Episode Transcript
The Finance Ghost: Welcome to episode 297 of Magic Markets. If you are in the car and you're hungry, then this might be a dangerous one for you because we're going to be talking about Yum! Brands, which is the owner of KFC (that's the brand we'll all know in South Africa) and a couple of other things as well, and PepsiCo.
The reason we'll be doing this is because PepsiCo spun out Yum! in 1997, so they have this very, very long history together. But now KFC - which is part of Yum! - is replacing PepsiCo with Coca-Cola across all their US restaurants (which is perhaps a bigger deal than you might think) and the international KFC stuff will continue to serve PepsiCo.
I must be honest, I haven't been to a South African KFC in a very long time, other than to buy some Pops for a belligerent preschooler, so I'm not sure what drinks you get here. But on the plus side, in the US, PepsiCo then went and secured an 11-year contract extension with Taco Bell, also part of Yum!.
The point is that these two companies do lots of business together. Coca-Cola's managed to get a foot in the door here.
Moe, let's get straight into it. Maybe you can explain to us whether losing KFC in the US is actually material for PepsiCo? Or is it perhaps more symbolic than it is a financial disaster?
Mohammed Nalla: Yeah, Ghost. This was certainly a very interesting story last week. I think at an earnings level, it's probably not material. I'll go through some of the numbers of why I say that.
But as you say, the signalling (or symbolism, as you put it), is definitely material. Certainly, given the long history and how Yum! was actually spun out of PepsiCo, I think that symbolism actually matters.
Now, if we look at what's actually happening here, the deal covers around 3,700 US restaurants, but the financial terms haven't yet been disclosed. The international KFC and Taco Bell renewals will also soften some of that economic blow.
This is very much a US situation. One US fountain contract isn't going to break up a group that generated nearly $94 billion in revenue last year, but it is strategically awkward because there's always been this market chatter about PepsiCo needing to spin off their soda business.
This relationship with KFC ran for roughly four decades and now KFC has gone and chosen Coke over PepsiCo after a very competitive process, and at a point in time when PepsiCo has placed beverages as a core part of its plan to revive US traffic and profitability. So, that’s why it's strategically awkward.
Now, Coke already accounts for around 70% of US carbonated fountain volumes, and that channel is a Coke fortress. It has just taken another very visible account from Pepsi, which is going to increase the temperature on that narrative that PepsiCo should reconsider its soda business, or at least how they go about doing business.
My overall read on this is that it's probably a small earnings event, but it is a large signal. Pepsi can absorb the lost syrup sales, but it can't get away from what this says about the bigger picture and around execution in North American beverages.
Ghost, obviously there are two sides to this coin. What are some of the key recent strategic takeouts from the comments made by the Yum! executives?
The Finance Ghost: Yeah, absolutely. So, there have been a couple of interesting executive comms that have come out. There was a conference presentation and an earnings call almost three months ago (so we're nearly due another one).
On the last earnings call, the execs said that chicken is “the fastest-growing protein around the world” (I'm quoting now) “driven by its affordability, versatility and broad consumer appeal. As the world's largest chicken restaurant brand, KFC is uniquely positioned to capture that demand growth.”
Those are obviously very strong words. I think they're right, for what it's worth. I can see the growth in chicken. We're seeing other brands talk about it. McDonald's, for example, has been focusing on chicken.
Now, just because KFC is the world's largest chicken restaurant doesn't mean they are winning everywhere. Chicken in the US is very competitive. I mentioned McDonald's there and how well they've been doing in terms of their focus on chicken and winning some market share.
Interestingly, KFC points out that the historical positioning of their bone-in chicken (so that's drumsticks, for example) and the buckets for sharing hasn't necessarily aged that well. So, that's part of why they've had market-share losses.
Still, KFC US is less than 5% of operating profit, so you actually have a scenario here where, at least in the KFC context, the US is not necessarily the key market. Taco Bell obviously makes the US more important to Yum! overall, but certainly from a KFC perspective, it's more of a global play.
Now, just to prove that point, at a recent conference presentation, a KFC exec said that Yum! China (which is a separately listed business by the way; you can sometimes buy these regional champions, and this is one example) used to focus on Tier 1, 2 and 3 cities for expansion. Now, they're on Tier 8 and 9.
It just shows you how they've penetrated the Chinese market and how they've grown their footprint there. So, even if the US is so competitive, there's lots that they can do elsewhere.
Another interesting point that came out from that conference presentation is related to the restaurant industry versus food at home. Obviously, with grocery stores focusing on convenience meals, they are competing directly with the typical takeout.
Yum! talks about how, over the past couple of years, the restaurant industry has managed to become more competitive versus food at home, and how consumers have been making very deliberate choices leading to a divergence in results in the sector. It’s quite interesting how that mirrors what we're seeing in retail in South Africa as well.
A final theme to touch on: GLP-1s. In response to a question about GLP-1s, KFC said that they “don't over-rotate to any single consumer trend”. There's a spectrum of trends that they are always adapting to, and they talk about the need to be flexible and adaptable in general.
So yes, lots of corporate speak there, but I think that there is a good underlying message here, which is to say, “Hey, chicken is really growing and we're happy to grow with it.”
