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"Performing while transforming": Nooyi in a White P lains, N.Y., Stop &Shop

Pepsi

Indra Nooyi's Pepsi challengeMay 29, 2012: 5:00 AM ET

By the numbers, PepsiCo has done a pretty good job since she took the helm six yearsago. So why is the CEO taking so much heat from investors?

By Geoff C olvin, senior editor-at-large

FORTUNE -- "Now tell me again --

what exactly is the issue with thiscompany?" Indra Nooyi asks with anedge to her voice.

She has just rattled off a list of statisticsdescribing the financial performance of PepsiCo ( PEP ), the company she hasrun since late 2006. They show that ithas been growing, earning high profitmargins, and payi ng r espectablereturns to shareholders throughdividends and stock buybacks. So, shewonders, what's the problem? Why onearth has she been taking such aninfernal amount of heat from investors,Wall Street analysts, and the media?For she has been, and she clearly resents it.

It's a drizzly morning, and Nooyi is aboard a company plane for the 25-minute flight fromheadquarters in suburban New York City to a Fri to-Lay plant in Killingly, Conn. She has been upsince 4 a.m., having gone to bed at midnight after watching The Daily Show and The Colbert Report , which she loves. "They say sleep is a gift that God gives you," she observes. "That's onegift I was never given." Definitely not fatigued, she explains how she's been transformingPepsiCo from "a North American fun-for-you company" -- maker of Pepsi, Mountain Dew, Lay'spotato chips, Doritos, Cheetos, and hundreds of other foods and drinks -- into a global enterprisewith a product line that can prosper in a world where obesity is fast becoming the No. 1 healthproblem. Making that profound shift, she says repeatedly, is "the right thing" to do. What's more,the company has been "performing while transforming," delivering those financial results shecites. Yet for all that, the conventional wisdom is that she and PepsiCo are in trouble.

More: PepsiCo: No. 41 on the Fortune 500

This is the hardest time in any transformation, when the returns haven't arrived and no one

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knows when or if they will. "The recent past reminds me of pivotal moments in our history whenbold leaders made decisions that weren't popular but were the right decisions to position thecompany for the future," says Steve Reinemund, Nooyi's predecessor as CEO, who until nowhasn't spoken publicly about the company's prospects. An example was president DonaldKendall's combining Pepsi-Cola with Frito-Lay in 1965. "Few people saw that as smart,"Reinemund says. "Major change is never applauded until your numbers prove it. And they will.I'm confident they will."

Are the critics nuts? The most widely repeated case against Nooyi is in fact off-base. It goes likethis: The stock has tanked on her watch, shaming PepsiCo in comparison with the eternal enemy,Coca-Cola ( KO ), which has soared ( see "The New Coke" ). And she has torpedoed thecompany's performance by committing far too much time and money to healthy products thatmake a CEO the darling of the Clinton Global Initiative but that real-world consumers don't wantto buy. None of that is true. The stock's total return to shareholders has exactly matched the S&P500 ( SPX ) over her tenure. The Coke comparison is invalid; when Nooyi got her job, Coke was

just starting to recover from a dismal decade, while PepsiCo stock was richly valued. There's noevidence that a greater focus on good-for-you products -- nearly all of which are in Quaker Foods, Tropicana, and Gatorade, businesses PepsiCo bought long before Nooyi became CEO --has damaged overall performance. So, as Nooyi defiantly asks, "What's the issue?"

Critics who have looked deeper point out that PepsiCo does face significant challenges that havehurt the company. Its all-important return on capital -- economic profit as a percentage of all themoney that investors have put into the company -- has plunged. Several of its most valuablebrands, such as Pepsi and Doritos, have lost strength or market share, or both. In an industry thatsurvives by exciting consumers with new products, innovation has been weak; the company has

introduced flavor tweaks such as Cherry Vanilla Pepsi, for example, but nothing to match Coke'shugely successful Coke Zero and attention-grabbing bottle and can designs . Basic execution --getting the right products into the right stores in the right quantities all the time -- has beensubpar; the company has had trouble holding its share of retailers' floor space. Overhead hasballooned, leaving the company less efficient and productive than it needs to be.

Combine those sins, and you get a company with a worrisome future. All the facts Nooyi citesabout PepsiCo's performance are correct, but they're measures of the past. Investors care onlyabout what's ahead, and they're not confident. Do the math on today's stock price, and it impliesthat investors don't expect PepsiCo's economic profit to increase for years; on the contrary, theyexpect it to decline slowly (see chart above) -- not an endorsement of management. "Themanagement team will have a period of time to execute," says Donald Yacktman, whose

Yacktman Fund is the largest non-index-fund holder of PepsiCo stock. "If they don't, you have an
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above-average bench behind them, and there'll be changes."

