PepsiCo profit dip could lift chain franchising

PepsiCo profit dip could lift chain franchising

Richard Martin

Seeking to reassure restaurant-wary Wall Street, PepsiCo Inc. has touted new-product results at Pizza Hut and Taco Bell and said the conglomerate may mimic its archrivals Coca-Cola and McDonald’s to expand more profitably.

In the wake of PepsiCo’s first-ever annual decline in restaurant earnings, chairman Wayne Calloway told analysts the company could temporarily cut off and reallocate its $1 billion-a-year capital investment in foodservice and rely on franchisees for a larger proportion of chain expansion.

“If our restaurants have plateaued, as rational business people we would obviously reconsider how we play our cards within our portfolio,” Calloway said, according to a transcript of his remarks to a Scottsdale, Ariz., convention of stock watchers.

“Obviously, we don’t believe that is the situation,” he added, in focusing on what he dubbed skeptics’ “No. 1 question of the moment: restaurants” But if real growth does not meet expectations, PepsiCo could curb its longstanding penchant for company-store dominance in development, he said. “So instead of having two-thirds of the new units we develop each year be company owned, we [might] hold it to 60 percent.”

Such a change, if implemented, “doesn’t sound dramatic, but it frees up $50 million in cash, increases the free cash from restaurants by 15 to 20 percent and still allows us to develop markets aggressively,” he added.

Another strategic scenario he said PepsiCo could follow, in the area of international development, “borrows’ from tactics already employed by McDonald’s and Coca-Cola. “They swap ownership within their systems as conditions develop,” Calloway said, referring to the burger chain’s 80-percent franchisee ownership and what he said was Coke’s practice of expansion funding through turnkey sales of regional bottling plants to licensees.

Because of PepsiCo’s 17-percent compounded rate of growth in restaurant operating profits in the 16 years preceding 1994, the company chose to retain ownership of most restaurants in its systems, unlike other leading franchisors. “But now, if we were to do [more franchising and joint ventures] with our international restaurants, we would reduce our capital spending by more than $300 million,” he said. “That would more than double our annual free cash generation.”

Those examples and “an almost infinite variety’ of other tactical alternatives were outlined by the PepsiCo chief to counter concerns generated by his company’s 6-percent annual dip in chain profits last year, to $730 million. The $50 million decline in restaurant earnings in 1994 came despite the PepsiCo chains’ 12-percent gain in revenues, to $10.5 billion, on global systemwide sales of $18.5 billion.

Calloway also addressed concerns that 1994 was a lean year for PepsiCo restaurants in the area of sales-sparking product introductions, and he acknowledged difficulties his chains faced in competing with 99-cent Big Macs and Whoppers made possible by low beef prices.

“One year without enough [positive] product news is not a trend,” Calloway asserted. Forecasting a turnaround on that front, he said tests of Pizza Hut’s newly launched stuffed-crust pizza had yielded “about 8-percent incremental same-store sales growth.”

He predicted that Taco Bell’s new Border Lights lowfat products, which he said generated about 15 percent of sales at test units, could become “to Taco Bell what diet drinks are to colas.”

Provoked by PepsiCo’s restaurant profit setbacks last year, critics recently have made comparisons between its strategies and those of another foodservice titan, McDonald’s. Last year McDonald’s scored nearly three times more in operating profit, from about $2 billion less in revenues. And McDonald’s did so while owning only 20 percent of its chain and with far less capital deployed than what PepsiCo commits to construction and acquisitions.

In contrast PepsiCo owned 54 percent of the 19,451 domestic Pizza Hut, Taco Bell and KFC units open at the end of 1994, and it owned or had joint-venture stakes in 42 percent of the chains’ 7,348 international outlets.

Critics have pointed out that PepsiCo’s $1 billion annual capital expenditure on its chains is about $270 million more than they yielded last year in operating profits. But PepsiCo derives a 21-percent cash return on average restaurant assets and sees prospects for growth “in the high teens or better,” Calloway said.

“How many businesses in the entire world have grown profits at 17 percent a year for about 15 years?” he asked the analysts, pointing out that in the six years since 1988 PepsiCo has increased its quick-service market share “from 11 percent of a $67 billion industry to more than 14 percent of an $85 billion industry.”

Still, last year’s slowdown continues to raise questions. Analysts this month predicted that Pizza Hut and Taco Bell would post declines in profits and same-store sales for the first quarter.

For its part, Taco Bell expects the costs of its current Border Lights rollout to begin yielding “tremendous increases” in the second quarter, according to chief executive John Martin. Even though some items in the low-fat line have yet to be rolled out, “we’re already there,” in terms of Border Lights’ accounting for about 15 percent of the chain’s sales, Martin said. “It’s a $750 million business for us and growing.”

He also pointed out that Taco Bell’s year-old “asset optimization” program of accelerated franchising is consistent with Calloway’s stated options for lowering capital exposure and increasing operating income. “The game has really changed,” Martin said, describing his division’s recognition last year that “a couple of hundred” of its 3,200 company-owned units are earning less than our royalty rate would be” from franchising them.

In a remarkable about-face from an aggressive and exclusive strategy of company-unit expansion of Hot ‘n Now, Taco Bell last fall said it would begin licensing existing branches of the drive-thru burger chain. Another apparent reflection of PepsiCo’s new franchising philosophy came to light last month when Pizza Hut Inc. agreed to sell 23 branches in five states to its largest franchisee, NPC International of Pittsburg, Kan., a company that formerly had expressed frustration at Pizza Hut’s acquisition of available franchises NPC sought to buy.

But Martin dismissed speculation in some industry circles that Purchase, N.Y.-based PepsiCo might spin off its restaurant assets — a supposition fueled by its creation last fall of the centralized PepsiCo Restaurants International division in Dallas under vice chairman Roger Enrico. Martin also rejected interpretations of Calloway’s recent remarks as being concessions that PepsiCo should have followed the McDonald’s model of franchise expansion.

Calloway, Martin said, “was trying to explain that PepsiCo is not in a box” and has available numerous avenues for trimming capital commitments and boosting profits through increased franchising and sales of some company-owned restaurants.

Analysts said PepsiCo’s dip in restaurant profits last year probably won’t lead to any dramatic changes in the company’s restaurant game plan. “I’d be surprised if PepsiCo announces this year it is going to spin off its restaurants,” said Bill Leach of Donaldson, Lufkin & Jenrette in New York. ‘It’s not like their restaurant business is in a free fall.”

Steven Rockwell of Alex. Brown & Sons in Baltimore said more franchising by PepsiCo’s chains would be “a way for them to lessen their exposure and make their revenue and earning streams more predictable.”

Clearly assuaged by Calloway’s presentation, Caroline S. Levy of Lehman Brothers in New York issued a report last month, saying that he “hinted at significantly reduced capital expenditure” on restaurants and a freeing of between $50 million and $2 billion in cash through stepped-up franchising, sales of restaurants and more joint ventures overseas.

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