Now Moe, this consumer pressure has an obvious read-through to PepsiCo, right? And so do the GLP-1s, by the way. But, without necessarily going into that level of detail, what have you seen in the latest PepsiCo numbers? How is this thing doing?
Mohammed Nalla: Yeah, Ghost, I think that's a very relevant question because PepsiCo is more than just Coke in a blue can (I say that very tongue in cheek). We've covered PepsiCo in Magic Markets Premium before and showcased how it's this behemoth of a snacks and beverage business.
Now, if you look at that, food represented 58% of revenue last year and beverages, only 42%.
Food includes some of your favourites, Ghost – Lay's, Doritos. They've also got Cheetos and Quaker. In drinks, very important, you’ve got drinks beyond the sodas. You've got Gatorade (which is a massive brand up here in the US) alongside things like Pepsi and Mountain Dew.
For South African listeners, it also owns the Pioneer Foods portfolio. So, if you think of things like Sasko, White Star, Bokomo, Ceres and Liqui-Fruit, that all falls into PepsiCo. And so, it's a much broader consumer business than Coca-Cola.
Looking at the latest quarter, it looked respectable at headline level. Revenue was $25.3 billion – up 5.6%, of which organic growth was 3.1%. Operating profit jumped 19%, but that did include a favourable acquisition, some divestitures and commodity-related items.
If you look at the core operating profit, that grew just 3%, and, importantly, core margin fell by 35 basis points. So, that's showing you that there are some cracks below the headline.
The big problem here is actually the North American beverage business. Because there, if you look at revenue, it grew 5% but mainly because of acquisitions. If you look at it just organically, revenue declined slightly and volume also fell around 2%. So, those are the cracks in the North American business.
Looking at just foods, food volume was broadly flat, but PepsiCo North America's core margin for foods fell 280 basis points. That is a big signal on this consumer story, because the company invested in affordability (effectively pricing, sizing and so forth). They also invested in advertising and marketing.
And then international, that was far healthier. International core margin expanded by 105 basis points.
Management also cut expected constant-currency core EPS growth for the year from the lower end of 4% – 6% to just 1% – 2%. So, those consumer pressures are definitely coming through. It's not a collapse in demand, but it showcases how a low-volume, high-cost squeeze has come through in the company's most important market.
Touching very quickly on the GLP-1s, I do see it as a structural issue, but it is too convenient to just blame everything on the GLP-1s. I think the story at PepsiCo is one of affordability, innovation and basic execution. Those are the more immediate problems.
But Ghost, there's also a lot going on at Yum!. I mentioned acquisitions and divestitures at PepsiCo. What's happening with Yum!? I believe they're looking at selling Pizza Hut. What's driving that?
The Finance Ghost: Yeah, so they are selling Pizza Hut. They're selling it to a combination of private equity and Yum! China (depending on the specifics of the deal and which underlying restaurants we're talking about) for around $2.7 billion.
This will leave them with KFC, Taco Bell and The Habit (Habit Burger & Grill) – I don't think any of us down here know the last name (I wish we had… Well, I don't know if I wish we had Taco Bell; I just wish we had good Mexican in South Africa), but we certainly know KFC – and they'll use the expected net proceeds of $2.3 billion to actually reduce debt.
Pizza Hut was around 10% to 12% of operating profits, so it's a significant change to the group. They are selling a chunk of their business here.
What's more interesting is they were asked at that conference whether they would look for another brand or just focus on what they have now. The answer was that they would look at a brand if the right idea is out there. But they also make reference to disciplining the portfolio, because they still have a very long growth runway ahead for KFC, Taco Bell and Habit.
Opening more outlets is key to any quick-service restaurant strategy, so that's really what they're talking about here.
At that conference, this rule of thumb came through around 5% per year unit growth as a magic number. Now, that may not sound like much, but it's hard to do it every year. And once you get to scale and you have thousands and thousands of restaurants, 5% a year becomes a lot of additional restaurants.
Of course, you're not going to do it unless you get proper payback. With Yum! quoting two- to three-year paybacks for units in regions like the Middle East and China, for example, those are really good returns for the people investing in these places.
That's like a 50% earnings yield, potentially and you get your money back in literally two years, which is incredible [laughing]. Great returns there for well-capitalised franchisees who can then push that growth strategy.
So, Yum! is simplifying its portfolio in terms of brands and growing its footprint, whereas PepsiCo, Moe, has a much broader portfolio. Do you think that diversification is still an advantage for them? Particularly when you compare it with Coke, which I guess is more focused?
Mohammed Nalla: I would see it as both an advantage and a burden, right? If you look at Coke's latest reported quarter, it was much cleaner than PepsiCo. Their global volume grew 5%, organic revenue up 6%, and they gained value share, so comparable operating margin also expanded, incidentally, from 34.7% to 35.6%. Pretty strong numbers coming through from Coke's side.
But now I wouldn't want to compare those margins blindly, because Coke largely sells concentrate through a franchise bottling system.
PepsiCo is a very different business. They own a lot more of the bottling, manufacturing and physical distribution. Plus, they have that massive foods and snacks business, as we discussed earlier.
