It's Time: The Case For Breaking Pepsi Into Two

Pepsico's (NASDAQ:PEP) management has long argued that combining the soda and snack food operations under one umbrella has been an advantage. This analyst believes that advantage is now gone, and the company should split into two. Here's why. 

Introduction

Normally when I write about a company here on Canadian Dividend Investing, I like to spend a little bit of time going over its assets, why those assets are interesting, and so on. 

Such an exercise seems like a waste of time for Pepsico. Virtually everybody in North America is familiar with the company's products, and the rest of the world isn't that far behind. Pepsi is a dominant multi-national corporation whose tentacles have snaked pretty much everywhere.  

Pepsico is divided into seven divisions, which include:

1. Frito-Lay North America
2. Quaker Foods North America
3. Pepsico Beverages North America
4. Latin America
5. Europe
6. Africa, Middle East, and South Asia
7. Asia Pacific, Australia, and New Zealand

In the interest of simplicity (and copying the company's lead), we'll break down Pepsico into three different parts:

1. North America Food (includes Frito Lay and Quaker)
2. North America Beverages (includes Pepsi and its various brands)
3. International (which includes both food and beverage sales outside of North America)

From a recent investor presentation, here's a quick look at the various brands that exist under the food and beverages parts of the business, respectively. You’ll likely notice a few regional brands under each category that are popular outside of Canada and the United States. 

Let's look at how the business has changed over the last decade or so. From the 2015 annual report, we can see that the company's revenue mix was 53% food, and 47% beverage. 56% of sales were from the United States, while 44% came from outside of the U.S. And the international part of the business accounted for 40% of sales back then, with Canada and the United States contributing 60% of total sales. 

We'll also note just how profitable Frito Lay North America was compared to the rest of the company. Despite contributing just 23% of sales, just one part of Frito Lay was responsible for nearly half (46%) of the company's operating profits. 

Fast forward to 2024, and a slightly different picture emerges. Food accounted for 58% of sales in 2024, with beverages dropping to 42%. Frito Lay (and Quaker) continued to deliver the largest share of operating profits in 2024, with 42% of total company operating profit coming from that division. Earnings from North America beverages dropped to 19% of total profits. The international division accounted for 39% of profits in 2024, compared to less than 20% of profits in 2015. 

In short, we've seen a few different themes emerge over the last decade, including:

• Strong growth in the international division

• Weakness in the North American bottling division

• Continued strength in the North American food business

Pepsi has been a stalwart blue-chip dividend growth stock for a long time. It has millions of happy shareholders who have enjoyed solid total returns combined with consistent dividend growth. Pepsico has famously increased its dividend each year for the past 53 years. That's a fantastic record. 

Despite this long-term success, investors have turned bearish lately. The stock has underperformed the S&P 500 over the last few years, and it has been especially weak over the last 12-18 months.

Two camps have emerged. Bulls say today is a great buying opportunity, enticed by the stock offering one of its highest dividend yields in recent years, and a relative low in valuation. Bears say Pepsi's best years are behind it, with issues like GLP-1 penetration, too aggressive price hikes, and government crackdowns on junk food potentially weighing on the stock for years to come. 

Rather than get into these arguments -- as so many Pepsi articles have done -- I thought I'd take a different approach. Today I'll argue that Pepsico shares are a buy, but they'd be a strong buy if management did the prudent thing and split the company into two. 

Let's take a closer look at a few reasons why this humble (and handsome!) newsletter writer believes such a move would unlock shareholder value and send shares higher. 

The synergy benefits are overstated

I'm not the first guy to bring up the idea of splitting Pepsi into two. Others have done it before me, and usually the response for doing so goes something like this. 

Pepsi gets many synergies from having both brands under one roof. Various parts of the company can work together and increase total sales by offering promotions or displaying products near each other. After all, soda and chips often go together, especially at places like gas stations or sandwich shops. 

I can personally attest that this benefit is overstated. I was a Frito Lay sales rep in the 2010s, and back then there were various initiatives to offer chip/soda deals. Those combination deals did virtually nothing to move sales on my route, and my peers reported the same thing. 

Remember, the two North American divisions are almost two completely separate entities. Pepsi, Frito Lay, and Quaker share a common owner, and that's about it. Beverages has its own dedicated sales force. So does Frito Lay. Pepsi and Frito Lay do direct store delivery. Quaker doesn't; its products are shipped to supermarket warehouses and then delivered from there. 

Because of the current setup, Pepsi isn't getting much benefit from synergies in North America. There are some synergies in the international operations, and I'll give the company credit for those. Which is why my version of a split Pepsico would keep the international division as it is today. 

The current setup hides Frito Lay's strong results

Frito Lay North America is quietly an excellent business that gets hidden as investors focus on the beverages part of the company. 

In 2024, on an adjusted basis, Pepsico generated $14.7B in operating profits. Frito Lay North America was responsible for 43% of those profits, or $6.3B. That works out to 25% operating margins, while the rest of the company could only deliver 12.7% operating margins. 

