The Business Of

Fast Food | PepsiCo | What Are Their Margins?

Morning All!

So, yesterday we dug into how PepsiCo makes money. And we saw that Walmart was their biggest customer, making up ~14% of PepsiCo’s revenues. We saw that pricing growth is usually limited because Walmart, Tesco and other big supermarkets have the power in negotiations. And we saw that volume growth for PepsiCo has been low for the last decade - below 2% per year. I guess there’s a limit to how much Pepsi and Doritos we can all consume! Even Joey has a limit…

But that’s enough about revenues! Let’s chat about costs and margins. And below, we can see there’s a little issue. PepsiCo don’t really break out their costs much on their income statement! With just ‘cost of sales’ and ‘selling, general and administrative’ figures given. Thanks PepsiCo… that tells us lots!

However, fear not! Like we did with Huel last week, let’s have a bit of fun. I’ve dove into the annual report. Done a bit of research. And actually, there’s plenty to chat about! This newsletter is slightly on the longer side. But I think it’s a super interesting one. So, without further ado!

The Sweetest Of Raw Materials

So, let’s start as always with ‘cost of sales’. What makes up PepsiCo’s cost of sales? Well, we saw last week, a large part of Huel’s cost of sales were the ingredients needed to make the Huel drinks. Remember this image…?

Well, with PepsiCo, it’s a similar story! The raw materials needed to make the food and drink are the majority of the company’s cost of sales. And one of the most important ingredients needed to make Pepsi is the sweetener. Which surprise, surprise, gives Pepsi (and Coke) their sweet flavours! However, the type of sweetener used can vary by product. High fructose corn syrup (HFCS) is used in normal Pepsi drinks. But because HFCS brings a lot of calories with it, the Diet Pepsi drinks are sweetened with less calorific, artificial sweeteners like aspartame.

Biology lesson over! So, how do Pepsi take these ingredients and make them into Pepsi? Well, this is actually an incredibly sophisticated process. I never realised quite how sophisticated! But to put it super simply - HFCS is mixed with water and other flavours to create the syrup. This syrup is then mixed with carbonated water and other ingredients (e.g. caffeine, citric acid, etc). And voila - you have Pepsi! This article here is a slightly more in-depth - but still simple - read about how this process happens!

Finally, PepsiCo Have Some Control!

Okay, so we’ve got the ingredients. And made the concentrate (basically the final mixture). And that’s the majority of cost of sales. But what other cost of sales are there? Well, this depends on who PepsiCo are selling their products to. If PepsiCo are selling directly to supermarkets, or restaurants, or stadiums, then there’s the cost of packaging. You can’t just give Tesco the Gatorade or Pepsi drinks without packaging! PepsiCo will need to put some drinks in bottles. Others in cans. They’ll need to put some food in boxes. Some in packets. And these materials required for packaging the products is another big cost.

However, what about when PepsiCo are just selling the syrup to their packaging partners? Well, in these cases, PepsiCo have no packaging costs! It’s their partners who take care of the bottling, canning, boxing, packeting. I think those are all words! The graphic below gives us a picture of how this works…

Now, what does this all really mean? Well, it means that PepsiCo’s gross margin when they sell to their packaging partners is higher than when they sell to Walmart. And there’s 2 reasons why this is the case. One, their costs are lower. They don’t take care of the packaging like we’ve seen.

But also, two, PepsiCo are the ones in control of negotiations. Remember what we said yesterday. When PepsiCo sell to Walmart, PepsiCo need Walmart more than Walmart need PepsiCo. But when PepsiCo sell to their bottling partners, PepsiCo make up a huge percentage of their bottlers’ revenue. Sometimes as high as 60%. And so, PepsiCo have a huge amount of power to set prices. Unfortunately, PepsiCo don’t split out the margin differences between selling directly to supermarkets vs selling to bottlers. But we can see how the company’s overall gross margin has trended over the last decade. And there’s not been much change here!

Tomorrow, we’ll talk a little more about the relationships PepsiCo have with their bottling partners. Because it’s really very interesting. And actually, really very similar to what McDonald’s have with their franchising model!

How On Earth Does Pepsi Get To 660,000 Restaurants?!

But let’s move swiftly on. So, PepsiCo either sell directly to customers. Or they sell to packaging partners who sell their products on. But one question we haven’t answered yet is - how do PepsiCo’s products get to their customers? And this is another huge part of PepsiCo’s costs - distribution.