Finished products generate a lot more revenue, but they then generally carry lower margins and require more capital, and that's why they're not directly comparable.
I think the business model explains some of the gap, but not all of it. Coke is growing volume and gaining share, but Pepsi is really in repair mode, specifically in North America.
That is why Elliott Investment Management's roughly $4 billion activist stake in PepsiCo is so important. I mentioned this narrative around PepsiCo's strategic direction: do they spin off the soda business or not?
If you look at Elliott Management, they've been pushing for lower costs, a simpler portfolio (as you mentioned), and potentially more beverage refranchising.
You asked the question whether Pepsi's breadth still creates that advantage or if it's just really an excuse for complexity. I would give you the other side of this, Ghost. If you look at something like Taco Bell, that demonstrates the bull case for strategic engagement by PepsiCo. Because there's a brand called Baja Blast which grew out of that partnership. It's now a billion-dollar brand.
So, PepsiCo can then combine things with their beverages and snacks. They can combine it in ways that Coke really can't. If you look at something like the Doritos Locos Tacos, that's an obvious example. It might be lost on South African audiences, but it's just showing you the use case for PepsiCo's products through various channels and strategic engagement.
Pepsi's best defence, I would say, is not trying to become a cheaper version of Coke but rather proving that this mix of the portfolio that they have (the integrated) produces more innovation and profit than a focused beverage model like you're seeing at Coke. I'm not sure they've illustrated that just yet.
Now, Ghost, quickly jumping back to Yum! – I know the next earnings call is November 3rd. That's right around the corner. Can you give us the highlights reel from the previous quarter that sets the scene here?
The Finance Ghost: Yeah, absolutely. It's always a good idea to just have some sense of what might be coming in the next set of earnings. So, if we look back at the second quarter (and if you exclude Pizza Hut, which is now important because it's been sold), then you'll see 6%-unit growth – so they are running ahead of that 5% magic number that came up at the conference – and 4% same-store sales growth.
So, overall? Solid. Number of restaurants, up. Growth per restaurant, also looking decent. Digital sales, up 25%. So, the omnichannel strategy is doing its thing when it comes to these restaurants as well.
South Africa did get a nod, by the way. Yum! described us as “an example of a more penetrated market where KFC is building more store density”. It ties nicely into that digital strategy that I've just mentioned and the overall market leadership story.
And that's really how it is for KFC. It's a big growth area. They believe they can develop very strongly in markets where they are still underpenetrated. It's much more than just a US company.
Moving on to Taco Bell, it’s a different story, and hopefully a temporary issue. After that quarter, they had a virus outbreak from iceberg lettuce which led to plunges in foot traffic – and in the share price, by the way. If you have a look in July, it fell from around $167 to $147, then went all the way down to $136 before coming back to $150. So, it's been super volatile.
This is part of the issue, because in the first few weeks of this next quarter that they will be reporting on, same-store sales in Taco Bell were down 2%. Obviously, no one wants to get sick. So, when you have a food safety problem, then it's a tough thing to manage, and people just avoid your stuff at all your restaurants.
That's the issue with having this nice big, branded footprint. It's great when everything's going well. It's not great when something goes badly.
So, Taco Bell, hopefully a temporary issue. KFC, really their big growth engine. So, if you like chicken and you fancy the thought of investing in chicken, then Yum! is trying to speak to you directly with this strategy.
And the share price is holding up a lot better than McDonald's, I must say, which has been under a lot of pressure recently. Management came out with a very expensive store remodelling strategy – we actually covered it in Magic Markets Premium when we did McDonald's. The market is less than enamoured with this plan, although also a very volatile share price because I think people are just very concerned about consumers, Moe.
Mohammed Nalla: Indeed Ghost, I think bringing the show to a wrap, you've touched on some of the investment performance there. If I bring that back to Pepsi and I look at Coke as well, the market's really already delivered that harsh verdict on Pepsi.
If you look at the share prices, certainly through the last week, Pepsi – down around 13% over the last 12 months, 16% over the last three years, and 17% over the last five years. Coke, by contrast – up approximately 37%, 71% and 71% over the same time periods.
Now, if you add back dividends, Pepsi is roughly flat over five years, but Coke has returned around 97%, and that is an enormous gap. If you look at that, Pepsi is now around a third of the value that it was in 2023 at its peak. It trades at the widest discount to Coke in more than 25 years.
This doesn't automatically make the stock cheap, but it is compelling if you believe a turnaround is possible, and that's what those activist shareholders are pushing for.
My key takeaway is that KFC alone doesn't define this whole Pepsi thesis, but there is a larger argument at play. It's being showcased very relevantly by those activists. And so, it's really a question of whether management will listen and then, beyond that, if they have what it takes to actually craft and deliver a proper turnaround.
Unfortunately, that's all we have time for this week. Let us know what you thought of the show. Hit us up on social media. It’s @MagicMarketsPod, @FinanceGhost and @MohammedNalla, all on X, or go find us on LinkedIn. Pop us a note on there.
Until next week – same time, same place. Thanks, and cheers.
The Finance Ghost: Ciao.
