepsiCo’s topline…

… but they also are the reason for the reduced margins! Because as we’ve just been saying, the bottling part of the business is a low margin operation! Now, it’s tough to give you exact margin figures because PepsiCo don’t give us this data!

But we can see the impact of these acquisitions when we compare PepsiCo’s margins to Coca-Cola’s. As we know, PepsiCo’s EBIT margin in 2022 was 13%. What was Coca-Cola’s? 25%… almost 2x higher! But why this difference? Well, we’ll go into more depth tomorrow. But it’s to do with franchising! In Coca-Cola’s 2022 annual report, they tell us that a massive 82% of the company’s sales volumes happened through franchise partners! Although we don’t know how many of PepsiCo’s ~4,000 facilities are run by franchisees. We do know that it’s going to be far less than 82% because PBG - who they bought - contributed to 32% of global sales!

Mission - Catch Coca-Cola Please!

Okay, so just before we wrap up. I said yesterday that there was another factor that’s held back margin progress for Pepsico. But to be honest it’s a little out of place in today’s topic! So, I’ll just mention it very briefly. As the chart below shows, PepsiCo’s EBIT margin has fallen every year since 2017. From 16.2% to 13.3% last year. And a big reason for this has been a shift in priorities.

New CEO, Ramon Laguarta, came into the top role in 2018 and almost immediately had the plan to get PepsiCo’s revenues growing again. And to increase market share to catch Coca-Cola. Even if it meant having to spend more in advertising, marketing and innovation.

So, what does this mean? Well, it means more adverts with celebrities. More payments to supermarkets for great shelf space. And more research and development into finding new, healthier, magical syrups. All great ideas to grow revenues. Unfortunately, not the best for margins… at least in the short-run. But Mr Laguarta will be hoping revenues - and hence margins - benefit in the long-run!

Did You Know…

Last thing! I thought you might find it interesting to know that until 1997, PepsiCo owned Pizza Hut and KFC! And then they sold both businesses! If you’re wondering why the Pepsi-owner sold 2 incredibly popular fast food chains, check out this article.

15th Jun 2023

Nigel Jacob CFA