Adam Fleck: We assign both co*ke and Pepsi wide economic moats, which may come as a bit of a surprise to some people given that co*ke has better beverage market share, higher profit margins, and ultimately better returns on invested capital.
However, the wide moat rating we assign Pepsi is primarily due to the company's food business. Snack foods like Lays Potato Chips, Quaker Foods, and Doritos drive about half of Pepsi's revenue and are actually more profitable than the beverage arm [of Pepsi] and other food manufacturers. We attribute this outperformance to Frito-Lay's dominance in the market. We peg Frito-Lay's market share at about 25% globally versus only single-digit shares for other competitors. This allows Pepsi to really control the aisle both in the at-home grocery store segment and in media consumption areas like convenience stores and gas stations. This builds the brand and ultimately drives better pricing power for Pepsi and backs up our wide economic moat.
I think the natural follow-up question then is why doesn't Pepsi split apart its beverage business and the snack business? We think that there are some substantial synergies in running these businesses together; there are probably about 1% of sales or so driven from central purchasing, cross marketing opportunities and even in some regions shared distribution assets.
We're not suggesting that co*ke needs to go out and buy its own snack-food business. Frito-Lay and Pepsi have been together since the 1960s. And admittedly though, Pepsi has had some success with split-offs in the past. Yum Brands comes to mind in the late 1990s. But ultimately we think that the potential management distraction and cost of such a separation presents a negative net present value.
Both co*ke and Pepsi do have sustainable competitive advantages, but right now we'd actually be buyers of co*ke before Pepsi. I think co*ke offers a better margin of safety, better opportunities internationally given its dominant presence in emerging markets, and an Exemplary Morningstar Stewardship Rating that we think backs up co*ke's higher multiple on our fair value estimate.