In 2022, PepsiCo spent a whopping $15 billion on distributing their products to customers! But what on Earth are these distribution costs? Well, PepsiCo have 3 main methods of distribution. And the image below illustrates each of them…

Their first distribution method is direct store delivery (DSD). This is where PepsiCo or their bottling partners deliver the finished goods (e.g. the Pepsi cans, Lay’s packets) directly to customers’ stores. The main costs here are the costs of the drivers and the petrol. Which might not sound like a lot. But given that there are more than 12,000 supermarket stores in the UK… these costs really start to add up! And that’s just the UK by the way. There are over 63,000 supermarkets in the US! No wonder PepsiCo are looking to Elon’s electric trucks for help…

The second method PepsiCo and their bottling partners use is slightly less expensive. And it’s where products are delivered to customer warehouses, e.g. Tesco or Walmart’s warehouses. It’s then up to Tesco/Walmart to transfer the goods over to their stores. Now, why is this less expensive? Well, because there’s far less warehouses than supermarkets! Tesco have ~2,500 supermarkets across the UK. But only 20 warehouses. It takes a lot less petrol ferrying goods to 20 locations rather than 2,500!

The final way PepsiCo and their partners distribute their goods is by using third party distributors. And a question you may be wondering is - why do they need to use an external company to help them? Won’t the first two methods be enough? Well, think about it. Yes, there are 63,000 supermarkets in the US. But how many restaurants are there? 660,000! How many stadiums? How many offices and schools? All of these locations need Pepsi, Lay’s and other PepsiCo products. And it’s simply not possible for PepsiCo to deliver to all of them!

One third party PepsiCo have used is Sysco Corporation. I doubt anyone’s heard of this company. But they’re actually a $37 billion company! Now, I don’t know about you - but I think this distribution section is pretty mind-blowing. The complexity involved here to distribute to THAT MANY locations is hard to comprehend. Clearly there’s some pretty smart people working at PepsiCo…!

Ahh That’s Why I Don’t See Pepsi On The Bottom Shelf!

Okay, so the final main expenditure for PepsiCo is advertising and marketing. And the company spent a sizeable $5.2 billion (~6% of revenues) in this area last year. Now, although advertising and marketing costs seem super obvious to understand. They’re actually not! But let’s talk about the obvious part first.

The obvious part is the adverts and sponsorships that PepsiCo run. On Monday, we saw Lionel Messi is an influencer for Lay’s. And back in February, Pepsi partnered with Ben Stiller and Steve Martin for this cracking Superbowl ad…

But there’s also a less obvious part of advertising and marketing. And the reason it’s less obvious is because it’s so natural for us. When we walk into a supermarket and see Pepsi cans, Walker’s packets, Quaker Oats boxes, all in the most ideal locations on the shelves. We probably don’t think much of it. Well, at least I don’t! But did you know… PepsiCo pay supermarkets for those locations!

They pay supermarkets to have dedicated Pepsi stands. To have Lay’s crisps at eye-level in the stores. And they’re doing this (and much more) so that their products are in the best place for customers to buy them. I mean, tell me the last time you saw a box of Pepsi cans on the bottom shelf… never! PepsiCo pay to make sure customers aren’t bending down so far to get to their products! And it’s not just PepsiCo by the way. The next time you see a Wrigley’s chewing gum stand right next to the checkout. Tempting you to just throw it into your bag. You know Wrigley’s have probably paid quite a lot for that!

Stagnant EBIT Margins…

Okay, so to wrap up, let’s put all these costs together. And have a look at what’s been happening with PepsiCo’s margins. Well, the chart below shows us that it’s a far from ideal picture! PepsiCo’s EBIT margin has declined from 18.5% in 2006 to 13.3% in 2022.

But why is this the case? Well, one main factor is what we discussed yesterday… currency movements! The negative currency movements impact revenue, and hence impact margins. But again, we can’t blame it all on currency.

There are two other factors at play here. But I don’t want today’s newsletter to drag on for much longer. And actually, these factors fit in pretty well with the topic tomorrow - so let’s save it for then! In the meantime, maybe you can have a think - why has PepsiCo’s EBIT margin struggled over the last decade?

14th Jun 2023

Nigel Jacob CFA