Pepsi pops with a snack-food empire

By Michael Brush

When a couple of bungling, wannabe corporate spies got caught red-handed allegedly trying to sell the top-secret Coca-Cola recipe to PepsiCo (PEP, news, msgs) last week, it seemed like someone had the script backward.

Given Pepsi's enviable recent track record, it is Coca-Cola (KO, news, msgs) that ought to be trying to swipe Pepsi's business plans.

Pepsi's knack for capturing consumer trends -- witness the success of Gatorade and Aquafina -- has helped reward shareholders with a 100% gain since the late 1990s, when the company first figured out that consumers were getting bored with old-school fizzy colas.

Even though the stock hitting all-time high $62.33 Thursday after the company reported a 14% jump in second-quarter profit, there's still plenty of room for Pepsi shares to run. The company's knack for innovation and a push to build an international empire in salty snacks could send Pepsi stock into the low $70 range in a year or so. Throw in an annual dividend of $1.20 a share, and that means gains of better than 15%.

And Pepsi doesn't need a boost from the broader market. Indeed, its shares should get some extra fizz as investors flock to "defensive" companies that sell products -- like Pepsi, Tropicana orange juice and Cheetos -- that people don't give up in an economic slowdown.

"In that kind of environment, Pepsi will stand out as being a stable company with relatively strong earnings growth," says Mark Petrie, portfolio manager at Hokanson Capital Management in Solana Beach, Calif., which owns Pepsi shares. He thinks Pepsi could outperform the market by 20% to 30%, in this scenario. "If you are tilting your portfolio toward slowing-growth scenarios, you've gotta like Pepsi," says Petrie.

Here's a closer look at why it makes sense to own Pepsi stock now.

Trend savvy

Pepsi placed its bet early that consumers would be drinking more noncarbonated soft drinks, making the choice in the late 1990s to become a "total beverage company," says John Sicher, editor of Beverage Digest. "Now they are firing on all cylinders. The two fastest growing major beverage categories are water and sports drinks. They have the No. 1 water in Aquafina and the biggest sports drink in Gatorade."

Pepsi also has the leading share in bottled tea with a line of products, including Brisk, co-marketed with Lipton. And it owns the ready-to-drink coffee category with bottled coffee products such as Frappuccino, sold in a joint venture with Starbucks (SBUX, news, msgs).

While sales of old-school carbonated colas remain sluggish, noncarbonated drink sales popped 18% in the first quarter. Popular beverages like Aquafina, Propel Energy drink and Lipton iced teas grew 30%. Gatorade generated low double-digit growth, a rate that should hold for the next five years, predicts Citigroup Research analyst Bonnie Herzog.

Pepsi's success with the Gatorade brand, which it acquired when it bought Quaker Oats in 2001, offers some insight into the company's marketing savvy. Pepsi has nearly doubled Gatorade sales in the past five years, partly by extending the brand with new lines that target niche groups. The company ginned up Gatorade X-Factor Thirst Quencher and Gatorade Fierce Thirst Quencher with a bolder taste to appeal to younger consumers. It'll continue the same trick with new flavors of Aquafina, Lipton tea and Starbucks coffee. You can also expect entirely new product lines like Ben & Jerry's Dairy Drinks, says Sicher.

Healthy junk food

If you doubt Pepsi's marketing genius, consider the feat it has pulled off in its Frito-Lay snacks division, which accounts for about 60% of the company's revenue.

For most people, Frito products like Cheetos and Doritos land squarely in the category of junk food. But in another show of its ability to finesse popular trends, Pepsi has managed to win over consumers by tweaking these goodies to make them seem healthier, says Peter Schofield a portfolio manager at Knott Capital Management, which owns shares of Pepsi. The push is part of an ongoing marketing campaign, called "Smart Spot," that emphasizes "better for you" products. Smart Spot products are items Pepsi markets as meeting nutrition criteria issued by the Food and Drug Administration and the National Academy of Sciences.

Pepsi has reduced its use of artificial trans fats -- thought to be unhealthy -- in Frito-Lay products. It also offers baked versions of potato chips, Cheetos and Tostitos that are lower in calories and fat. It has rolled out potato chips with less salt and low-sugar granola bars from Quaker. The company also offers 100-calorie "mini bite" packages of products like Doritos and Cheetos.

Next up for U.S. consumers: Potato chips cooked in sunflower oil to reduce saturated fats. Pepsi is already selling these in Great Britain through a division called Walkers Snack Foods. The initial response has been good, and the company is experimenting with these in the northeastern United States.

This isn't to say Frito-Lay has escaped the junk-food category. But at least these are healthier variations on junk, and they're helping the division hold the line in an environment where consumers are putting more emphasis on healthier foods. "Smart Spot products currently account for about two-thirds of volume growth," says Morningstar (MORN, news, msgs) analyst Matthew Reilly.

Foreign growth

Pepsi began laying the groundwork for international expansion in the late 1990s by building up a manufacturing and distribution base and a network of home-grown managers.

Now those efforts are paying off -- and analysts expect more of the same ahead. Morningstar's Reilly believes Pepsi may ultimately build a global empire in snack foods the way Coca Cola has built a worldwide soft-drink empire. UBS Investment Research analyst Caroline Levy sees Pepsi as a relatively low-risk way to play volatile emerging markets such as Mexico, China, Russia and Brazil. Here are the highlights of Pepsi's foreign efforts.

• Rather than push products popular with Americans, the company draws on the expertise of local managers to invent snacks catering to local whims. So Pepsi's Frito-Lay division in Mexico sells chips with chili, plantain and lime flavors. In China, they offer crab- and duck-flavored chips. Go to India, and you'll find lentil-based snacks from Frito-Lay. These products are sold by companies with local-sounding names, like Sabritas in Mexico. The strategy seems to work. In the first quarter, Pepsi gained share in 21 out of its top 25 snack markets globally.

• There's a growing middle class in emerging countries that can now afford inexpensive "luxuries" like a bag of chips and soft drinks, says Stifel, Nicolaus & Company analyst Mark Swartzberg. He says 52 countries with a population of 1.5 billion have now reached income levels similar to those in the United States in 1947. "We believe that this sort of backdrop translates into considerable opportunity for major consumer products companies such as PepsiCo," says Swartzberg.

• Profit margins abroad will increase as sales expand but costs remain relatively stable, because much of the company's infrastructure is already in place, says Morningstar's Reilly.

Cheap, for now

Despite the strong advance in Pepsi shares over the past few years, the stock still looks relatively cheap, says Knott Capital's Schofield. It trades for about 18.5 times next year's earnings estimates. Pepsi's mean price-earnings ratio over the past five years was 21.3 times earnings.

One thing that should help shares appreciate is Pepsi's ongoing use of its formidable cash flow to buy back shares and hike its dividend. Pepsi returned more than $4.6 billion to shareholders last year through buybacks and dividends. Merrill Lynch (MER, news, msgs) analyst Christine Farkas expects the company to outdo itself this year by returning $4.8 billion to shareholders.

At the time of publication, Michael Brush did not own or control shares of any of the stocks listed in this story. Brush is an award-winning New York-based financial writer who has covered business and investing for The New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.