Nooyi acknowledges that PepsiCo has to change. In a corporate mea culpa before a roomful of Wall Street analysts in February, she and other top executives essentially confessed their sinsand outlined a plan to correct them. The company will get leaner by firing 8,700 employees(about 3% of the total), consolidating facilities, and finding other efficiencies, saving about $1.5billion over the next three years. It will increase advertising and marketing by $500 million to $600million this year, or about 15%, focusing on a handful of big brands like Pepsi and Doritos inNorth America. "We don't believe we are delivering enough incremental innovation," Nooyiallowed, and described a plan to introduce more and better new products. The cost of makingthose changes, combined with expected jumps in the prices of corn, potatoes, aluminum, and fuelwill push profits down this year. Then, the company projects, slowly but surely it will finally startraising its return on capital next year. Achieving those goals is no slam-dunk, but the plan isplausible. For PepsiCo's future and Nooyi's legacy, much depends on whether it works . For investors, as CFO Hugh Johnston says, "The question right now is, very simply, 'Show me.'"

The stakes are high. Morgan Stanley analyst Dara Mohsenian describes them starkly in hisrecent report arguing for buying the stock: Either the plan works, in which case "the stockoutperforms," or it doesn't work, which "may lead to more drastic action," such as "managementchanges" or "strategic action" -- Wall Street code for breaking up the company. Either way, thestock goes up -- a "win-win" for investors, he says. But in the second scenario, PepsiCo as weknow it, and presumably Nooyi, may be gone.

How did it all come to this -- thousands of layoffs, falling profits in a growing economy, analystsspeculating on breakups? Nooyi, who joined PepsiCo from the Swiss-Swedish conglomerate

ABB (ABB ) in 1994 as chief strategist, got the CEO's job because the board wanted thecompany transformed. She and the directors saw two massive trends that could enrich or threaten the company: globalization and the worldwide rise of lifestyle diseases -- diabetes,coronary artery disease -- influenced by what people consume. "The board put in Indra as, Ithink, it believed PepsiCo needs to recast itself over a decade or so, and it saw her as a changeagent," says John Sicher, publisher of Beverage Digest . "If it stayed mainly a North Americansnacks and soft-drink business, its days of strong growth were numbered due to limited North

American growth potential."

On globalization she had to move fastand big. PepsiCo's business reliedoverwhelmingly on developed markets,especially the U.S., which were matureand growing slowly. The rise of theBRICs was not exactly a secret, andPepsiCo trailed far behind major competitors like Nestl and Coca-Cola,which had been thoroughly global for decades. So she began buying foodand beverage companies in emergingeconomies worldwide -- Brazil, India,Ukraine, and many others --
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A good idea at the time: PepsiCo bought back U.S. bottlers after therecession, largely to control pricing. The result of that and other acquisitions? Return on capital plunged.

culminating in two big Russian outfits,the Lebedyansky juice company andWimm-Bill-Dann , which is mainly adairy business. That's a lot of buying --

over $7 billion just for the two Russian companies. But "doing it the slow way, organically, wouldhave set us back," says Nooyi. "We had to power forward and then build from there ."

Responding to the lifestyle-disease trend was at least as urgent. Obesity was moving beyond itsrole as the West's worst health problem and becoming a concern in emerging markets. For acompany that urges billions of people to consume ever more snack foods and soft drinks ,that's a problem.

Nooyi decided that PepsiCo needed a serious R&D operation to get ahead of the looming threat.The company already employed plenty of food scientists who could formulate Spicy Sweet Chili

Flavor Doritos, but it wasn't conducting serious research on how to take sugar, salt, and fat out of products. So she hired Mehmood Khan, previously a pharmaceutical research director and chief of the Diabetes, Endocrine, and Nutritional Trials unit of the Mayo Clinic, and asked him to build abig new R&D program. As they both recall, he told her, "It will take five years before we'll see anyresults. Do you have the patience for that?" She replied, "It's not whether I have the patience. Idon't have a choice."

But as the U.S. economy dived into recession and then stayed weak, a new problem emerged.PepsiCo didn't own its U.S. bottlers, having spun them off into a separate, publicly tradedcompany in 1999, as Coca-Cola had done 12 years earlier. The move worked great -- it took tonsof capital out of PepsiCo and left the company in the ultra-profitable business of selling

concentrate to the bottlers. But in a down economy like 2008-09, the model falls apart ascooperation turns to a no-win war over who will suffer most. And with huge national retailersbecoming more important -- Wal-Mart ( WMT) alone accounts for 11% of PepsiCo's total business-- the company needed control of its distribution and pricing. So it bought back most of its bottlers(Coke did the same months later) at a cost of $7.8 billion.

Aggressive acquisitions worldwide plusthe bottlers deal weren't cheap. Nooyiborrowed big and tripled the capital inPepsiCo from $22 billion to $66 billion.Yet profits barely budged. Result: Thecompany's return on capital plungedfrom 22% to 11% (vs. mid-to-high teensfor competitors). Investors hate whenthat happens.

