Since I recommended PepsiCo Inc. (NYSE: PEP) on Oct. 20, the stock has greatly outperformed the market, up about 10%. 

However, the stock has underperformed since the market began its rebound on March 10. And since the end of March, Pepsi’s shares have lagged those of arch rival, The Coca-Cola Co. (NYSE: KO), since the end of March, as well.  I recommended Coca Cola last week after the company reported stellar growth in the emerging markets.

While Pepsi’s less-than-stellar performance is not yet a major concern, the trend is discomforting.  In addition, there has been a major divergence in the strategies of these two companies. 

While both Coke and Pepsi divested of their bottling operations many years ago, Pepsi just agreed to buy back two of them: Pepsi Bottling Group Inc. (NYSE: PBG) and PepsiAmericas Inc. (NYSE: PAS). And it paid a stiff premium in each deal, about 24% and 23%, respectively, above their pre-deal market prices. The total value of the deal was a cool $7.8 billion. 

Now allow me to say that these companies are impressive operations by themselves:

• Pepsi Bottling Group is PepsiCo’s largest bottler. The company takes in $14 billion a year and operates in the United States, Canada, Greece, Mexico, Russia, Spain and Turkey, and boasts 67,000 employees.

• Pepsi Americas is PepsiCo’s second-largest bottler. It brings in $4.9 billion annually from operations in the United States, Ukraine, Poland, Romania, Hungary, the Czech Republic and Slovakia.  In addition, its new joint venture covers the Caribbean and Central America.

So why bother with these acquisitions?

The justification for this move is that “in a rapidly changing, more-complicated global market, a leaner, more agile business model is pretty important," said Pepsi Bottling Group Chief Executive Officer Eric J. Foss.

Pepsi touted the tie-up itself, citing such advantages as attempting to create a more-flexible, efficient and competitive system that is more inclusive of other Pepsi brands.

The idea is that a merged operation will allow for much faster introduction of new products, for bundled offers, for enhanced customer service, and for cost savings from redundancies and economies of scale.

Sure, we can buy into many of those ideas, which are sure to result in some gains.  In fact, we can even envision the many new marketing initiatives that will result from these acquisitions.

But make no mistake: What has pushed Pepsi to go in this direction is the superiority of Coca Cola in the emerging markets.  While both firms prided themselves on product innovation and marketing, Coca-Cola has come out on top, as I wrote last week.

In addition, the capital requirements of a bottling and distribution operation are very high and the return on equity is much lower than Coca-Cola’s core business of creating the product, marketing it, and selling the concentrate and bottling rights to bottlers.  This decision will make less cash available in the immediate future for stock buybacks and dividend increases and represents a big gamble.

There are two pressing questions to have in mind:

• Will the marketing synergies PepsiCo claims it will garner from the deals be successful in winning market share away from its rival and thus justify the added capital requirements of the newly acquired operations?
• And will Pepsi be able to capture the synergies from the merger fast enough?

What’s for sure is that Pepsi’s action goes against its decision to concentrate on its core competencies. Management theory has proven time and again that companies should concentrate in one segment of the entire value chain (in Coca Coal’s case, product innovation and marketing) and leave the less-attractive and less-profitable areas to others.

Furthermore, it’s clear to me that “asset-light” companies – firms such as C.H. Robinson Worldwide Inc. (NYSE: CHRW), whichdivested assets that have large financing requirements and that carry large fixed costs – reduce the cyclicality of the business, and thus reduce the risks to profits from economic downturns.  That means “asset-light” companies are preferable to “asset-heavy” companies.

Therefore, my bias is against the added complexity and capital requirements involved with the Pepsi deal.  And we must now wait to see if the company can deliver on the two key questions above.  But we can never count out Pepsi’s innovation and resiliency, and so we will give them the benefit of the doubt.

PepsiCo stock closed down 9 cents, or 0.16%, at $57.74 a share Friday. That’s up 32% from its hit 52-week low of $43.78, reached in Early March.

Recommendation: “Hold” PepsiCo Inc. (NYSE: PEP), but do not add to your position, and give preference to Coca Cola’s stock – at least until Pepsi is able to prove that it can execute the merger efficiencies and win market share from its arch-rival (**).

** Special Note of Disclosure: Horacio Marquez holds no interest in PepsiCo Inc.

By Horacio Marquez
Money Morning

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