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
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-----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.