Other embarrassments and misstepscompounded their worry. "The problemwas, as she was thinking about how to move the company into the future, there were somehiccups in North American beverages," says Beverage Digest's Sicher. Those were hiccups thatshook the whole body. The business declined through a combination of weak innovation, skimpyadvertising -- no Super Bowl Pepsi commercial in 2010 after 23 consecutive years of
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advertising in the game -- and just plain lame marketing. (Can you think of a Pepsi slogan fromthe past five years?) While PepsiCo makes most of its money from foods, the performance of itsfamous drinks in the world's largest market disproportionately influences how the company isperceived by investors, retailers, vendors, and consumers. Pepsi's U.S. market share hasdropped from 11% in 2006 to 9.2% last year, says Beverage Digest . A Tropicana packageredesign in 2009 so baffled consumers and hammered sales -- it looked like a bargain-pricedhouse brand rather than a premium product -- that it was withdrawn in less than two months. Theblunder didn't cost PepsiCo much, but it further shook investor confidence in Nooyi.

For Nooyi and the company, things got really ugly last fall and winter. With the stock price havinggone nowhere for two years while the S&P was surging, analysts began talking up the idea of splitting the company into two, snacks and beverages, which Nooyi adamantly opposed.Bernstein Research's Ali Dibadj, top-ranked in Institutional Investor's analyst ratings, calculated itwould unlock some $14 billion of value. When he asked 70 major investors an open-endedquestion about "the biggest source of potential upside" for PepsiCo, their No. 1 answer was asplit-up. Around the same time, a series of articles in the New York Post citing "a source close tothe board" claimed that "Nooyi is testing the patience of company directors," who were said to befed up with the flat stock and management missteps. The company didn't comment on thereports. That's also when Relational Investors, an activist shareholder, began buying stock.

More: Fortune 500 social media stars

Thus the stage was set for Nooyi, Johnston, and the company's top operating executives to meetwith analysts and investors in February. Beyond the promised operational improvements, thecompany pledged to throttle back its capital-spending spree and give managers incentives to

raise economic value added (EVA), spurring them to increase returns on capital. The companyprojects that those crucial returns will rise just half a percentage point a year. After an 11-pointdrop since 2006, that's not much. But it could be enough. Crunch the numbers, and if returnsincrease at that pace -- more precisely, if investors believe they'll increase at that pace -- then thestock should start to rise. That would spell vindication for Nooyi.

For her, PepsiCo's performance is now a race against time. The big investments are largelycomplete -- "The building blocks have all been put in place," she says -- and the question is howwell and how soon they'll pay off, plus how much longer she'll remain CEO. She has already heldthe job slightly longer than her two immediate predecessors, Reinemund and Roger Enrico, andin March the company positioned three executives as succession candidates. They are JohnCompton, previously head of the food business in the Americas, who was put in the new positionof president; Zein Abdalla, European operations chief; and Brian Cornell, who succeeds Comptonrunning the Americas food business and who had left PepsiCo in 2004, rejoining from his mostrecent position as president of Wal-Mart's Sam's Club. (Most company Kremlinologists seem tofavor Compton.)
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When PepsiCo has lined up CEO candidates in the past, the transition has usually come within ayear. But Nooyi is only 56. She could stay on two or three more years if her transformation showssigns of succeeding. That's the giant "if" hanging over the company now.

There are reasons for hope. The major investments in emerging economies could start to panout. The new R&D lab is yielding results. Chief scientist Khan, who told Nooyi the effort wouldtake five years to get rolling, notes that "this is year five." A new mid-calorie cola, Pepsi Next, was

just introduced and seems to be doing well; the concept has been tried before, but this time theflavor is supposed to be much better. The lab has found a way to make potato chips taste just assalty with less sodium; the result hit the market last year. In a joint venture with Germany's Mller Group, PepsiCo has developed fruit-and-yogurt technology that makes the fruit taste fruitier and

lets it sit on top of the yogurt instead of underneath. Most important, the scientists are working onsweeteners. An all-natural zero-calorie sweetener that could be formulated into great-tastingdrinks and other products would profoundly change the business. "Based on everything we'veseen, we are ahead" of competitors in finding one, says Nooyi.

Until PepsiCo's transformation shows signs of paying off, Nooyi will endure more doubts fromWall Street and the press. She knows it, and it's wearing. "Courage in leadership is very difficult,especially in today's world, where the media doesn't take the time to really understand you," shesays. She has finished her visit to the Frito-Lay plant and is back on the plane, returning toheadquarters. The edge is gone from her voice. She speaks very quietly: "And so ! whenpeople write all the crap that they do, just ! get stoic about it."

This story is from the June 11, 2012 issue of Fortune .

Posted in: beverages , Coca-Cola , Fortune 500 , Indra Nooyi , Pepsi , PepsiCo
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