We'll also note that 2024 was a bit of a bad year for Frito Lay North America. In 2023, that part of the company generated 26.9% operating margins. 

I'll also highlight the strong performance from the company's LATAM division, which is approximately 90% food sales, compared to just 10% beverage sales. Pepsi's operations in Latin America generated a 19% operating margin in 2024, with this strength driven mostly by potato chip sales. Sabritas is a strong brand, and the company basically owns potato chips in LATAM.

Frito Lay is a wonderful business. It has grown consistently over the last decade -- 2024's weak results were the exception, not the norm -- and generates much better margins than the rest of the company. If it were its own company, I can guarantee it would trade at a premium valuation compared to the beverages business. 

Beverages are weighing down everything else

The North American beverage business is really weighing down the rest of Pepsico. It’s slowly shrinking, too.

To demonstrate, let's take a closer look at 2015's results. In that year, the North American beverage division generated $2.75B in operating profits. That number was slightly higher than results in 2014 and 2013, which both saw operating profits in the $2.6B range. 

In 2024, as we saw above, the same part of the company generated operating income of $2.3B on sales of $27.8B. So sales were up, but profits were down. 

We'll note that North America Beverages did report a $2.5B operating profit in 2023, which could mean that 2024 was a bad year. 

Still, the overall point remains. The North American Beverages division has delivered subpar growth compared to the rest of the company. Investors can see this, and they put a lot of emphasis on that. This weighs down the stock. The solution? Spinning this part of the company into its own entity.

Other companies have been successful splitting up

It wasn't very long ago that Kellogg's management realized shareholder value could be created by taking this drastic approach. In 2023, the cereal giant officially split into two companies.

Kellanova got the company's snack food assets, along with its international cereal operations and North American frozen foods portfolio. WK Kellogg Co retained the North America cereal assets. 

Shareholders of both companies have benefited from this move. Mars is in the process of acquiring Kellanova for $83.50 per share. WK Kellogg has also agreed to be acquired, with Italian food giant Ferrero Group agreeing to buy the company for $3.1B. 

Both deals gave shareholders a nice premium, and both companies' shares have been strong while the rest of the consumer staples sector has been weak. 

There's no guarantee either part of Pepsi would be acquired if it was split into two companies, but splitting the company could make certain parts of the company -- like the slow-growing North American Beverage assets -- more attractive to outside buyers. 

Valuation 

Perhaps the strongest argument I can make in favor of Pepsi splitting into two companies would come down to valuation. 

There are a million different ways Pepsi could split itself up. In my scenario I'm going to keep most of Pepsi intact and simply strip out the North American beverages business. This is pretty much exactly what Kellogg did; it put the international assets and snack assets under Kellanova, isolating the slow-growth North American cereal assets as WK Kellogg. 

Pepsico generated approximately $12B in operating profits in 2024. The stock has a market cap of $196B as I write this. That puts the company at 16.3x 2024's operating profits. 

Pepsi Beverages North America generated $2.3B in operating profits in 2024. Since this part of the business isn't growing very quickly, I'm going to assign a 12x operating income multiple to it. Therefore, it's worth $27.6B. 

Investors already value Pepsi at a premium versus peers, and that's despite the drag on the business caused by the North American Beverages division. Without that anchor weighing down the company, I would expect the rest of the company to trade for approximately 20x operating earnings. 

The rest of Pepsi generated $9.7B in operating profits in 2024. Therefore, I would value it at $194B. Put the two together, and we get a value of $221.6B. The company could create more than $25B worth of value by splitting into two. 

Some may argue that Frito Lay and the international operations of Pepsi aren't worth 20x operating income. I'll admit that at first glance giving these assets a 20x valuation might seem high, especially when I value the North American beverages part of the company at 12x. 

However, I'll counter the argument by pointing out that, at its peak, Pepsi had a market cap of approximately $269B. This level was set in 2023. In 2022, the entire company generated $12.3B in operating income. Therefore, the entire company traded at a valuation of 21.9x operating income, and that's without the slow-growing beverage assets stripped out. I believe that Frito Lay would could command that premium valuation again, since it’s obviously the best part of the company.

The bottom line

With Pepsico shares underperforming the market on a one-year and five-year basis, shareholders are starting to get impatient. Many are arguing for drastic change. 

Splitting the company into two parts could be the catalyst needed to move the stock higher. Such a move would put more emphasis on the growthier parts of the company, and it would isolate the weaker division -- North American Beverages. 

Kellogg's separation into two could be used as an example. That split only took a couple of years to work out well for shareholders. 

I'm not sure it will ever happen, however. Pepsi's management has consistently been against the strategy. Fortunately for Pepsi bulls, I believe the strength of Frito Lay alone will be enough to drive the stock price higher.

Ultimately, I believe that Pepsi shares will eventually recover and march higher, even without breaking into two. But that doesn’t mean management shouldn’t explore splitting the company into two. It’s the perfect time to give the stock a little nudge, and I believe splitting up the two would free the beverage part of the business to become a massive share buyback machine — creating growth in earnings per share by cutting costs and hoovering up outstanding shares.