By David Kathman, CFA, Ph.D. | 04-30-99 | 12:00 AM | Email Article
In the flurry of high-tech IPOs these days, you might have missed the debut of Pepsi Bottling Group PBG earlier this month. A 60% stake in the world's largest bottler of Pepsi products was spun off to the public from parent PepsiCo PEP without a lot of fanfare, and the stock hit the market with a thud, drifting downward from its offering price of $23 to $21.69 at Thursday's close. No wonder; it's not the most exciting company in the world, and its financials are nothing to shout about.
David Kathman, CFA, Ph.D., is a senior manager research analyst for Morningstar.

The main interest here lies not in PBG itself, but in what the spin-off will mean for its former parent. Pepsi's decision to retain 40% of its bottler was a deliberate one, designed to turn its bottler into what's known as an "equity investee", or a subsidiary that's 20% to 50% owned by a parent company. Once a parent's control of a subsidiary dips below half, some accounting magic happens that usually boosts the parent's profit margins and otherwise makes its income statement look better. The reason has to do with the differences between the consolidation accounting method (used when the parent owns 50% or more) and the equity method (used when it owns 20%-50%).

Under consolidation, all of the subsidiary's revenues and expenses are included in the parent's income statement, and the part of the profits attributed to the part of the subsidiary not owned by the parent is subtracted out. Under the equity method, things are reversed. None of the subsidiary's revenues or expenses are included on the parent's income statement, but a percentage of its profit (the "equity income") gets added in, corresponding to the part of the subsidiary that is owned by the parent. The amount of profit is ultimately the same under the two methods, but reported revenue is less under the equity method, increasing the company's net margin (profit divided by revenue). That's why companies prefer the equity method -- unless the subsidiary is much more profitable than the parent -- and why they often keep their control of subsidiaries just under 50%.

The specific case of PepsiCo and PBG illustrates this very well. In 1998, PepsiCo had a net margin of 8.9% on revenues of $22.3 billion. Pepsi Bottling, which at the time was a wholly owned subsidiary, lost $192 million on revenues of $7 billion; it had been barely profitable in each of the previous five years, with net margins around 1%. If PepsiCo had spun off PBG at the beginning of 1998, and thus subtracted all of PBG's figures from its income statement, its net margin would have been around 14%. Nifty, eh?

In spinning off its major bottler but retaining an equity interest between 20% and 50%, PepsiCo follows the lead of its rival Coca-Cola KO, which did the same thing back in 1986. Coke's spinoff of Coca-Cola Enterprises CCE was engineered by an accounting whiz named Douglas Ivester, who's now the company's CEO; it gave a considerable boost to the company's margins, since Coke's bottling operations are just as low-margin and capital-intensive as Pepsi's. In fact, Coke owns an equity interest in many of its bottlers all over the world, and when these bottlers show a profit -- as they have most years -- the equity income they contribute can make a nice addition to Coke's bottom line.

But that's not all -- these equity-owned bottlers can also boost Coke's profits through something called gains on issuances of stock by equity investees. When one of the bottlers issues stock to a third party at a price higher than the price Coke originally paid for its stake, Coke's equity in the bottler increases, and that gain eventually makes its way into Coke's income statement. In 1996 and 1997, several of Coke's bottlers issued large amounts of stock to fund acquisitions, from which Coke reaped several hundred million dollars each year. In fact, income from its equity bottlers -- the combination of equity income and gains on issuances of stock -- accounted for 18% of Coke's total net income in 1996, and 14% in 1997. That's about equal to Coke's earnings growth in those years.

The Pepsi Bottling Group is not likely to provide such windfalls for PepsiCo. Even in its good years, PepsiCo has barely managed to break into the black, and last year it lost money, which shaved a little off Pepsi's earnings. But getting PBG's numbers off Pepsi's books will more than make up for that. As Coke's example has shown, spinning off most of a low-margin subsidiary can make both the parent and the child look better.
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David Kathman, CFA, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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